The horizon is not so far as we can see, but as far as we can imagine

The American Choice: Break up and regulate companies or suffer another crisis

Too big to fail means to big to live. This is the mantra which many people have taken up since the financial crisis exploded last year, and 15 trillion dollars or so was spent, loaned, committed and guaranteed by the government in response to systemic failures both in and out of the financial sector (the latter stemming mainly from financial sector failure.)

Or, as Frank Borman put it, capitalism without bankruptcy is like Christianity without hell.  (Perhaps I should capitalize Capitalism, since it’s become a religion).

Letting firms and individuals take on risk is important.  Most new start-ups fail and the more ambitious they are, the more likely they are to fail.  The cycle of technological process includes periods like the end dot-com boom where the vast majority of new start-ups are crushed.  It is natural to the way that markets (not necessarily free markets) operate.

But, in order to work, capitalism requires that those who lose, lose.  Fundamentally the last 9 years didn’t happen, in economic terms.  The banks, on aggregate, made no money.  The economy, on aggregate, added no jobs (they’ve all been wiped out and by the end of this most of the gains of the 90’s will be gone too.)  When you screw up that badly, the discipline of markets requires that you lose everything.

The reason is moral hazard.  Simply put, if I know that if I gamble a trillion dollars and lose, I won’t pay the full price, but if I gamble a trillion dollars and win, I will get it all, I’ll gamble.

And if a case can be made that in letting me take my losses, you’ll destroy the entire economic system and throw the world into a great depression, well, you won’t have any choice but to bail me out, will you?

So any company which is too big to fail, is to big to be allowed to exist, because it makes moral hazard inescapable.  The only way such a system can not run moral hazard is if it is really willing to have a great depression it could otherwise avoid.

This is step on in any real financial reform: the break up of “too big to fail” companies.  If a regulator looks at a company and says “realistically we’d have to step in and keep you alive”, then the company is too big.  Period.  The Obama administration’s current proposal is to make big financial companies pay more in terms of reserve requirements and other fees in order to encourage their breakup.  This is insufficient because as with Structured Investment Vehicles (SIVs), the large financial companies just find ways to take liabilities and assets off book, or to book them at fake prices.  The record of regulators indicates they will allow them to do so.

So just break them up.

If you’re big enough to set prices, you’re too big to live, or at least to live free.

One of the greatest intellectual sins of this era is the deep and continuing confusion about what a free market is.  A free market isn’t a market in which the government plays no role and has no rules.  A free market is one in which (among other things) no market participant has enough market clout to enforce prices, in which market participants all have equal information and which has few barriers of entry.

Free markets are actually very vulnerable things.  The drive to monopoly or oligopoly is part of capitalism and markets in general.  The first thing most economic actors will do, once they’ve “won” the market, is buy up the market and use their market clout to take monopolistic profits.  This doesn’t require being the only market participant, if there are just a few dominant players they can form an oligopoly and take oligopolistic profits, which while not quite as high as monopolistic profits are still high enough to be worth bothering with.

The major test of an inefficient (non free) market in practice, as opposed to theory, is this: doe the market participants consistently make profits which are much higher than the economy in general?  If they do, the market is inefficient, and not free, because in a free market what would happen is either new competitors would step in to get some of that above normal returns money or current participants would cut prices to get more market share.  In either case competition would drive down profits to the norm for the economy (in theory to near zero, but in as close as we normally get to free markets, they’d still make more than near zero.)

By that test, the banks, brokerage and so on were not part of a free market.  They were either colluding or they were taking advantage of information asymmetries (trading on knowledge other folks didn’t have) or they were benefiting from high barriers to entry, or, well, all of the above.

Now this is a bit of an oversimplification.  There are certainly industries which are  a natural monopolies (for example, ground telecom communications or power provision.  Running multiple lines to each house makes zero sense).  There can also be scale effects which are considered so valuable to the economy as to be allowed.  If having one firm manufacturing a million units of something means that the cost is half of what having 10 firms doing it, perhaps the end result is worthwhile.

