The Outrage Game

As a follow-up to last week's post, Joe Klein has a fine column on the AIG bonus outrage:

There is a real crisis out there. It has existed for a while. It has been spreading slowly as factory after factory has shut down, as the gap between rich and poor ballooned, as the rich found ways to get richer betting on exotic financial instruments with all the economic substance of a roulette wheel, as the middle class found it harder to pay for college, for health care, for gasoline.

But most of the anger we see and hear comes from people who are paid to be angry, on cue, on cable television--as opposed to people with actual grievances. Suddenly, the White House press corps goes barking mad over the AIG Bonuses. It is said that the bonuses are an aspect of the bust that the "public" can understand; in truth, the bonuses are an aspect of the bust that reporters can understand. Suddenly, the Obama Administration has a "crisis." The President has to go on television and act as if he's angry, even though he knows these bonuses are the tiniest outcropping of outrageousness.

A bunch of people on Wall Street engaged in high-stakes gambling with a lot of other people's money and the reputations and stability of financial institutions that had endured for many decades. They amassed personal fortunes that the rest of us could scarcely imagine while burning down their firms and taking the entire global economy down with them. That's outrageous. That is un-fucking-believably outrageous. That a CEO at AIG who had been installed by the federal government to clean up the mess (along with some folks in the Treasury Department) decided it wasn't worth fighting in court over $150m in bonuses that the company was contractually obligated to pay--that's not outrageous.

Financial Regulation

I'm somewhat perplexed by this blog post by Richard Posner on financial regulations. Posner argues that there should be no new financial regulations until the current recession has bottomed out. There is a basic intuitive support for this argument in that additional regulations could limit risk-taking and drive up the cost of lending at a time when the federal government is desperately trying to encourage new lending. But Posner's position is focused primarily on uncertainty in the marketplace. He writes:

Any regulatory initiatives at this time will simply increase the already great uncertainty in which the financial industry is operating; and as Keynes pointed out, anything that increases uncertainty in a depression causes hoarding, which can in turn precipitate a deflation likely to deepen and protract an economic downturn.

His point is well taken, but I think he gets the matter of uncertainty backwards. The uncertainty Posner appears to be worried about is already priced into the market. The one thing that investors are not uncertain about at this point is that there will be new financial regulations. I don't think anyone doubts that at this point. The uncertainty is about what those regulations will be. The sooner the government can spell that out, the sooner this uncertainty will be diminished. The additional benefit is that the financial crisis has severely undermined public confidence in the banking system, and if the new regulations are well-crafted (or at least are broadly perceived to be), they can begin to restore some confidence. And in any case, when it comes to the Obama administration and Democratic congressional leaders, all of these concerns may be secondary to the fact that there is huge public support for financial regulations at present, leading to a desire to strike while the iron is hot.

Understanding an Economic Apocalypse

This is tremendously useful:


The Crisis of Credit Visualized from Jonathan Jarvis on Vimeo.

Too Big to Be Privatized

There has been buzz for the past several days that the federal government would move to bail out Fannie Mae and Freddie Mac, and now appears the rumors have proven correct. This follows not so long after the bailout of Bear Stearns. I don't know enough about the banking market to say whether the government has made the right moves with respect to these bailouts, but it strikes me as odd that any private entity should be considered "too big to fail". It seems there two potential routes around this: either ensure that no single firm in a given market obtains enough market share to make its collapse catastrophic, or simply put the critical functions under public control. The former option is problematic in that a) it would require a far more robust (and I mean FAR more) and aggressive type of antitrust regulation than we currently have, and b) it is easy to imagine that, even with a larger number of firms, intense competition might lead the firms to adopt similar approaches such that numerous firms would teeter on the edge of collapse at the same time, and a bailout would be required anyway. The latter option is problematic for the obvious reason that markets are generally more efficient than government management. But this system where private companies are free to reap really impressive profits (as the investment banks have), but the public ultimately bears the downside risk seems untenable.

This problem has always been at the foundation of my opposition to any sort of privatization of social security. In fact, it's worse for social security than for the banking system, because with social security you've got two levels risk to deal with--the institutional and individual. Because even if whatever private institutions we hand the system over to don't fail, if a significant number of individuals managed their risk poorly and get cleaned out, I find it inconceivable that the government wouldn't step in to rescue them. That is, after all, the entire point of the program. It's social security. And once that happens, of course we'd expect everyone else to try to shoot the moon with their investments, because what's the downside? This is the sort of risk we don't want to be distributed. It only works when the risk is pooled. Look for similar problems with some sort of hybridized public/private health insurance. Once we've made a social decision that some service is necessary, for whatever reason (economic stability, national security, moral obligation), handing it over to private entities will necessarily create serious problems with risk management and moral hazard.

I'm not necessarily arguing that, for example, our entire banking system or health care system should be government run. But I do think that in terms of structuring the mix of government and private management of such critical functions we need to try to identify key breaking points and either put them under direct government control or develop some clever system to ensure that private entities approach these functions with the right set of incentives.

Update (7/14): Sebastian Mallaby appears to have a similar take on the issue to mine.

The Housing Market Bailout

I'm usually on here defending regulation from Henry and V, but this story just irks me. Ohio is raising $100m to bail out homeowners with ARMs facing foreclosure. Who the hell gets an ARM when interest rates are at their lowest levels in many decades? An ARM is a wager between you and your lender: if interest rates fall, you win, if they rise, they win. If you start from an historic low, who do you think is going to win that wager? This is a market populated by predatory lenders and foolish debtors. Dumping tax dollars in to keep it afloat may not be the brightest idea.