Where "Choice and Competition" meet profits and losses
Today in a speech that was basically a stern lambasting of Wall Street that described similar regulatory structures to those he's proposed before, Obama claimed that Wall Street would retain robust "choice and competition," a phrase we've heard quite a bit recently in the health-care debate. The irony, to me, when the phrase is used in that political context is that some new government run system of providing health insurance to those who either are unemployed and don't qualify for a government subsidized program like Medicare or Medicaid, or don't get insurance through their job and can't afford or choose not to buy health-insurance, often have few choices in private plans to buy and have to "pay retail" for an individual plan precisely because Federal and State governments restrict competition between insurers to sometimes a very large extent. At the very least, plans must be provided by an in-state provider, the provider must cover a minimum list of procedures, the composition of which is subject to the manipulation of special interests (should your health insurance be forced to cover your Chiropractic appointment?) and in some states like New York, "community rating" in addition forces a maximum price differential for the most and least risky insurance buyers in order to pool the risk.
Now the community rating laws work to increase access to insurance--the net income on a young healthy person who pays a minimum premium helps subsidize the premium of an older, sicker person who the insurance company knows would be a net loss at almost any premium rate. Competition in the general sense when talking about economics is the idea that when a market has a level playing field and there are low barriers to entry, the more players in a market there are the more pressure there is to drive down prices to win market share. The idea that this would be the effect of a public option is hard to fathom, and the result seems to be to redefine the meaning of "competition" as that the existence of a public option that could in theory run at a loss and even if it didn't exist, if it could be "triggered" if insurance companies don't mean targets, is that "competition" means providing monopoly pressure to get all insurance companies to provide uniform coverage that satisfies political objectives of expanding coverage, etc.
Similarly, Obama wants to maintain competition and choice in the financial sector. Unfortunately, recent financial history seems to show a problem with robust competition in financial markets and the kind of sensible regulation that Obama wants to prevent this type of crisis from occurring again. Again unfortunately, if anything seems to be apparent from the history of bubbles, from speculators driving the price of some tulip bulbs above that of a house in 17th century Holland, to a rogue Scotch murderer bankrupting the French Monarchy by selling colonial estates on Louisiana swamp land to having two real-estate speculation driven crisis in about 20 years the ingenuity of greedy people to avoid the gaze of financial regulators seems boundless. And of course, greed is a part of human nature that will not go away after this economic crisis.
More than a year ago, before Lehman was allowed to collapse, Hank Paulson, then Treasury Secretary and former CEO of Goldman Sachs (a rival of Bear Stearns) had two conflicting problems that would define the initial phase of the crisis. First, he didn't seem to understand both the scope of the interconnectedness of the various "shadow banks," that is, financial institutions that held deposits and loaned out money to make a return on investment that were not commercial banks, and also failed to perceive the degree to which their mortgage-backed securities were vastly overvalued. His second problem was that he wanted to avoid a problem that has been and remains a fundamental tenet of management of risk management in a system of interconnected entities: moral hazard. As Americans learned in a visceral manner, moral hazard is the risk that if an entity that takes an overly large risk is about to go bust but is saved by intervention from overseers--in the case of Bear the Federal regulators at Treasury--in other words, if regulators act on the belief that some group of entities are "too big to fail," that action sends a strong message to similar entities that they will not be allowed to fail either. This creates perverse incentives for, in this case, the firms in the shadow banking sector not to perform sufficiently rigorous and conservative internal risk management. While ratings agencies had given nearly worthless paper grades of A, AA and AAA, truly prudent firms would not have relied on a few outside opinions and examined the fundamentals of these securities, especially before betting on them in such a highly leveraged manner (i.e. with borrowed money, meaning that if the investment goes completely belly up then the loss can exceed the amount of money that was put in by a large multiple.)
When Bear was stuttering Hank Paulson tried to split the difference by basically trying to create what he thought was a bailout that no other business would want to undergo; a company whose share price was about $60 a month before its crisis was told it was not going to be allowed to go bankrupt by Treasury, but instead of being bought out at the taxpayer's expense at what people were predicting would be something like $20 a share, the grim news was that the buyout would be $2 a share. People with large positions in Bear had significant fractions of their portfolio wiped out. If Bear had been a single rogue company that had been betting on these treasury backed securities and other companies had been more responsible, perhaps this bailout nobody else would want would have circled the square of avoiding moral hazard and allowing Bear to survive and eventually recover.
Of course that didn't happen. Many other firms were staring oblivion in the face. A year ago today, due to the lack of understanding of the interconnectedness of the banks, Paulson did not repeat the action with Lehman. Merrill Lynch had to have a hastily financed sale to Bank of America to avoid completely evaporating. At this point Treasury realized its colossal error and prevented one of the largest insurers in the world, AIG, from collapsing, and forced a number of other firms to take government money to back up confidence that the firms were solvent. In further actions the Obama government would attempt a Keynsian injection of a similar but slightly smaller scale to the original emergency backstop of TARP and diverse firms in other sectors of the economy were further deemed too big to fail for political reasons: some banks but most notably GM, which has essentially been nationalized.
