The Enlightened Caveman


Are They Too Big To Fail or Are We Too Ignorant To Get It?
April 28, 2010, 10:28 am
Filed under: Economics, Politics | Tags: , , , ,

I try not to get too political these days, since I find that I usually end up in the middle of some holy war between ideologues.  However, this financial reform thing is too big a deal to leave alone.  As usual, the political class has misplaced blame – whether purposefully or not – for why we are where we are, which means the solutions they are advocating have exactly zero chance of helping.  Allow me to offer an alternative.

First, a little backstory.  Those who know me know that I am a libertarian-minded guy.  So, back in 2008, when Bush was in bailout mode, many were shocked that I was in favor of what he was proposing.  How could a free market proponent go along with massive Uncle Sam bailouts of financial institutions that had clearly been making foolish decisions for quite some time?  Wouldn’t the libertarian position be to let them fail and let the market adjust?  Yes, that’s what the free market position would be…in a vacuum.  The reality, however, was that bailouts were the only option.

My reasoning was (and is) less about the reality of “too big to fail” than it is about perception .  In 2008, had some major banks gone belly-up, we would have had a major crisis in consumer confidence, which could have pushed us right off an economic cliff.  In those days, no one had ever considered the possibility that an organization as massive and influential as AIG might go bankrupt.  So, we were faced with the possibility of runs on banks and all of the panic and chaos that would accompany them.  But that was then, and what have we learned?  Nada.

The notion of “too big to fail” is a financial “mulligan,” something you get maybe once in a generation, when you get caught with a general public that is too ignorant to ride out a blip in a financial cycle.  The fact is that, on its face, there is no size institution that is too big to fail.  The only question is what happens when they fail. But no one is talking about this at all.  The default assumption is that “too big to fail” is a legitimate concept.  Consider the following.  Apparently, there are only three real options in the financial reform debate.  As this article in the Washington Post explains it, they are:

  1. No bailouts.  Easy.  If a financial institution fails, it ends up in bankruptcy court, and the chips fall where they may.  Aside from the fact that most companies will not believe that there really won’t be bailouts, the real concern is the panic that could come from massive failures – the “too big to fail” problem.  This is the fallacy I’m addressing here, so I’ll come back to it.
  2. Limit the size of financial institutions.  Don’t let them get big enough to be too big to fail.  The problems with this are numerous, but the bottom line is that it’s hard to define size in a meaningful way, and sometimes size is critical to global competitiveness.  So that one is off the table, too.
  3. Finally, we have the Chris Dodd solution – creating a new power base in the federal government that allows the executive branch to take corrective action with troubled financial institutions.  In principal, this works as an alternative to bankruptcy, but in reality, this is yet another power grab by the politicians.

So there you have it.  Our three options.  I’m a little disturbed that our immensely innovative and creative policy-makers can’t come up with anything better than these three options, but it really doesn’t matter.  Our solution is here.  It’s number 1, despite the fact that it is rejected out of hand by most everyone these days.

But wait!  Number 1?  Aren’t we back to 2008, where we’re balancing libertarian principles against unacceptable realities? No, because we’re not IN THE CRISIS.  We have the benefit of looking forward.  We can examine what would happen if the top 10 financial institutions became insolvent, and we can educate the general public as to how things would play out.  The free market really is capable of dealing with the failure of any size institution.  People just need to understand what is happening under the hood.  This, to me, is THE issue here.

The most important thing to know is that, even in 2008, in the midst of massive bank failures, there were banks that were doing fine.  Wells Fargo just sat back and watched as the other big players imploded.  And then they came along and picked up the pieces – getting massive assets for pennies on the dollar.  That was a good thing, one that should have been shouted from the roof tops. It illuminated one of the most important aspects of the financial world – it really is a zero-sum game.  When someone wins, someone else has to lose, and vice versa.

The point is that just because a big bank or two loses, there’s no need to run to the other banks to empty bank accounts and stuff everything in mattresses until the crisis passes (as if that’s even possible).  Indeed, the ONLY real concern in 2008 was that the general public would freak out and come to eventually realize that the total amount of cash in our society is a small fraction of what is actually on the books.  The whole bailout deal was really about maintaining the public’s ignorance about how the financial world really works.  And back then, with all that was happening, it made sense.  Now it doesn’t.  Now we can pull back the veil and let people know a) how banks really do business and b) what happens when the big ones fail.  Is that really so hard?

