September 21, 2008 to September 28, 2008
The Financial Crisis: the Role of Government
The Financial Crisis: the Role of Government--Posner
I agree with Becker that capitalism will survive the current financial crisis, even if it leads to a major depression (which it may not). It will survive because there is no alternative that hasn't been thoroughly discredited. The Soviet, Maoist, "corporatist" (fascist Italy), Cuban, Venezuelan, etc. alternatives are unappealing, to say the least. But capitalism may survive only in damaged, in compromised, form--think of the spur that the Great Depression gave to collectivism. The New Deal, spawned in the depression, ushered in a long era of heavy government regulation; and likewise today there is both advocacy and the actuality of renewed regulation. I would like to examine the possibility that government is responsible for the current crisis; for if it is, this would be a powerful intellectual argument against re-regulation, though not an argument likely to have any political traction.
I do not think that the government does bear much responsibility for the crisis. I fear that the responsibility falls almost entirely on the private sector. The people running financial institutions, along with financial analysts, academics, and other knowledgeable insiders, believed incorrectly (or accepted the beliefs of others) that by means of highly complex financial instruments they could greatly reduce the risk of borrowing and by doing so increase leverage (the ratio of debt to equity). Leverage enables greatly increased profits in a rising market, especially when interest rates are low, as they were in the early 2000s as a result of a global surplus of capital. The mistake was to think that if the market for housing and other assets weakened (not that that was expected to happen), the lenders would be adequately protected against the downside of the risk that their heavy borrowing had created. The crisis erupted when, because of the complexity of the financial instruments that were supposed to limit risk, the financial industry could not determine how much risk it was facing and creditors panicked. Compensation schemes that tie executive compensation to the stock prices of the executives' companies but cushion them against a decline in those prices (as when executives are offered generous severance pay or stock options are repriced following the fall of the stock price) further encouraged risk taking. Moreover, even when businesses sense that they are riding a bubble, they are reluctant to get off while the bubble is still expanding, since by doing so they may be leaving a lot of money on the table. Finally, if a firm's competitors are taking big risks and as a result making huge profits in a rising market, a firm is reluctant to adopt a safe strategy. For that would require convincing skeptical shareholders and analysts that the firm's below-average profits, resulting from its conservative strategy, were really above-average in a long-run perspective.
It should be noted that because of the enormous rewards available to successful financiers, the financial industry attracted enormously able people. It was not a deficiency in IQ that produced the crisis.
Becker makes incisive criticisms of the government's responses to the crisis. He points out that those responses create moral hazard, specifically a bias toward financing enterprise by bonds rather than by stock because the government's bailouts are limited to the bondholders and other creditors; create additional moral hazard because the responses include extending government insurance of deposits to money market funds; impede hedge funds by forbidding short selling, which enables the funds to hedge their risks; reduce information about stock values (another consequence of forbidding short selling); increase regulation of financial markets, which will carry with it the usual heavy costs of heavy-handed regulation; blur the role of the Federal Reserve Board by increasing its powers and duties; and increase the federal deficit.
But here is a remarkable thing about these responses. To a great extent they are not responses by government, really, but by the private sector. Bernanke and Paulson are neither politicians nor civil servants; Bernanke is an economics professor and Paulson an investment banker. Their principal advisers are investment bankers rather than Fed and Treasury employees. Even the prohibition of short selling, which seems like a product of the kind of mindless hostility to speculation that one expects from politicians, has been strongly urged by Wall Streeters, including the CEO of Morgan Stanley. The White House, the Congress, and even the SEC have been only bit players in the response to the crisis. In effect, the government's power to repair the crisis that Wall Street created has been delegated to Wall Street.
It is true that the top financial officials of our government have usually come from the financial industry or academia. The difference is how recently Bernanke and especially Paulson were appointed, how heavily they are relying on financial experts from the private sector rather than on civil servants, and how small a role the politicians in Congress and the White House have played in shaping the response to the crisis.
I do not criticize the delegation of the handling of the crisis to (in effect) the finance industry. I imagine that Bernanke and Paulson and their private-sector advisers are the ablest crisis managers whom one could find. I merely want to emphasize that the financial crisis is indeed a "crisis of capitalism" rather than a failure of government, though it will not and should not lead to the displacement of free-market capitalism by an alternative system of economic management. But it is already shifting the boundary between the free market and the government toward the latter.
The Financial Crisis II-Becker
In considering what needs to be done to improve the functioning of the financial system, it is necessary to distinguish steps to avoid a major depression in the near term from long run reforms of the financial system. The Paulson Plan naturally concentrates on the very real short run emergency. I first discuss this plan and other suggestions, and then briefly consider long-term reforms.
