Wednesday, October 15, 2008

What We Need Now is Some Good Old-fashioned "Collusion"

The last debate starts in an hour or so. I can't do it, really. I'll be ill if I try. After watching the last several weeks of an incredible resurgence of statism from government intervention in the economy, it really doesn't matter what the candidates say.

I was tempted for a while to vote McCain, just because the economic crisis is so bad, and will potentially be so devastating if mishandled. My hope was that there was some semblance of basic economics somewhere in his camp. However, after reading about what Franklin Roosevelt promised regarding monetary policy and what he actually did after being elected (which you can find in this publication: The Great Myths of the Great Depression) it's clear to me that a vote for a pragmatist who says he's for the free market, and consistently bashes it in word and deed is no vote at all. The Republicans are slaves to religion and a pragmatist like McCain will go wherever his handlers lead him. And a Democratic Legislative / Executive combination can only do no good. There is no choice this year. I'm sitting this one out. I'll use the time to pen a few letters to my congressman, and maybe some Letters to the Editor.

Today I read of the heavy handed tactics used by Treasury on our nine largest banks. I read of force used to take ownership rights in banks in exchange for capital. Forced used on both good banks and bad banks alike, and capital thrust upon good banks that didn't need or want it. You should read some of the account here. It is chilling.

The only difference between Hank Paulson and Hugo Chavez is that Paulson "feels badly" about what he's done. Our American statism takes the unique form of a seemingly concerned, reluctant paternalism.  Here, instead of the stern dictator, we have the "reluctant father." Never mind that both have to punish their misbehaving children, in exactly the same fashion.

But I digress. On to the topic at hand.

Megan McCardle almost had me snookered last week, but not this week. She's concerned about something in the market called "systemic risk," and thinks that this is cause for some form of government regulation in the financial markets. For those of you who don't know finance, systemic risk is risk that an entire system is subject to. It is said to be the risk that you cannot eliminate through diversification. This concept however has become the basis for a line of thought which has a parallel in the environmental movement, namely The Doomsday Scenario. Last week this scenario was posited for the commercial paper and money markets.

The idea is that these systemic risks threaten the very existence of the financial markets, and because the markets move so fast it is possible that once they near a certain point, it will be impossible to stop the financial system from imploding. Therefore one needs to regulate the markets in such a way that they are kept away from these systemic "cliffs." While markets do move quickly, and can get themselves into trouble, I think it is fallacious to then posit that the outcome is catastrophic, and that it can be mitigated by government action.

I'm not suggesting that such risk doesn't exist, but I am seriously questioning that idea that one can mitigate it by regulation. Forgetting for a second that governments themselves are subject to systemic risks, that their meddling can in and of itself be a systemic risk through unintended consequences (as is the case in this crisis), and that systemic risks are in part unmitigatable because the are unforseeable (making one wonder how one a priori regulates against them). The argument that caught me off guard was her thought on why governments are uniquely qualified to do the damage control when a crisis hits.

In her discussion on the crisis with Yves Smith of Naked Capitalism (whose blog I have come to rely on for its up to the minute detailed information on this crisis, and who is "gobsmacked" at the Paulson bailout. For her take on why the bailout won't work see her BloggingHeads with McCardle - 18:00. It's quite good.) Megan posits (bold mine),

One of the core issues here, I think what the government is really good at in doing this kind of regulation is first of all it's great at transparency and it's really good at coordination. And so some of the things that people are suggesting, like Luigi Zengales is saying 'look just force people to do an equity transfer' and the reason you want the government to do this is that anyone who does it by themselves sends a bad signal to the market, but if you force everyone to recapitalize at once, then there's no signaling of [balance sheet problems].... But the government is really good at that stuff, when you have a collective action problem in the financial markets which you often do. (passage starts at 38:30, the whole discussion of systemic risk starts at 28:00)

My first response to this was "hmm, ok, yes government can generate broad, unified action." It is of course telling that she uses the word "force" since that is the mechanism by which government accomplishes "unified" action. And it is true that this crisis needs a unified action. I spent a day noodling on that problem, until one of my favorite capitalists, J.P. Morgan, gave me the answer. Back to my post of last week, Morgan's answer to the crisis of 1907 was to bring all bankers together, turn out balance sheets, and restructure them with capital infusions and write-downs.

In a sense the action required here is the same, a unified action, involving all the main banks, restructuring through write-downs and capital infusions. A free market could do this on it's own. Treasury might be able to do it, but it inherently requires nationalization. So why isn't the free market acting? Why is government supposedly better at such action? Because if bank heads do this today, it goes by the term collusion, and it is patently illegal. But it should not be! Government is better at it because it has made the act of doing it illegal for all but itself. Also, for the CEO who has managed his bank poorly, the free market option means he will lose his firm. Such a person, acting pragmatically, would rather hold out for a government bail-out, even if he risks bankruptcy. Implied government action creates that moral hazard that prevents these free-market-led negotiations!