In such cases, however, where you decide you’re going to allow a monopoly or oligopoly, the rule is to regulate it very strictly, in the way that utilities were once regulated.  “You will make 5% a year.  No more.  No less.  You will reinvest.  You will not lobby the government.  You will not do bad things.”

But if the effects of scale aren’t so valuable to the economy, then in any case where markets are found to be long term inefficient, and therefor not free, the answer is to break them up.  This is what was done to Bell in the old days, and until the Baby Bells reconstituted themselves into a small number of oligopolistic providers capable of throttling innovation, so that Americans have “broadband” which is is so much slower than in Asia and Europe that it’s a joke, that break up worked well to drive down prices and increase innovation.

Since the financial sector has just wiped out 10 or more years worth of economic growth it’s pretty clear that “scale effects” have only allowed them to do more damage, not less.  They aren’t a free market by any metric (when you have the ability to borrow money at subsidized rates and to create money through fractional lending the idea is a joke anyway).

So break them up.  Make them so small that they can’t move the market.  And regulate them so they can’t break the market again.

Perverse Incentives. This is potentially very broad, and it doesn’t always require a break up.  For example, the ratings agencies, because they were paid by the firms whose securities they rated, had perverse incentives to rate securities higher than they deserved.  Breaking the companies up wouldn’t fix the problem, changing how they get paid is required (I am aware, so far, of no serious proposals to do so.)

But the main perverse incentive I have in mind is high pay.  When decision makers or important workers in a company are paid too much their incentives change.  If you are, say, earning $200,000 a year, even though that’s a lot of money to ordinary people, it’s not enough so that you don’t need to keep your job.  Even 20 years from now, you’re still going to need a job.  So it’s in your interest to make sure that your employer survives, and that you don’t take on risks you can be blamed for.  Old style loan officers in banks, for example, were conservative because if a loan went bad 10 years from when they approved it, they’d be in their managers office justifying it.  If too many loans went bad, well, they’d be out of a job.  When I worked in insurance, the underwriters were paranoid of having too many claims on the policies they approved.  So they only approved good risks.  Why?  Because if they approved too many bad risks, they’d be out of a job.

On the other hand, if you’re being paid 5 million or 10 million (or more) a year, what matters is your bonus this year and next year.  If your company goes under you’ll still be rich for the rest of your life.  You don’t need a job after the first few years at these compensation rates, so it becomes just a game for you.  Long term risk means nothing compared to next month’s commission or next year’s bonus season.  And if it does all fail, heck, you may even get a golden parachute of 10 million dollars or more.  Failure looks pretty good in the world of high paid executives.

To a lesser extent this is true down the chain.  If you’re a loan broker paid on commission, and you can make a million a year, well, you’re in the same boat.  A few good years and you can retire for life.  Maybe, unlike your bosses, you can’t live in the Hamptons for the rest of your life, but you’ll certainly never need a job again.

And then there is risk offloading.  One of the biggest causes of the housing crisis was that mortgages were bundled and sold to third parties.  If you know (or believe) that you aren’t taking on any of the risk, why should you bother with oversight?  All that matters is that some sucker buy, and once they buy, it’s not your problem any more.  This works because the only people really capable of assessing risk properly are the primary loan issuers who live and work in the community.  Investors from other countries, or even other counties can’t go and check every house, read all the loan applications and check the tax returns.  Only the issuer can do that.  But because they didn’t have the risk, most of them didn’t bother, and in fact got rid of most of the people whose job it used to be.

In any of these cases of pervasive perverse incentives, there is an argument for changing the incentives.    The simplest way to change income incentives is high progressive taxation.  Tax all income over a million at 90% with no exemptions, and all income over 5 million at 95% and most of this stupidity would stop overnight, as well as having the effect of drying up bribes… er, donations, for politicians.  Require companies to keep most of the risk they take on and not pass it off, and they would start doing due diligence again.  When I worked in an underwriting department we understood that giving someone a loan they couldn’t afford made the eventual default as much our fault as theirs.  This simple understanding seems to have been lost.