The Treasury's announced insurance of all money market funds carries considerable moral hazard risks, but it has not aroused much controversy. The Paulson Plan goes much further and involves purchases from banks of up to $750 billion of assets that have uncertain worth. I say uncertain worth since there is essentially no market for many of these assets, and hence no market pricing of them. The government hopes to create this market through using reverse auctions. In these auctions, banks would offer their assets at particular prices, and the government would decide whether to buy them. This part of the Plan has been heavily criticized because it gives great discretion to the Treasury Secretary since the total value of the assets that would be purchased at this point is not known. In addition, many are repelled by the intention to bail out companies and their executives who made decisions that got the companies into trouble. There is also much concern about the moral hazard consequences for the future behavior of banks if they are led to expect to get rescued by the government when their investments turn sour.
While I find helping these banks highly distasteful, moral hazard concerns should be put aside temporarily when the whole short term credit system is close to a complete collapse. However, the proposed Plan does indicate, as I suggested in an earlier post (April 28, 2008), that the $29 billion bailout of the bondholders of Bear Stearns in March was a mistake. It probably did have a moral hazard effect by encouraging Lehman brothers and other investment banks to delay in raising more capital because they too expected to be helped if times got much worst.
The agreement apparently just reached between Congress and the White House does allow the government to purchase distressed assets up to about $700 billion- I would have preferred a considerably smaller initial limit. It does have a provision for Congressional oversight of the Treasury's use of the funds, whatever that is worth, and has several other features as well. For example, it includes pay limits for executives whose firms seek government help. That is too much micromanagement of the operations of these banks, even though no one can think much of executives who led their banks into such a mess.
I am also not enamored of the apparent provision that gives the government an equity stake in some banks that they help if these banks should prosper. It is unwise to allow governments in general to have equity interests in private companies, particularly if this equity gives them voting rights on company policies. Perhaps inevitably, this did occur in the AIG bailout. Many examples in recent history, such as the current Alitalia fiasco, show that political interests outweigh economic ones when governments have partial ownership of alleged private companies.
The agreement appears to require the government to use their new ownership of distressed mortgage-backed securities to reduce home foreclosures. Homeowners as well as bankers should have known that the insanely good times in the housing and mortgage markets could not last forever. However, consumers are less well informed about financial matters and housing pricing than are the supposed expert executives at banks. Helping homeowners also uses taxpayers money, but in a way that would generally aid people with modest to moderate incomes. Indirectly, moreover, it would also help banks by increasing the value of the mortgage-backed securities they hold.
One suggested supplement to the Paulson Plan is to require investment banks and other financial institutions to raise additional capital now, so that they have resources to start widespread lending again. Such a requirement would be unwise since banks that can raise capital readily are already doing so, as illustrated by Warren Buffet's investment in Goldman Sachs, and Mitsubishi's purchase of a stake in Morgan Stanley. Were such a requirement imposed, weaker banks might cut their lending even further in the attempt to increase their liquid capital. Milton Friedman and Anna Schwartz argue convincingly in their Monetary History of the United States that the Fed's raising of reserve requirements for commercial banks during the mid-1930s contributed to a prolonging of the Great Depression. For it induced these banks to further contract their lending in order to gain the liquid assets that were removed by higher reserve requirements.
The main problem with the modern financial system based on widespread use of derivatives and securitization is that while financial specialists understand how individual assets function, even they have little understanding of how the whole incredibly complex financial system operates when exposed to various types of stress. In light of such ignorance of the financial system's mode of operation, it is difficult to propose long-term reforms. Still, a few seem reasonably likely to reduce the probability of future financial crises. The capital requirements of banks relative to assets might be increased, so that the highly leveraged ratios of assets to capital in financial institutions during the past several years would become less common. Possibly a minimum ratio of capital to assets should be imposed by the Fed on investment banks and money funds. As much as possible, the measure of capital should be market, not book, value, such as the market value of publicly traded shares of banks. My discussion last week indicated that book value measures badly missed the plight of Japanese banks during their decade-long banking crisis of the 1990s.
The government should as quickly as possible sell Freddie Mac and Fannie Mae to fully private companies that receive no government insurance or other help. These two giants did not cause the housing mess, but in recent years they surely greatly contributed to it, partly through Congressional pressure on them to increase their purchases of sub prime loans. They owned or guaranteed almost half of the $12 trillion in outstanding mortgages with less than $100 million of capital. The housing market already has excessive amounts of government subsidies, such as from the tax exemption of interest on mortgages, and should not have government sponsored enterprises that insure mortgage-backed securities.
Finally, the "too big to fail" approach to banks and other companies should be abandoned as new long-term financial policies are developed. Such an approach is inconsistent with a free market economy. It also has caused dubious company bailouts in the past, such as the large government loan years ago to Chrysler, a company that remained weak and should have been allowed to go into bankruptcy. All the American auto companies are now asking for handouts too since they cannot compete against Japanese, Korean, and German carmakers. They will probably get these subsidies, even though these American companies have been badly managed. A "too many to fail" principle, as in the present financial crisis, may still be necessary on hopefully rare occasions, but failure of badly run big financial and other companies is healthy and indeed necessary for the survival of a robust free enterprise competitive system.