Meanwhile, in the year since the crash, a vague sense of normalcy (and salaries) have return as Wall Street has rebounded and markets have recovered. Obama's scolding of the businessmen who he addressed today, unfortunately, is perhaps the best he can do in terms of trying to circle the square that Paulson could not. Overly burdensome regulation could stifle one of the most productive sectors of the U.S. economy; while liberals might glee in the idea of the downfall of Wall Street, without the income taxes on the high incomes of individuals in a sector of the economy that in the boom years of the early 2000s was 20-30% of the economy financing government programs seems even more problematic. The idea that we can eliminate systematic risk by limiting executive compensation or with more moderate reforms (like the type Obama has proposed) like increased transparency in hedge funds or limits on the degree to which investments can be levered might be true; the idea that these reforms would both have a benign effect on the financial sectors' profitability and perhaps more importantly prevent systematic risk in the future are overoptimistic.
In this global economy capital can easily flow out of the country in order to seek a greater return if American funds are limited in their suite of investment tools, and if a new regulatory structure is backward looking and regulates the sectors of the economy where high-risk, high-reward strategies were tried in the past allows the same high-risk, high-reward strategies to simply flow somewhere else, then you've simply shut the barn door after the horses left. One more problem is that a contributing factor to the crisis was that the mortgage was far from free--two of the biggest nominally private firms that were government creations, Fannie Mae and Freddie Mac, combined held over 50% of U.S. mortgages and contributed to the sense that the whole panoply of financial institutions could not be allowed to fail. A year in retrospect, some argue that this might not have been entirely true. While the depth and severity of the crisis probably would have been significantly worse if the government had simply sat and watched as huge firms holding a large fraction of U.S. mortgages went broke, the fact that massive spending, monetization of debt, and domestic reforms have trumped reform of Wall Street's rule in the wake of the crisis signal that for all the talk of getting tough with Wall Street that the end result of this once in a lifetime crisis might be little more than talk.
I'll be honest: it's talking out of both sides of your mouth to oppose regulations that meaningfully eliminate systemic risk and to outright oppose any further government intervention into the financial sector: if the government hadn't provided a backstop for the financial sector then much of it wouldn't exist anymore to have gotten back to generating large revenues again. This is a case where bi-partisan efforts can truly be useful, if we come at the problem from the perspective that capitalism is generally a good thing, but like any system that allows actors significant freedom, is prone to those actors either intentionally breaking the rules or making stupid decisions. If the government can recognize that the point is not to punish Wall Street for its perceived sins but to try to fix problems where they exist and to try to allow Wall Street firms to thrive while decoupling their actions from a system where risk is so intertwined and massive that a speculative bubble in one firm can trigger a systematic collapse, change, of the good kind, could result.
Now the community rating laws work to increase access to insurance--the net income on a young healthy person who pays a minimum premium helps subsidize the premium of an older, sicker person who the insurance company knows would be a net loss at almost any premium rate. Competition in the general sense when talking about economics is the idea that when a market has a level playing field and there are low barriers to entry, the more players in a market there are the more pressure there is to drive down prices to win market share. The idea that this would be the effect of a public option is hard to fathom, and the result seems to be to redefine the meaning of "competition" as that the existence of a public option that could in theory run at a loss and even if it didn't exist, if it could be "triggered" if insurance companies don't mean targets, is that "competition" means providing monopoly pressure to get all insurance companies to provide uniform coverage that satisfies political objectives of expanding coverage, etc.
Similarly, Obama wants to maintain competition and choice in the financial sector. Unfortunately, recent financial history seems to show a problem with robust competition in financial markets and the kind of sensible regulation that Obama wants to prevent this type of crisis from occurring again. Again unfortunately, if anything seems to be apparent from the history of bubbles, from speculators driving the price of some tulip bulbs above that of a house in 17th century Holland, to a rogue Scotch murderer bankrupting the French Monarchy by selling colonial estates on Louisiana swamp land to having two real-estate speculation driven crisis in about 20 years the ingenuity of greedy people to avoid the gaze of financial regulators seems boundless. And of course, greed is a part of human nature that will not go away after this economic crisis.