And whoever you’re supposed to regulate should not pay you fee services for the regulation if they have a choice of regulator.  This applies to ratings agencies (which are regulators in drag).  It applies to the FDA, which has been captured by the drug companies it regulates.  And it definitely applies to all financial regulatory agencies.

Concluding Remarks

None of what I’ve written above should be controversial.  Companies shouldn’t be too big to buy the market or set prices.  Incentives for employees should be aligned with what society needs, not with short term profits at the expense of causing economic cataclysms.  Companies which are too big to fail and substantially private are not appropriate in any country which claims to believe in free markets, because they make the discipline of free markets impossible to apply, and there is no free market or capitalism for companies which are so big the government has to bail them out.  (That’s socialism.)  Companies which are too big to fail, if judged to be in the public interest, should either be owned by the public (notice that Fannie Mae, for example, only went off the rails after it became a private company) or should be heavily regulated and forbidden from an variety of lobbying so they cannot game the political system and the regulators.

We know all this.  These aren’t fringe theories.  They come, clearly, out of basic economic theory.  Adam Smith railed against oligopolies, monopolies and bailouts, for goodness sakes.

Capitalism is a great thing, properly regulated.  Free markets are indeed wonderful generators of wealth.  But free markets cannot exist without an outside force (government) making sure that market winners don’t use their power to buy up the market.  Capitalism cannot exist without both creation and destruction, and without companies and individuals bearing the risks of their economic actions.  And the larger, and richer a participant is, the more important it is that they reap those consequences.

Finally, no system can survive if the incentives in the system encourage looting the system for short term gain over long term growth.  We are seeing the results of that now, an entire decade of illusionary economic growth revealed as having been fake, and being wiped away.

I do not see, at this point, the political will to fix most of these problem.  If they are not fixed, then they will, inevitably, lead to another crisis.  That crisis will be larger than this one.  And I strongly suspect it will be the last crisis, because it will lead to a full meltdown of the US system.

In the sense that we know what to do to stop it, this is not inevitable.  But in the sense that there appears to be no will amongst decision makers to stop it (since it’s them who got rich, and it’s themselves they’re bailing out) it appears to be sadly inevitable.

All great nations are destroyed from within.  In some cases an external foe appears to push over the rotten edifice, in others they implode without an external push, but both only happens after the rot has destroyed the nation’s integrity from within.

America has a choice.  I hope it hasn’t already been made.


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  1. John B.

    Wow. What an essay. That’s quite a post Ian, and I sure do hope it get read by a wide array of folks, and hopefully folks that can help to affect change…

  2. “A free market isn’t a market in which the government plays no role and has no rules. A free market is one in which (among other things) no market participant has enough market clout to enforce prices, in which market participants all have equal information and which has few barriers of entry.”

    Thanks, Ian. Didn’t know that. A truly eloquent and educational post.

  3. Penny

    Ian, have you read “The Collapse of Globalism and the Remaking of the World” by John Ralston Saul? He makes these points and much more that have broad implications for where we are right now.

  4. Ian Welsh

    Penny, I’ve read most of his books and I’ve probably read that one (I did read his most recent book on Canada which was excellent). I don’t always agree with Sauls prescriptions, but I tend to agree with his diagnosis.

  5. Penny

    Yes, the recent book on Canada is excellent – we Canadians could understand ourselves a lot better if we understood the historically complex relationship we have with aboriginal values. Doing so could lead to the kind of leadership that the planet needs.

    However, as he describes in “Globalism” the neo-conservatives/neo-liberals have already begun spinning this current failure as a failure to go far enough. Just don’t pay attention to poor New Zealand.

  6. melo

    Great synopsis of the current institutionalised malfaisance, Ian, would that Obama had the stones to put your suggestions to good effect.

    But then he dances with the ones who brought him to the ball.

    Thanks for a great essay

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