A "collective action" problem is better handled by the free market, but today such action is illegal. It should not be. The truth is that instead of Henry Paulson forcing good banks to accept nationalization, it is the good banks who should be presiding over the recapitalization of their more poorly-run brethren.

Lasseiz faire!


Burgess Laughlin said...

I have a general suggestion, for a general audience.

> "I'll use the time to pen a few letters to my congressman, and maybe some Letters to the Editor."

LTEs are like sawdust in a bonfire: a spark of light and then they are gone.

Why not write a book instead? Books last a long time. Books get handed from person to person and even generation to generation. Besides, the expertise one develops in the process of preparing to write a book makes one an expert who can fire off many LTEs with little extra preparation.

There will be many more crises ahead. We can let others chase ambulances, pragmatically lurching from one crisis to the next. Why not be proactive--perhaps picking a specialization that will someday inevitably reach a crisis stage? An example is Social Security. Another is anti-trust laws. I am sure a little research will uncover many more that are brewing because of laws passed by Congress years ago.

The best guide to pick a subject for long-term work might be one's own central purpose in life. What statist actions threaten it? Focus on one of those.

This is the process I am going through now.

softwareNerd said...

Great post.

When the better type of people say "we need government to step in here", they usually mean that we need some type of coordinated action.

For instance, they'll say that we need public libraries. Or they'll praise the mayor of a town for going to Japan, talking up the town's virtues to investors, or they'll priase the state's tourism-promotion program.

Sometimes, business rivals have to sit down together and work on things at the "industry level". Collusion is exactly what we need. Orders from Washington might get us over some immediate problem, but will not be as resilient as a solution that comes from the ground.

As for the crisis mentality, I think the Democrat legislature who likened the government's rhetoric to their Iraq-war fear-mongering was not too off base. All the commentators on CNBC read up about LIBOR, and are suddenyl concerned about it. However, I have not seen them answer this question: granted that today's LIBOR is higher than from some months ago, however it is just starting to reach the levels of 1 year ago. So, why is this more of a crisis today than it was in Oct 2007?

The government seems to have its eye on the stock market. In recent decades, some CEOs have monitored quarter-by-quarter stock moves at the cost of thinking long term. Now, we have our government emulating that, and looking week-by-week.

You mentioned structural changes being required. That is vital. Throwing enough cash at the problem can get us over it, but at what cost. If the government had anyone who leaned slightly free-market, they would take this as an oppotunity: in this time of crises, we will throw some money at the problem on the condition that we have the following structural changes. Instead, what we're witness is money being thrown, with structual damage added in to boot.

Kendall J said...

Burgess wrote:
LTEs are like sawdust in a bonfire: a spark of light and then they are gone.

Why not write a book instead? Books last a long time. Books get handed from person to person and even generation to generation. Besides, the expertise one develops in the process of preparing to write a book makes one an expert who can fire off many LTEs with little extra preparation.

You're absolutely right Burgess, and the concept of writing additional work that is more lasting is something I'm considering (right now, I aspire to author a TOS article). At the same time, I think there is a heirarchy of learning or experience that one progresses through to get to that point.

I think blogs are also "sparks then gone", but they are far better than simply discussing issues on an online forum. The level of presentation of ideas, the potential impact, and durability of form all increase as one heads toward the idea of writing a book.

My aim is in that direction. Maybe my first leaps aren't as big as they could be, and I appreciate the challenge!

Kendall J -

Burgess Laughlin said...

To avoid misinterpretation, I want to make a couple of points: (1) LTEs are not a waste of time; they do have some effect, but they have max effect when written by someone immersed in the subject, especially if he has a title in that field.

(2) As you suggest, weblogs are more enduring than LTEs, in general, all other factors being equal. I think the reason is because they are more accessible and because the writer can spend more time on each post and provide some integration through links and side comments.

One of the effective aspects of planning a book is that the writer can always use his research and insights (acquired for the book) for LTEs and a weblog. So, in a sense, there is one ideal choice (a book) with pay offs in the two other areas--LTEs and weblog posts, as well as articles for journals, either ones in your field or more general ones like The Objective Standard.

In summary, planning a book integrates what would otherwise be merely a pile of separate bits of knowledge. A book that flows from one's central purpose in life (the very purpose of which is integration) creates a satisfying life, maybe even a happy one.

I wish you the best with your journal article and book. Remember you can always hire help at every stage: planning, researching, writing, editing, critiquing, and proofreading. That's part of what money is for: helping us achieve our highest values in life.

Galileo Blogs said...


You make a great, original point about the outlawing of collusion (under the antitrust laws) in the current crisis. Banks today legally could not agree to pool their resources, which they did in the Panic of 1907 under the leadership of J.P. Morgan, and as they did in many prior crises.

Since banks cannot act to voluntarily coordinate their actions in mutual self-interest, the Treasury and Federal Reserve forcefully take on this role. The difference is that as a political action, it violates the rights of the bankers and, unsurprisingly, is harmful rather than beneficial.

Kendall J said...

Thanks GB!

And you have, as eloquently as ever, summarized my thesis as I'm not even sure I could.

Kendall J