David Leonhardt (HT: Arnold Kling) finds a fascinating paper by Akerlof and Romer from 1994 called "Looting." It's an analysis of the moral hazard problem that results when too many financial institutions are considered too big too fail. I will read the original article but in the meanwhile, Leonhardt's summary is well worth reading and consistent with Allan Meltzer's claim (start listening around the 42 minute mark). One highlight from Leonhardt:
Promised
bailouts mean that anyone lending money to Wall Street â ranging from
small-time savers like you and me to the Chinese government â doesnât
have to worry about losing that money. The United States Treasury (which, in the end, is also you and me) will cover the losses. In fact, it has to cover the losses, to prevent a cascade of worldwide losses and panic that would make todayâs crisis look tame.
But
the knowledge among lenders that their money will ultimately be
returned, no matter what, clearly brings a terrible downside. It keeps
the lenders from asking tough questions about how their money is being
used. Looters â savings and loans and Texas developers in the 1980s; the American International Group, Citigroup, Fannie Mae and the rest in this decade â can then act as if their future losses are indeed somebody elseâs problem.
Do you remember the mea culpa that Alan Greenspan, Mr. Bernankeâs predecessor, delivered
on Capitol Hill last fall? He said that he was âin a state of shocked
disbeliefâ that âthe self-interestâ of Wall Street bankers hadnât
prevented this mess.
explains why his laissez-faire theory didnât hold up. The bankers were
acting in their self-interest, after all.
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"The paperâs message is that the promise of government bailouts isnât merely one aspect of the problem. It is the core problem."
Oops.
"The looting theory explains why his laissez-faire theory didnât hold up. The bankers were acting in their self-interest, after all."
this is great. it's important to realize that it was greenspan's laissez-faire theory. most of us don't see laissez-faire that way. it's kind of like all those who refer to bush as a free market ideologue.
Leonhardt is on the mark. In reality, this rent seeking permeates nominally "Capitalist" economies. I don't want Congress collecting more booty from taxpayers any more than I want Congressional cronies in the nominally "private" sector collecting rents otherwise, but the oft-lamented desire of common taxpayers to "soak the rich" with progressive income taxes involves resentment of this rent seeking as much as it involves simple envy of the rich.
Rent seeking is not limited to Federal government politicians and bureaucrats or the upper echelon of banks declared "too big to fail". It's not simply a product of the Federal Reserve that never existed before 1913. Rent seeking exists on many different scales, and people know it. Who believes that Chicago mayors and their buddies in the local construction business are immune to this defect?
When some local entrepreneur profits by bringing some novel service to the market, his neighbors typically celebrate his good fortune, but few people imagine that all income occurs this way, because all income does not occur this way as a matter of fact. When people want to "soak the rich" with progressive income taxes and other confiscatory rents imposed directly by the state, they don't imagine these local entrepreneurs. They imagine wealthy people with high incomes generated by other rents.
These people don't want to rob the entrepreneur of the means of expanding his service. They want to take rents away from the rentiers, and they see no way of doing this other than empowering some other, more central rent collector to impose more rents on the less central rent collectors. When libertarians address support of progressive income taxes with reference to productive entrepreneurs, they only talk past these people, so their arguments fall on deaf ears.
How about this little "it's not the fed's (and thus my) fault" nugget from Greenspan!
http://online.wsj.com/article/SB123672965066989281.html
Leonhardt's last statement makes no sense.
The looting theory explains why his laissez-faire theory didnât hold up. The bankers were acting in their self-interest, after all.
An economic system that features government bail-outs to prevent the economic failure of private companies is decidedly NOT laissez-faire capitalism, even if every last soul participating in the economy is acting 100% "in their interest".
Laissez-faire capitalism is a term that has a specific meaning — and that meaning is not changed every time some alleged advocate of laissez-faire advocates something different than laissez-faire.
For instance, to use an example involving another type of economic system, when Stalin relented (a little) and allowed the peasant farmers to keep a small plot of their land for âprivateâ use, that did not mean that from that time forward the definition of communism became, âAn economic system featuring near-total control of the economy but with farmers permitted to keep a small amount of their land for private use.â It simply meant that from the time Stalin made that change, the U.S.S.R. was not completely communist — just 99% with 1% of economic freedom permitted.
