Saving Regulation From Itself

The Times' Dealbook reports:

Paul A. Volcker, a top White House economic adviser... [and] former Federal Reserve chairman, told Congress that by designating some companies as critical to the broader financial system, the administration’s plans would create an expectation that those companies enjoy government backing in tough times...

He urged lawmakers to make clear that nonbank companies would not be saved with federal money... he took "as a given" that banks would be bailed out in times of crisis.

Volcker makes reasonably explicit what I claimed in my previous post, that the intent of the administration is to insulate "critical" firms from market discipline. Smaller firms, attempting to operate without governmental guarantees will be at an obvious disadvantage competing against firms blessed as "critical". Costly and complicated regulation being considered in the name of weeding out systemic risk will create significant barriers to entry serving to further defend "critical" firms from the threat of meaningful competition.

Theoretically, as the President outlined, this may entail such firms being subject to increased regulatory scrutiny to ensure they do not take undue risk. In practice, even this will not likely come to pass. It is unclear that such regulation would be, in any way, more onerous then that which smaller firms will be subject to in the name of filling gaps in the regulatory fabric. It is unclear that the politically influenced regulators will serve to dampen, rather than spur excessive risk taking. Finally, it is unclear with what degree of seriousness we can take anything the President said considering the as-a-given dismissive-ness, his senior economic adviser treated the declaration of intent, in the same speech, to "put an end to the idea that some firms are 'too big to fail'."

In that politically astute speech, the President captured the common sense lesson reasonable people took away from the credit melt down: Too big to fail is too big. Washington's regulatory class, apparently, learned the opposite lesson: Not too big to fail is not big enough.

This is a clarifying moment, as Republicans have no real ability to influence the outcome. If, as appears likely, the administration, under the banner of tighter regulation, uses the power of government to distort markets in the service of large Wall Street banks, Democrats will not be able to blame corrupted Republicans. Rather, it will demonstrate, as clearly as can be, corruption in the heart of the idea of regulation.

If the goal of the regulatory class is to protect capitalism from itself, who, or by what means, will they (and we!) be protected from themselves?

Wall Street Compensation

Eric Dash blogging in the NY Times explains What’s Really Wrong With Wall Street Pay.

The easy observation that Wall Street compensation policies are unsustainably flawed does not at all support the current push for regulatorily controlled compensation.

Free markets, of course, feature a wonderfully elegant regulatory mechanism for dealing with firms unable to set interest-aligned and sustainable compensation policies: They go out of business. It is only in a regulatory-jungle system like ours, where the government dutifully insulates powerful firms from market discipline, that issues like this arise.

Time was when progressives could maintain the conceit that the idea of regulation was to protect the market from itself. As it stands, it is a barely disguised euphemism for command.

Obama's America

There appears to be such a mountain of forensic evidence linking janitor Raymond Clark, III to the murder of medical student Annie Le, that authorities do not feel the need to lock down his motivation.

From the reporting it appears that achievement/class resentment was likely involved. The executive director of the American Association for Laboratory Animal Science has been quoted to the effect of: The gap in education levels shouldn't necessarily lead to tension if there is a culture of respect. The latent blaming-the-victim implication horrifies.

Von Hayek notes that envy, according to Mill the most evil of all passions, is sanctified in our society by the formula "social justice". What the successful once dismissed as envy on the part of the less successful is, in the view of the less successful -- or as we are obligated to see them: "less fortunate" -- righteous indignation in the face of gross injustice.

Even if we sympathize with the aspiration towards equality of opportunity and admire the charitable impulse, we must recognize that the equation of unfairness with injustice sits, precariously, on a slippery slope.

Overseen on a morning cross-town bus: suited father and pre-school daughter, perhaps 4 years old. Father and daughter are reviewing addition and subtraction on his fingers.

It is hardly fair that products of less invested parents will have to, one day, compete against that little girl. Just as it is hardly fair that people less naturally gifted have to, every day, compete against people more naturally gifted. Or that people with weak work ethic have to compete against those who seem to enjoy hard work.

A society in which parental investment, natural ability and hard work are more generally rewarded is one that will generally progress farther. A rising tide, in turn, lifts all ships. But try explaining that to Raymond Clark, III.

Racketeering

Drudge posted a report that public trust of media has fallen to record lows. It is unsurprising that an industry that sells -- above all -- trust suffers economically as it loses trust. On the other hand, perhaps trust is merely more diffuse. Media does increasingly market "Trust Us, Don't Trust Them."

One source of any loss of trust is that, as people receive information from multiple sources, slanted editing is readily apparent and, therefore, costly.

