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January 2, 2011
David Warsh, Proprietor


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The Ninth Decision… and the Road Ahead

When you look back on the eight key economic decisions of the Obama presidency as identified the other day by Ezra Klein, in The Washington Post, what stands out is a ninth choice – the measures that were not taken.

The interventions in the financial, auto and housing sectors; the stimulus package; the health care bill; cap-and-trade environmental legislation; the Dodd-Frank financial regulations; and the tax deal: all these have been hashed over pretty well.

The ninth decision – the opportunity on which Obama and the 111th Congress took a pass – was the chance to tackle the massive concentration and dysfunctionality of the US financial industry that emerged from the crisis of 2008.

Instead of using the short period between his election and inauguration to draw up blueprints for a restructuring of the banking industry, including its deeply-troubled government-sponsored mortgage markets, Obama and his economic team simply ratified the emergency policies of the autumn of 2008 – policies that made US financial institutions bigger, fewer, more dominant and probably less stable than before.

Was there really anything that could have been done in the wake of the crash that might have restructured the banks and put them on a path to another fifty years or so of stability, as did the Glass-Steagall Act of 1933 with its combination of government insurance and extensive partitions?

Probably not, given the state of the economics profession at the time. The danger had been very great in October, on the eve of the election. The situation that had given rise to it was still poorly understood on the day Obama took office. Despite the inchoate longing for some sort of “Volcker Rule” to prevent excessive speculation that might have started the industry down that path to greater safety, the only practical proposal that emerged – the creation of “narrow-funding banks,” designed to buy securitized products and issue liabilities in a closely-regulated environment – came too late for consideration. (Some new details can be found in Douglas Clement’s interview with Yale’s Gary Gorton in The Region, the monthly magazine of the Federal Reserve Bank of Minneapolis.)

So history probably will view the president’s determination to take it slow and easy as caution appropriate to the circumstances – much like his decision to reappoint Ben Bernanke, the hero of the crisis, to a second term as chairman of the Federal Reserve Board.

Still, it needs to be remembered that the decision to defer major surgery, emergency room or elective – just to stand there instead of doing something – was the only policy of the Obama administration’s first two years whose magnitude was comparable to its health care initiative. It was not so much the ninth decision as the other strategic economic dimension of things.

That something needs to be done is pretty clear. Wall Street veteran Henry Kaufman made the case (registration required) the other day in the Financial Times. The Dodd-Frank Act did nothing about the extraordinary concentration of assets that had taken place, he noted. The ten biggest institutions share of assets grew from 10 percent in 1990 to well over 70 percent today. Future failures could only increase that concentration, just as they did last fall.  Where else to put the assets of a failed bank but in the hands of the other giants? Small banks will be squeezed further in the years ahead, competition will decrease, volatility and risk-taking will increase, wrote Kaufman, until in the end there will be no choice but to recreate a system with a large number of smaller institutions no longer deemed too-large-to-fail.

To this point, the most penetrating voice has been that of Simon Johnson, of the Massachusetts Institute of Technology, author (with his brother-in-law, software developer/legal philosopher James Kwak) of 13 Bankers: The Wall Streeet Takeover and the Next Financial Meltdown, and proprietor of the influential blog Baseline Scenario. Oligarchy is a blunt word that doesn’t quite fit the situation. But Johnson is an indefatigable guide to the literature of political and regulatory capture. Kenneth Rogoff, of Harvard University, noted long ago that the financial sector had grown inappropriately large since 1980, an observation greatly amplified by Charles Ferguson’s film about the crisis, Inside Job. The search is on for the mechanisms by which this hypertrophy occurred.

A promising new line of argument was raised last fall in the FT, though if you blinked you would have missed it. “Healthy Banking System is the Goal, Not Profitable Banks” asserted the headline of a letter that appeared there on the eve of the G-20 meeting, in Seoul, in November (and available here under a different title). Signed by twenty prominent economists, most of them specialists in corporate finance, the letter noted bankers’ tendency to prefer debt financing to equity and asserted that much trouble could be alleviated simply by imposing far deeper capital requirements on them than those currently contemplated by the authorities. The letter-writers were not, for the most part, the experts to whom bank regulators ordinarily turn for guidance, but their insight seemed surprising and valuable because of the linkage it identified between leverage and bankers’ compensation.

(The finance professors’ argument is elaborated in Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive, by Anat Admati, Peter DeMarzo and Paul Pfleiderer, all of Stanford’s Graduate School of Business, and Martin Hellwig, of the Max Planck Institute for Collective Goods in Bonn, a paper which also casts a skeptical eye on various schemes currently popular among regulators to rely on “contingent capital,” meaning debt that becomes equity under some carefully specified circumstances, to keep bold risk-takers in check. For a whimsical and pithy gloss on the question, see On the Relevancy of Modigliani and Miller to Banking: A Parable and Some Observations, by Pfleiderer alone).

For the moment, responsibility for determing capital/debt ratios rests with the Basel Committee on Banking Supervision of the Bank for International Settlements. Far-reaching reform thus presumably could be achieved through the strokes of a few regulators’ pens.  Don’t hold your breath. Banks Best Basel As Regulators Dilute or Delay Capital Rules was the headline on an authoritative story last month by Bloomberg’s Yalman Onaran recapping the state of play.

Issues like these will be all over the program when the American Finance Association and the American Economic Association and some fifty some smaller organizations hold their annual meeting in Denver later this week. Experts will labor for the next several years, mostly behind the scenes, to tie the various skeins together.

At some point, the next crisis will begin. With some luck, economists will be ready for it.

.                                 xxx

There is a lot of talk in Washington, these days about the 112th Congress ending the custom of legislative earmarks as a way of life.  I do not know if that is going to happen, but I am pretty certain that if it weren’t for US Rep Jeffrey Flake (R-Arizona) and newspaperman Robert Kaiser, they wouldn’t be talking about it.

Kaiser is the author of. So Damn Much Money: The Triumph of Lobbying and the Corruption of American Government.  Not so many people in Washington read books, but everybody reads The Washington Post. It was there in 2007 that associate editor Kaiser rolled out a 27-part series (which promptly moved on to Post’s website) chronicling the invention of a vast new industry by lobbyist Gerald Cassidy.

Flake is easily the most indefatigable and effective opponent of pork-barrel politics in Washington. He gets re-elected by large percent margins despite his steadfast opposition to bringing home bacon – or, rather, because of it.

Together, with others, they appear to have elicited, at least for a time, an emotional state thought to have become impossible the nation’s capital:  shame.

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