This guest post is contributed by StatsGuy, one of our regular commenters. I invited him to write the post in response to this comment, but regular readers are sure to have read many of his other contributions. There is a lot here, so I recommend making a cup of tea or coffee before starting to read.
In September, the first Baseline Scenario entered the scene with a frightening portrait of the world economy that focused on systemic risk, self-fulfilling speculative credit runs, and a massive liquidity shock that could rapidly travel globally and cause contagion even in places where economic fundamentals were strong.
Baseline identified the Fed’s response to Lehman as a “dramatic and damaging reversal of policy”, and offered major recommendations that focused on four basic efforts: FDIC insurance, a credible US backstop to major institutions, stimulus (combined with recapitalizing banks), and a housing stabilization plan.
Moral hazard was acknowledged, but not given center stage, with the following conclusion: “In a short-term crisis of this nature, moral hazard is not the preeminent concern. But we also agree that, in designing the financial system that emerges from the current situation, we should work from the premise that moral hazard will be important in regulated financial institutions.”
Over time, and as the crisis has passed from an acute to a chronic phase, the focus of Baseline has increasingly shifted toward the problem of “Too Big To Fail”. The arguments behind this narrative are laid out in several places: Big and Small; What Next for Banks; Atlantic Article.
This argument has two components:
Moral hazard: Institutions that are too big to fail create systemic risk; thus the government must rescue them if they make bad bets. This creates asymmetric incentives (one-sided payoffs), which encourage them to make excessively risky bets, thereby encouraging the very systemic risk that regulators are trying to avoid. Governments cannot credibly threaten to let such banks fail because the results (e.g. Lehman) are catastrophic.
The Oligarchs: This argument is best laid out in the Atlantic piece, in a discussion of previous IMF efforts to restore countries to monetary balance:
Typically, these countries are in a desperate economic situation for one simple reason-the powerful elites within them overreached in good times and took too many risks. Emerging-market governments and their private-sector allies commonly form a tight-knit-and, most of the time, genteel-oligarchy, running the country rather like a profit-seeking company in which they are the controlling shareholders.
Although theoretically compelling, most of the evidence for this version of TBTF is indirect:
- Higher concentration and profits in the banking industry: (note that the primary source of concentration is clearly M&A activity over 20 years).
- Increasing share of the financial sector in world GDPs and as a percentage of US corporate profits and average wage through 2006.
- The Goldman Sachs mafia (courtesy markets.aurelius).
- Various stories of insiders and whistleblowers who recount specific instances of perverse incentives that encouraged risky behavior.
Along with the explanations underlying Too-Big-To-Fail (TBTF) come certain policy prescriptions that have proven to be very controversial:
a) Take over large insolvent banks (through temporary nationalization or FDIC receivership), sell off performing assets to smaller banks or investors, and break the bank into smaller pieces.
b) If needed, employ anti-trust legislation to break apart healthy mega-banks
c) Build an enduring system that prevents big banks from recreating themselves through M&A (mergers and acquisitions).
Challenges to Too-Big-To-Fail
Timing and Expedience
Is it really imperative to address TBTF first? Attacking banks in the middle of a crisis has high costs (remember Lehman). Would it not be better to wait until the credit/equity markets have fully stabilized and confidence has recovered, and then attack the problem in a quiet orderly manner when banks are not wielding a poison pill over the global economy?
This response to TBTF is rooted in the observation that what began as a financial crisis turned into a global panic, and then morphed into the most intense global recession in 70 years, which almost certainly would have become a depression without aggressive govt. response (capital injections, stimulus, base money expansion). TBTF may have been the trigger, but is not necessarily the most critical step to solving the current global crisis – and solving the financial crisis is critical to addressing multiple other crises (food, water, energy, environment) that were ignored for the past 15 years (and which were recently designated by the National Intelligence Council as threats to national security).
In response, the window does not seem that narrow. In a March 26-29 poll, respondents primarily blamed banks and large corporations for the crisis, followed by President Bush (scroll down to see poll). This allocation of blame has been relatively consistent since last October. Obama’s poll numbers seem to have dipped during the February thru March debacle (after Geithner’s disastrous first speech), then recovered as the stock markets staged a rally. Recent in-depth polls showed that the public continued to disapprove of Obama’s handling of bank bailouts even as his overall ratings recovered. The public hates bank bailouts, but not as much as economic decline.