Greenspan has a point. The Fed is not faultless, but anyone who wants to lay all of the blame for the "crisis" at Greenspan's feet must explain how low interest rates on T-bills and overnight lending between banks can translate into low rates on 15-30 year loans secured by home mortgages.
"As I noted on this page in December 2007, the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005."
I don't dispute this point, but ignoring the role of population aging is incredible. China didn't only grow rapidly. It grew rapidly by exploiting the "demographic dividend", essentially by killing hundreds of millions of its own children and eating its own seed corn, thus freeing more of the labor of its citizens of child bearing age.
This policy doesn't slow labor force growth until decades later. It's now decades later.
China is not unique in this regard, of course. Japan is the world's poster child for population aging. Some European states are close behind, and so is Europe generally. So is the U.S. but to a lesser degree.
"That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble. (The U.S. price bubble was at, or below, the median according to the International Monetary Fund.)"
Another good point. I spent a lot of time in Europe in the last few years, and the bubbles over there make our bubble look like Bazooka Joe's hiccup. Not surprisingly, Europe also has a more aged population.
As a core principle of any new financial regulation, I suggest we adopt "Too big to fail is too big to be". The essence of the regulation would be a "stress test" to determine if the institution (or for that matter any asset group in the institution) is so large that it's failure would adversly affect anyone outside of immediate owners/shareholders. If the answer were yes, then the regulation would not allow it "to be". Probability of failure would be immaterial, thus avoiding the optimistic mind set (ie. housing values never fall) problem common to us all.
Any thoughts from those of you much more finanically savvy than me?
Works for me. Of course, the biggest of the "too big to fail" crowd is the U.S. government, and everyone wants of piece of its action, while it wants a piece of everyone else's action.
Leonhardt and Romer appear to draw precisely the WRONG inference from the analysis:
"Above all, as Mr. Romer says, the federal government needs the power and the will to take over a firm as soon as its potential losses exceed its assets. Anything short of that is an invitation to loot."
Instead of acknowledging that the government and taxpayer money should be kept out of markets, he suggests they need to go deeper. To avoid the possibility of looting the government steps in as looter in chief earlier in the process?
"He shouldnât have been. The looting theory explains why his laissez-faire theory didnât hold up. The bankers were acting in their self-interest, after all."
I am sorry, Greenspan had a laissez-faire theory? How did I miss that one?
Dave,
"As a core principle of any new financial regulation, I suggest we adopt "Too big to fail is too big to be"."
Pity that consumers do not know it and will never coordinate to make it happen, but they have the power to make this happen without government assistance or interference.
Hey, your slogan fits the government, eh?
I agree with you M. Brock that the aging population of Europe and Japan poses a bigger long-term question of economic growth (for them anyway) than the slump we're currently in. Whether the one child policy of China will come and bite 'em in the backside in the coming decades (what with men vastly outnumbering women) and put the brakes on China's growth.
The compensation for Sr. Management was de-linked from the performance of the institutions managed years ago. This is true with many other large companies. When this de-linking occurs, you find larger and larger salaries, corporate perks out the butt, and new and cleaver schemes to get more money out of the institution – like re-pricing options – so when you fail – its the environment and not management.
Laissez-faire works if management's futures are tied to the health and wealth of the company. The de-linking – which is easy to see and smell – is the clue to short the stock since now the long term future of the company is at odds over the short term gains of both labor and management.
As for an entity that is too big to fail, it is our own fault as a nation allowing the concentration of power and assets, and most importantly of all the market places for these assets.
The market place for these assets should be independent of all of the institutions – so when the institution fails – the market place just removes their brass plate and we move on.
As for Leonhardt and Romer they had interesting insight – but did not understand fully what they saw. Since we cannot agree on how to price assets, the idea of forced liquidation is chum to the sharks to force a recasting of an institutions balance sheets and wipe out a competitor.
With 10 years in investment banking and 20 years in due diligence and fraud recovery – I have lived the economics mused about in some of the postings.
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