Hat tip to the much-missed Callimachus who snuck into my comments section in the dark of night to urge me to keep an eye out for David Leonhardt’s column on the role of looting in the current financial crisis. Looting is different from plain old moral hazard:
With moral hazard, bankers are making real wagers. If those wagers pay off, the government has no role in the transaction. With looting, the government’s involvement is crucial to the whole enterprise.
Think about the so-called liars’ loans from recent years: like those Texas real estate loans from the 1980s, they never had a chance of paying off. Sure, they would deliver big profits for a while, so long as the bubble kept inflating. But when they inevitably imploded, the losses would overwhelm the gains. As Gretchen Morgenson has reported, Merrill Lynch’s losses from the last two years wiped out its profits from the previous decade.
What happened? Banks borrowed money from lenders around the world. The bankers then kept a big chunk of that money for themselves, calling it “management fees” or “performance bonuses.” Once the investments were exposed as hopeless, the lenders — ordinary savers, foreign countries, other banks, you name it — were repaid with government bailouts.
In effect, the bankers had siphoned off this bailout money in advance, years before the government had spent it.
There is a fundamental problem of incentives involved in all of this:
the bottom line is the same: given an incentive to loot, Wall Street did so. “If you think of the financial system as a whole,” Mr. Romer said, “it actually has an incentive to trigger the rare occasions in which tens or hundreds of billions of dollars come flowing out of the Treasury.”
Unfortunately, we can’t very well stop the flow of that money now. The bankers have already walked away with their profits (though many more of them deserve a subpoena to a Congressional hearing room). Allowing A.I.G. to collapse, out of spite, could cause a financial shock bigger than the one that followed the collapse of Lehman Brothers. Modern economies can’t function without credit, which means the financial system needs to be bailed out.
Mr. Leonhardt’s prescription for resolving the problem, following Ben Bernanke’s cues from his speech yesterday, is extended oversight:
Firms will have to be monitored much more seriously than they were during the Greenspan era. They can’t be allowed to shop around for the regulatory agency that least understands what they’re doing. The biggest Wall Street paydays should be held in escrow until it’s clear they weren’t based on fictional profits.
I don’t think that Mr. Leonhardt has thought this through to its logical conclusion. First, I don’t believe there is a legal way to hold these paydays in escrow at least not automatically, cf. the takings clause of the Constitution. Second, in the specific case of the sorts of financial instruments that are causing so much trouble there is no way to determine whether they’re based on fictional profits until the mortgages on which they were ultimately based reach their full term and since tiny fractions of multiple mortgages with wildly differing terms are involved it might be decades before one could really have confidence that the profits were real, if ever. That’s a crate that will never get off the ground.
Even more seriously there’s a fundamental assumption being made that I simply don’t think holds water: that regulators can be cleverer on a systematic basis than those whom they’re regulating. The incentives involved are enormous. If it were possible to be beyond the dreams of avarice, the trillions of dollars involved would certainly meet that standard. That means that the financial institutions can attract some very, very clever people. And that brings up another terrible dilemma.
Nearly fifty years ago Dwight Eisenhower, in his farewell speech as president, warned of the military industrial complex:
Until the latest of our world conflicts, the United States had no armaments industry. American makers of plowshares could, with time and as required, make swords as well. But now we can no longer risk emergency improvisation of national defense; we have been compelled to create a permanent armaments industry of vast proportions. Added to this, three and a half million men and women are directly engaged in the defense establishment. We annually spend on military security more than the net income of all United States corporations.
This conjunction of an immense military establishment and a large arms industry is new in the American experience. The total influence — economic, political, even spiritual — is felt in every city, every State house, every office of the Federal government. We recognize the imperative need for this development. Yet we must not fail to comprehend its grave implications. Our toil, resources and livelihood are all involved; so is the very structure of our society.
In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the militaryindustrial complex. The potential for the disastrous rise of misplaced power exists and will persist.
Today there is a financial-political complex the dangers of which extend worldwide and which controls sums so vast that all of the money we’ve ever spent on armaments looks like small change in comparison. Bankers become bank regulators and the regulators of financial institutions become financiers with terrifying ease. This is a conflict of interests that cannot be mitigated and is practically impossible to prevent.
We’re left on the horns of an awful dilemma. Either we must prevent financial institutions from growing to this sort of size and power or we must be prepared to deal with the consequences of financial institutions that are beyond the power of national governments to regulate and, as Mr. Leonhardt recounts so frighteningly, have every incentive to loot the national wealth of the countries in which they operate.
Megan McArdle ably explains the incestuous relationship between financiers and financial regulators:
Financial expertise is not nearly as interchangeable as most people think. For the same reason that you do not want your dermatologist removing your gallbladder, someone like Nassim Taleb would not make a good regulator of the financial system. Nassim Taleb knows a lot about the markets he trades in. He does not, I would wager, know much about the theory behind US securities law.
In normal times, this doesn’t matter as much as it does now. We’re already months behind where we should be on a plan to fix the banking system, because the administration put its focus on passing a stimulus plan instead. We don’t really have time for on-the-job training for the undersecretaries.
I understand that but don’t find it particularly reassuring. Quis custodiet ipsos custodes?