I would therefore argue that the primary order of business is stabilizing the economy. Everyone agrees that attacking TBTF will not be pretty, however – it will take many months to dismantle organizations with trillions of dollars in assets, and the costs of doing this quickly are enormous. (Consider the massive losses suffered in the accelerated AIG unwinds.) In the S&L crisis, the FSLIC and Resolution Trust Corp. did not fully dispose of S&L assets until 1995. The current crisis is worse, and the FDIC and Fed are facing limited organizational capacity. In the meantime, the big banks will not stand idly by.
Rather than attacking TBTF immediately, we may be better served by building a plan that can be implemented after stabilization is achieved. For instance, we might pass anti-lobbying legislation now (something that isn’t likely to cause a collapse in the Dow Jones). Ideally, Team Obama is already building a plan, but if they were, the last thing they would do is announce it. For those who still hope the administration has resisted co-option and corruption in spite of recent revisions of Obama’s anti-lobbying pledge, the Obama Team’s strategy for GM & Chrysler suggests a road forward. The markets may be seeing this as well – as suggested by the recent divergence between bank stocks and CDS prices for bank debt (as SJ and JK note here).
Some TBTF advocates have raised a second justification for attacking TBTF immediately. They worry that the oligarchic bank lobby may sabotage or pervert other reforms, unless the oligarchs are first weakened, and they cite intense lobbying efforts by banks. Reforms such as credit card billing rules seem to be passing at the moment, yet we have no assurance that the Obama Administration will remain able to push such reform through Congress in the future. The rejoinder to these worries is that the Obama Administration’s ability to make future changes will depend on the status of the economy when those changes are sought, which begs the question: how critical is TBTF to securing a recovery?
In its strongest form, the case for attacking TBTF right now states that the economic crisis will not end unless we first deal with TBTF. In other words, TBTF is a root cause of the crisis (though not necessarily the only cause), and any short-term relief we might gain by temporarily accommodating big banks will only backfire in a few years. Although the balance of Baseline’s posts suggests there are many causes, the Atlantic piece does identify the overreaching of elites as the “one simple reason” underlying the economic desperation of developing countries in crisis (which are then compared to the US).
The argument for fixing TBTF immediately to resolve the current crisis thus hinges on the importance of TBTF in causing the crisis. If TBTF is to become one of the dominant narratives behind this crisis, it must contest against other narratives. There are (at least) three groups of narratives that seem to competing with TBTF.
Narrative 1: Systemic Risk
A massively leveraged and unregulated financial system is inherently vulnerable to shocks that rapidly get magnified. Perceived (or imagined) risks can create self-fulfilling outcomes, and such risks can be manufactured by large unregulated actors (e.g. hedge funds, which have been immensely profitable for investors over the last 15 years even counting the recent hit).
Moreover, tight coupling of global financial systems and economies causes shocks to transmit rapidly throughout the system, with limited fire-breaks. Contagion, once considered a low risk, can spread rapidly throughout sectors and then throughout the world. IMF report, Figures 1.2 and 1.11 (heat maps)
All of this is worsened by extreme leverage, which has been noted by many scholars (and challenged by some).
Systemic risk was further magnified by the utter elimination of sensible regulation at the behest of free-market ideologues, and indeed the active encouragement of policymakers to engage in risky behavior. Here is a timeline.
In addition, systemic risk is intensified by pro-cyclical policy responses (easing of money in good times, and pro-cyclical factors like mark-to-market in combination with the capital-asset ratio constraints embodied in the Basel Accords).
And finally, systemic risk is massively intensified by the complexity of financial instruments (CDOs, CDSs) which allegedly increase liquidity and volatility (evidence for this is mixed; the VIX volatility index declined through 2006 even as CDO usage intensified), exacerbate systemic linkages (IMF report, Figures 2.1 and 2.6), and decouple the financing/servicing aspects of loans that are usually married together in vertically integrated banks (both creating information barriers, and making loan restructuring more difficult).