Evidently it is.  The government is fired up to educate us about getting involved in the community, but it never crosses the bureaucratic mind that some PSAs about the ins and outs of the financial industry might be of value. Of course not.  What we need is more government.  Unfortunately, where government intervention always causes problems is in distorting the market signals that individuals use to make decisions.  When management knows that the bank will be dissolved if it makes really bad decisions, they will err on the side of caution when it comes to creating investment instruments and/or loaning capital.  Conversely, if a consumer knows that any bank will be bailed out, he or she has no incentive to bank with strong financial institutions with a reputation for stability.

Yet again, we see our politicians asking for the power to do the impossible.  They want the power to make decisions for financial institutions, when they have neither the information nor the expertise to do this as well as the managers of those institutions.  Oh, how the arrogance astounds.  The solution, which has been validated time and time again throughout history, all over the world, is to let the markets adjudicate the winners and losers.   And what is it that keeps a free market running smoothly?  An educated and informed population. We just need to take on the problem of public ignorance.  Ironically, it is that very same public ignorance that will ultimately pave the way for this massive expansion in government power, so I’m not holding my breath.

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3 Comments so far
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There is a better option for resolving ‘too big to close’ financial institutions. All the deposits and other liabilities can take a haircut, and the bank can re-open under the creditor’s control. See http://www.rbnz.govt.nz/research/bulletin/1997_2001/2001jun64_2carr27jun.pdf . Also, the FDIC now requires the largest institutions to be able to do a creditor recapitalisation upon its failure without delay.

Comment by David Hillary

My level of ignorance of the inner workings of top tier investment banks is embarrassing. That said, I was under the impression that the major impact of the failure of AIG, Lehman Brothers (and the near failure of others) on the broader economy was the tightening credit for IPOs, large corporations, and ‘regular’ banks (which then became less able/willing to lend to small businesses and individuals). This domino effect helped to create a huge reduction in investor and consumer confidence, resulting in lower consumption and increased unemployment, which helped to exacerbate the mortgage defaults that played a large role in the overleveraging the ill-fated investment banks in first place.

If that’s even close to accurate, it seems to me that a run on local banks, while a real concern, was a lower priority than ensuring that the top of the financial food chain remains solvent in order to keep the spigot of credit open for those down stream. In this respect, allowing Goldman et al. to fail would’ve been disastrous…for the entire economy. But still, I’d say some smart (targeted, limited in scope) regulation is in order.

Comment by Robert Bell

David – agreed. There are lots of other options to address what went wrong to avoid similar situations going forward. Here in the US, this is really about one thing – neutering Wall Street because the liberals think it’s all greedy, rich people who feed like leeches off the hard working good people on Main Street. Classic class warfare.

Robert – you’re right about all those consequences of the meltdown. However, my point is about bailouts. I sided with Bush in 2008 because I didn’t think the general public could handle something so disruptive as the closing of some major financial institutions. It would have been bank runs on those failing banks, which would have precipitated runs on other banks, none of which would have been able to withstand the demand for cash from customers. Conclusion – breakdown of the civil society, at least temporarily.

Keep in mind that the spigot of credit has been closed tightly for nearly two years, so if that was their main concern, they certainly failed miserably.

The only regulation I support at this point is the prohibition of credit default swaps, collateralized debt obligations, and any other kind of derivative that has no anchor in reality. In the broadest sense, the situation went down like this…

1. The Democrats forced banks to loan money to anyone who sign an application. This is the most important thing – it is the FIRST CAUSE.

2. Wall Street saw this massive increase in demand for loans and the subsequent run-up in property values and took the opportunity to ratchet up their experiments with derivatives. Suddenly, mortgages were being lumped together and sliced and diced into dozens of financial securities, most of which were nothing more glorified bets ala Vegas.

3. The smart folks on Wall Street started seeing that the situation was untenable and started pushing the investment banks to create ever more of these derivatives.

4. The whole thing came tumbling down when the ARMs matured and huge masses of people stopped sending their mortgage checks. Suddenly, the banks had no capital to fund what they were doing and they were being forced to pay outrageous amounts of money to organizations that bet on the housing industry going belly up.

And here we are. There are really only two big lessons to learn.
1. Let bankers decide who they want to lend to based to upon their own criteria. This alone would have prevented the entire mess.
2. Don’t allow Wall Street to create financial instruments that are anchored to nothing tangible.

That’s my limited understanding of it. David – I’m sure you have a more erudite explanation…

Comment by Chris Wilson




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