An example from yesterday's news: Reading the Times one is led to believe that the proposed BofA SEC settlement was thrown out of court over concerns about irresponsible management and overly lax regulation. Obama, according to the Times, is, of course, rushing to save the day by pushing for "tougher" regulation. Along the way the health care debate is mentioned and the gentle reader is informed of Obama appointee Mary Schapiro's heroic efforts to revive the SEC's "reputation as an effective watchdog of Wall Street."

The actual facts -- buried, mostly, in the bottom of the article -- are these: BofA was coerced by the Governments, as part of effort to stem the financial crisis, to purchase Merrill. The S.E.C. then turned around and sued BofA management claiming -- apparently with justice -- that it failed to adequately inform shareholders of pending Merrill bonuses. The parties agreed that BofA should pay $33M. The judge, above all noting the gross injustice of making the alleged victim -- BofA shareholders -- pay the penalty ripped the racketeers, both of whom profit from the arrangement (The S.E.C. by getting to claim that it is exposing wrongdoing). A dozen lines up from the bottom, the article notes that screwing shareholders in this manner (perhaps, amongst others) is a long-standing S.E.C. practice.

The readily apparent takeaway: The Judge’s issue was with an until-now-unchecked, out-of-control, regulator abusing the people it was charged with protecting; the precise opposite of the "overly-lax regulator" trip the Times tried to sell.

More accurate reporting of the decision is available from this WSJ op-ed.

Babies With Candy (or Baby Sitting on Capitol Hill)

The heart of Krugman's Times Magazine article is a cute"parable" about the Capitol Hill Baby Sitting Co-Op, first recounted in a 1977 article:

This co-op... was an association of about 150 young couples who agreed to help one another by baby-sitting... To ensure that every couple did its fair share of baby-sitting, the co-op introduced a form of scrip: coupons... entitling the bearer to one half-hour of sitting time. Initially, members received 20 coupons on joining and were required to return the same amount on departing the group.

Unfortunately, it turned out that the co-op’s members, on average, wanted to hold a reserve of more than 20 coupons, perhaps, in case they should want to go out several times in a row. As a result, relatively few people wanted to spend their scrip and go out, while many wanted to baby-sit so they could add to their hoard. But since baby-sitting opportunities arise only when someone goes out for the night, this meant that baby-sitting jobs were hard to find, which made members of the co-op even more reluctant to go out, making baby-sitting jobs even scarcer. . . .

[in] this particular example... a recession is a problem of inadequate demand — there isn’t enough demand for baby-sitting to provide jobs for everyone who wants one...

Freshwater economists... believe that all worthwhile economic analysis starts from the premise that people are rational and markets work, a premise violated by the story of the baby-sitting co-op. As they see it, a general lack of sufficient demand isn’t possible, because prices always move to match supply with demand.

To Krugman's perverse view, we are always in a recession as there is never enough demand for -- to take an example -- Princeton Economics Proffessors or New York Times Columnists to provide jobs for everyone who wants one. More sensibly viewed: The problem was that people went out less then they otherwise might have.

Reading the actual 1977 article, it is evident that Krugman, for his purposes, misrepresents crucial detail:

• The price of the scrip was constitutionally pegged to one half-hour of sitting time.


• According to the authors the shortage of scrip did not stem from irrational fears of co-op members. Rather there was an ill thought out co-op management regime which removed about 5% of scrip from circulation annually.


• The co-op first attempted a rule mandating that members go out more. When this failed, they adjusted the rules such that new members received 30 scrip but only had to pay 20 on exit. According to the authors this worked for a while but eventually resulted in the reverse problem where more people wanted to go out than babysit.

The "Freshwater" premise, that free markets work because prices move to match supply with demand could hardly be violated by dysfunction in a "market" in which prices were constitutionally fixed.

The key to this whole thing is the silliness of the scheme. The scrip served no earthly good. There is no advantage to a couple babysitting for scrip to spend on babysitting over babysitting for dollars to spend on babysitting. The value the co-op created by establishing a babysitting exchange was impaired by the demand any transaction be in the heavily regulated scrip rather than dollars.

This was, in other words, a market designed to fail by regulators who didn't believe in markets. The primary lesson of this parable is the opposite of what Krugman would have his readers believe.

There is, to my mind, a more interesting take away from the observation that given the silliness of the scheme, there was an anti-market selection bias amongst people choosing to participate. More enterprising people may well have created a black market for scrip in which prices varied with changing supply and demand, saving the co-op from itself.

If this can be applied more broadly, it would argue that a foolishly regulated market economy (and, frankly, which isn't?) depends on a market-oriented culture to function well. In such an economy, market dysfunction can be caused by cultural change.