In the Systemic Risk narrative, fixing TBTF plays an important role in solving the problem, but not the primary role. The systemic risk narrative suggests that stabilization can be achieved through other mechanisms (reinstating lapsed regulation, lowering overall leverage, reflating the non-debt money supply, better oversight of banks, etc.) Preserving these reforms against political challenges over time is difficult, however, and that is where TBTF becomes important.
Narrative 2: Destruction of the Middle Class
This narrative ascribes the root cause of the crisis to a long-term decline in middle class spending power; the recent financial crisis was merely the straw that broke the camel’s back. The various causes are debated widely, but the end result is clear.
Perhaps the most popular version, however, focuses on massive trade imbalances due to unfair trade practices and/or trade with repressive foreign regimes. Unfairly cheap imports have resulted in the hollowing-out of the US economy, loss of real jobs making real things, decrease in labor bargaining power, declines in real median income, increases in US household debt in order to finance stable consumption levels, and a long-term decrease in spending power. The trade deficit data is indisputable: US current account deficit data is here; China specific data is here.
However, the link between international trade and “middle class decline” is heavily disputed (especially by neoliberal economists). Nonetheless, this narrative has begun to win some backing even among free trade elites. For example, Hank Paulson made it part of his mission to convince China to allow the Yuan to appreciate (to address the trade balance) when he became Treasury Secretary, but the world still remained dangerously addicted to US consumption which was largely financed by foreign debt. (45% of world net capital inflows went to the US in 2006)
The “Free-Trade” version of this narrative sometimes focuses on NAFTA, sometimes on China or other countries. It is generally inseparable from a similar narrative that focuses on Greedy (selfish, lazy) US Consumers who spent instead of saved, with the exception that the Free-Trade version blames foreign trade policy and the Greedy US Consumers version blames US consumers who spend more than they earn. Yet the remedy to both is similar – decrease foreign imports, either through dollar devaluation (if you believe foreign economies are manipulating exchange rates and/or the dollar’s reserve currency status caused the dollar to be overvalued) or through trade barriers (if you believe repressive foreign regimes or foreign trade barriers caused the imbalance). Both methods force the US to supply its own consumption. Critics will point to the disastrous results of such policies in the Great Depression (Smoot-Hawley, etc.), particularly when implemented rapidly, globally, and during an economic downturn – so even if trade caused the problem, now might not be the best time to radically reduce imports.
TBTF plays only a limited role in the Middle Class Decline narrative (although the “oligarch” version of TBTF may argue that financial elites engineered the downfall of the middle class to suit their interests). Fixing the problems requires deep structural changes, which may require the eventual political expulsion of special interests (like the oligarchs). But again, this implies that the timing to attack TBTF is a key tactical question.
Narrative 3: Irrational Exuberance (Soft Money, Normal Business Cycle)
The Irrational Exuberance narrative was recently re-popularized by Shiller’s book.
The essence of this narrative suggests that our brains are fundamentally wired to behave irrationally. Behavioral economists are rapidly assembling data to support this assertion. (For example.)
When irrational exuberance takes hold, money becomes cheap as investors expect growth to persist. Consumers and businesses optimistically avail themselves of the cheap credit and increase leverage, until a shock crashes the system and everything reverses. Investors tighten credit, consumers and businesses turn pessimistic, and leverage causes bankruptcies that magnify the problem (just as soft money magnified the boom).
Bank managers have incentives to ride along with the cycle. When everyone else is earning more, bank managers who are “underperforming” are often punished. When the crash comes, managers are often forgiven since everyone else made the same mistakes. Both mass psychology and the competitive environment reinforce this dynamic.
In this narrative, it is hard to argue that bank size matters. Notably, many past financial crisis involved massive numbers of smaller banks, such as the 1930s Great Depression and the 1980s S&L Crisis. Even in the current crisis, many regional banks are also approaching insolvency.
Indeed, we can even cite circumstances in previous history where collusion by large banks has prevented financial crises from become depressions, such as JP Morgan in 1907.