More than a year ago, before Lehman was allowed to collapse, Hank Paulson, then Treasury Secretary and former CEO of Goldman Sachs (a rival of Bear Stearns) had two conflicting problems that would define the initial phase of the crisis. First, he didn't seem to understand both the scope of the interconnectedness of the various "shadow banks," that is, financial institutions that held deposits and loaned out money to make a return on investment that were not commercial banks, and also failed to perceive the degree to which their mortgage-backed securities were vastly overvalued. His second problem was that he wanted to avoid a problem that has been and remains a fundamental tenet of management of risk management in a system of interconnected entities: moral hazard. As Americans learned in a visceral manner, moral hazard is the risk that if an entity that takes an overly large risk is about to go bust but is saved by intervention from overseers--in the case of Bear the Federal regulators at Treasury--in other words, if regulators act on the belief that some group of entities are "too big to fail," that action sends a strong message to similar entities that they will not be allowed to fail either. This creates perverse incentives for, in this case, the firms in the shadow banking sector not to perform sufficiently rigorous and conservative internal risk management. While ratings agencies had given nearly worthless paper grades of A, AA and AAA, truly prudent firms would not have relied on a few outside opinions and examined the fundamentals of these securities, especially before betting on them in such a highly leveraged manner (i.e. with borrowed money, meaning that if the investment goes completely belly up then the loss can exceed the amount of money that was put in by a large multiple.)
When Bear was stuttering Hank Paulson tried to split the difference by basically trying to create what he thought was a bailout that no other business would want to undergo; a company whose share price was about $60 a month before its crisis was told it was not going to be allowed to go bankrupt by Treasury, but instead of being bought out at the taxpayer's expense at what people were predicting would be something like $20 a share, the grim news was that the buyout would be $2 a share. People with large positions in Bear had significant fractions of their portfolio wiped out. If Bear had been a single rogue company that had been betting on these treasury backed securities and other companies had been more responsible, perhaps this bailout nobody else would want would have circled the square of avoiding moral hazard and allowing Bear to survive and eventually recover.
Of course that didn't happen. Many other firms were staring oblivion in the face. A year ago today, due to the lack of understanding of the interconnectedness of the banks, Paulson did not repeat the action with Lehman. Merrill Lynch had to have a hastily financed sale to Bank of America to avoid completely evaporating. At this point Treasury realized its colossal error and prevented one of the largest insurers in the world, AIG, from collapsing, and forced a number of other firms to take government money to back up confidence that the firms were solvent. In further actions the Obama government would attempt a Keynsian injection of a similar but slightly smaller scale to the original emergency backstop of TARP and diverse firms in other sectors of the economy were further deemed too big to fail for political reasons: some banks but most notably GM, which has essentially been nationalized.
Meanwhile, in the year since the crash, a vague sense of normalcy (and salaries) have return as Wall Street has rebounded and markets have recovered. Obama's scolding of the businessmen who he addressed today, unfortunately, is perhaps the best he can do in terms of trying to circle the square that Paulson could not. Overly burdensome regulation could stifle one of the most productive sectors of the U.S. economy; while liberals might glee in the idea of the downfall of Wall Street, without the income taxes on the high incomes of individuals in a sector of the economy that in the boom years of the early 2000s was 20-30% of the economy financing government programs seems even more problematic. The idea that we can eliminate systematic risk by limiting executive compensation or with more moderate reforms (like the type Obama has proposed) like increased transparency in hedge funds or limits on the degree to which investments can be levered might be true; the idea that these reforms would both have a benign effect on the financial sectors' profitability and perhaps more importantly prevent systematic risk in the future are overoptimistic.
In this global economy capital can easily flow out of the country in order to seek a greater return if American funds are limited in their suite of investment tools, and if a new regulatory structure is backward looking and regulates the sectors of the economy where high-risk, high-reward strategies were tried in the past allows the same high-risk, high-reward strategies to simply flow somewhere else, then you've simply shut the barn door after the horses left. One more problem is that a contributing factor to the crisis was that the mortgage was far from free--two of the biggest nominally private firms that were government creations, Fannie Mae and Freddie Mac, combined held over 50% of U.S. mortgages and contributed to the sense that the whole panoply of financial institutions could not be allowed to fail. A year in retrospect, some argue that this might not have been entirely true. While the depth and severity of the crisis probably would have been significantly worse if the government had simply sat and watched as huge firms holding a large fraction of U.S. mortgages went broke, the fact that massive spending, monetization of debt, and domestic reforms have trumped reform of Wall Street's rule in the wake of the crisis signal that for all the talk of getting tough with Wall Street that the end result of this once in a lifetime crisis might be little more than talk.
I'll be honest: it's talking out of both sides of your mouth to oppose regulations that meaningfully eliminate systemic risk and to outright oppose any further government intervention into the financial sector: if the government hadn't provided a backstop for the financial sector then much of it wouldn't exist anymore to have gotten back to generating large revenues again. This is a case where bi-partisan efforts can truly be useful, if we come at the problem from the perspective that capitalism is generally a good thing, but like any system that allows actors significant freedom, is prone to those actors either intentionally breaking the rules or making stupid decisions. If the government can recognize that the point is not to punish Wall Street for its perceived sins but to try to fix problems where they exist and to try to allow Wall Street firms to thrive while decoupling their actions from a system where risk is so intertwined and massive that a speculative bubble in one firm can trigger a systematic collapse, change, of the good kind, could result.
Labels: economics, government
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