Babies with Candy

If Paul Krugman is, indeed, a brilliant and rigorous thinker, he hides it awfully well. In a Times Magazine article he divides the world into two sort of economists. Freshwater economists believe markets are always perfect and workers choose not to work during recessions. Saltwater economists believe that markets are deeply flawed and require strong government participation to function well. He demonstrates the superior wisdom of the Saltwaters by the existence of bubbles, the fact that workers do not choose to be unemployment during a recession and the greater prestige of their affiliations (Harvard, MIT, Princeton).

Somebody in Krugman's prestigious university should explain him what a logical fallacy is.

It is very easy to argue that markets can mis-price things, or that recessions produce more than creative destruction; It is much more difficult to demonstrate that governments will generally, or even often, price things better or that fiscal policy will generally, or even often, does more good than harm. There is very little basis -- particularly in the context of the current financial crisis -- to believe that government can generally be expected to act more rationally then investors or consumers. On the contrary...

Krugman's beef, above all is with the theory of rational markets:

As I see it, the economics profession went astray because economists... fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets...

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets...

To Krugman, this argues for increased governmental babysitting of the economy.

It is hard to see, as Krugman does, in the failure of our heavily regulated financial markets, proof that ungoverned free markets fail. Or that what our financial markets require is more, not less, heavy handed government meddling.

In the end, it ought be stated, Krugman's line of argument is inherently anti-democratic. In a democratic government, limitations of individual economic decision making will be reflected in governmental decision making. There is no reason to believe that government -- riddled with agency cost, sitting on top of the food chain -- is not itself an institution at particularly high risk of running amok.

The belief that government can somehow stand above the fray, making rational and beneficial decisions, even as irrationality infects the hoi polloi, requires belief in a government that is something other then of and by the governed.

Government Re-Insurance

The FDIC appears close to insolvency. This comes on the heels of the insolvency of Fannie Mae + Freddie Mac, and with that of the PBGC, Medicare, Social Security and, many suspect, the FHA, looming on the horizon. There are, of course, no shortages of private sector bankruptcies in the current disrupted economy, but there are good structural reasons to question whether a democratic government can be expected to well manage an insurance program.

The fundamental problem is the asymmetric interest and information involved in such a program. Groups paying premiums have will lobby as hard as they can to reduce their payments far below any risk adjusted fair value. Tax payers, less likely to be aware of the down-the-line costs-to-them politically reduced premiums are likely to bring, will not exert meaningful countervailing pressure. Political decision makers will grease the squeaky wheel.

The general hybrid regime we have of nominally private sector insurance, heavily regulated and implicitly backstopped by the government works reasonably well. Structurally, it creates an interest group able to check political power of premium payers and markets within which risk can be, more or less, priced.

On the other hand, the complexity of the hybrid econo-system reduces cost transparency and accountability. For example, if medical insurance companies were regulatory required to take on previously uninsured sick people at the same price they take on healthy people, insurers would raise rates on everyone. Customers would have general difficulty attributing cause, especially as there would be politicians and affiliated media arguing that the rate increases were due to private "waste" or "greed". A hybrid insurance system, whether or not it effectively produces a public good, is also vulnerable politically to the charge of "socialized risk, private profit." Given a byzantine regulatory framework precludes a reasonably competitive market, its easy to imagine insurers take more than market profit.

In short, the current hybrid system has the advantage of a market for price discovery, but suffers from having too many chefs in the kitchen.

The difficulty with a purely private approach for key forms of insurance is removing the implicit government backstop. If, for example, a life insurer of any reasonable size failed, the politics would tend towards a bailout for beneficiaries. Its hard to imagine how a insurance market could well function without any insurers of reasonable size.

The least bad approach might be "publically provided, privately priced". To take a "Public Option" as an example, such a system could work roughly along the following lines: The Insuring Agency sets its policies as far as what it pays for what and what premiums it charges. The Agency issues "re-insurance" securities with a moderate duration, perhaps three years. In the event the Agency ran out of premium money, holders would pay in the notional value of their securities before a government bailout. In exchange they are paid a fixed monthly rate.

It would not be to difficult to construct a reasonable feedback mechanism. For example requiring the agency sell a certain amount of new "re-insurance" securities in an annual all-or-nothing auction within a set price band. An auction failure -- indicating a lack of market confidence in the Agency's solvency over the three year window -- would trigger mandated steps -- reducing benefits, raising premiums, federal cash infusion -- to restore fiscal health established by a successful auction.

There is, of course, devil in these details. As a general principal, it is hard to imagine our Government creating a market that serves a purpose other than funneling taxpayer dollars to Government/Sachs. More concretely, it is easy to imagine that the Government will motivate the heavily regulated large players to dampen any negative market signals.