Importantly, there are two distinctive flavors of the Irrational Exuberance narrative – the Austrian version and the Keynesian version. They dramatically differ in their interpretation of government’s role in causing, and solving, economic downturns.
The Austrian School (e.g. Hayek, Schumpeter, Von Mises) contend that bubbles are exacerbated by government activity (and especially by central banks and soft money policies, but also by government spending). According to advocates of this version of the narrative, deregulation did not cause the crisis, it merely happened at the same time. Irrational exuberance can’t be stopped. Bubbles are the problem (made worse, or even caused, by government action), and the “fix” is depression and deflation.
The Keynesians identify the business cycle as a natural outcome of developed economies and capitalist “animal spirits” (alternatively, “spontaneous optimism”), but contend that the system is not self-stabilizing. Notably, business cycles can create credit collapses that cause deflation, and individually virtuous behavior (excess saving) can perpetuate deflation. The system requires an exogenous demand/credit source (like government) to restore equilibrium.
(At this point, I will abuse my role by noting a few interesting data points:
- Contrary to Austrian predictions, the intensity of economic cycles in the US decreased substantially after WWII, when the govt. actively managed the business cycle.
- As Brad DeLong notes, the end of the gold standard marked the beginning of recovery for every major industrial power during the Great Depression (chart on page 4).
- As Paul Samuelson argues, every major US economic expansion died prematurely at the hands of the Fed … This was before Alan Greenspan – a noted fan of Hayek – facilitated and defended the greatest bubble in recent history.)
The Irrational Exuberance narrative is perhaps the least friendly to TBTF. Even the Austrian version identifies TBTF as a problem only because governments have powers they should not have. Remove those powers, and the world-wide depression will hastily fix TBTF. (Notably, this did not happen in the Long Depression of 1873-1879, which was followed by an anemic recovery and the massive inequalities of the Gilded Age). In the Keynesian version of Irrational Exuberance, TBTF is only a problem if the Lords of Finance oppose the aggressive government action that is needed to restore growth.
So Where Does That Leave Us Now?
Your own favored response to the current economic downturn probably depends on which of the narratives above you find most convincing – Systemic Risk, Middle Class Decline, Irrational Exuberance, or Too-Big-To-Fail.
But of course, more than one narrative may be true, and some of these narratives reinforce each other. Combining Systemic Risk and Irrational Exuberance is particularly nasty, for example.
Interestingly, Too-Big-To-Fail synergizes well with the Systemic Risk narrative, and the Oligarchy version of TBTF plays well in the Middle Class Decline narrative. TBTF has a more diminished role in the various Irrational Exumberance narratives.
In the broader context, the Too-Big-To-Fail narrative seems like an upstart next to the other narratives, but it has a few things working in its favor. For one thing, it points the blame at a specific group of people, and Americans really want someone to blame for this crisis. TBTF also taps a populist/anti-elitist sentiment that harkens back to Teddy Roosevelt’s battles against the Robber Barons.
My own objections to TBTF are primarily that TBTF is probably not the dominant cause of the crisis, that attacking TBTF right now could exacerbate the downturn, and that dismantling big banks will require additional measures to address unforeseen complexities (e.g. competing international big banks with lower cost of capital, reduced tools to implement US foreign policy). TBTF is undoubtedly a problem, but is it our most serious and immediate problem?
We are fortunate to have champions like Johnson, Hoenig, and others carrying the banner of Too-Big-To-Fail. Yet while I agree with Baseline Scenario that many other problems in this global crisis require quick action and overwhelming firepower, addressing TBTF requires deliberate and patient action.
I am confident this action can succeed over the long term (should the Obama Administration pursue it) for one primary reason – recent events have widely discredited the dominant paradigm of neoclassical economics. This paradigm, which arguably began with Milton Friedman and was propagated in the public sphere by well-funded think tanks, served as the intellectual artillery that allowed the Oligarchs to shred the laws and regulations that prevented excessive concentration and abuse of financial power. The willingness of respected economic scholars to step forth with new and pragmatic economic ideas is more encouraging than any single change in policy that I could imagine.