Sunday, January 17, 2010

Chicago School interviews

John Cassidy has the interviews he did for this article on the Chicago School and the financial crisis up on his New Yorker blog.

I particularly liked the comments of Raghuram Rajan.

... All I am saying is that there are no easy answers in this thing … and one doesn’t have to be corrupt or in the pay of the financial sector to say, hey, wait a minute: it’s not as simple as letting them all go under or taking them all over. That’s my rant about the banking sector. By and large, I think we’ve done all the things that needed to be done. I think the downside of what we haven’t done is that we haven’t made the banks face up to more pain. That would have made it politically easier to do what needed to be done.

When you say, “make the banks face up to more pain,” what do you mean? Tougher regulation? Big equity stakes for the government—along the British lines?

Equity stakes and other things. For example, even now [the government] can require all compensation above a certain amount to be paid in equity, and equity that is real equity. The way banks do it now is they pay people in shares, but they also buy back equal amounts of shares [in the market]. So there is no increase in capital.

What we have right now is a situation where every saver in the country is, essentially, paying a huge tax to bail out the banking system. We are all getting screwed on our money market accounts—getting 0.25 per cent—and the banks are making a huge spread on nearly every asset they hold, because they are financing them at pretty close to zero rates. Another way of doing this—a way that would be nice to try—is to force the banks to load up on capital.

What is the point of all this? The point of all this is to get banks to lend. Well, they have been doing everything else except lending. Now, it may be that there aren’t that many profitable lending opportunities at this point. But if there aren’t, why are all the savers paying for this? Because you are not getting them to lend any more, and you are not getting more investment, which was the whole point of having interest rates so low. In fact, what you are doing is setting up a whole lot of other asset bubbles at this point.

Another way would be to put more direct pain on the banks. For example, if they were flush with capital and found they couldn’t pay bonuses, so all of this [money] went into increasing the capital base, they would have an incentive to make loans to reduce the effective capital that they had. What we have at the moment is that the citizenry is paying for the banks. Get the banks to pay for themselves.

That gets away from the whole Chicago issue. But what I’m arguing is in Chicago you have the extreme, which says, “Let the chips fall they may. What’s the problem with letting a few banks go under?” Whether you hold that view depends on how much you think the banks as an institution matters. Doug Diamond and I think it does matter. There is a lot of organizational and relationship capital embedded in the banks. If you let them go, it is very hard to start them up [again].

I think the average person can (maybe) grasp that we want to recapitalize the banking system, but I don't think anyone understands why bankers should be getting record bonuses just a year or two after nearly destroying our economy and suffering losses equal to many past years of "earnings" that they've already been paid for.


Anonymous said...

I don't understand this passage very well (not surprising, given that I'm not an economist). What scenario does the second highlighted paragraph actually describe? Banks get capital infusions, but are forbidden from paying out bonuses or playing with non-lending fire?

And I don't understand why savers are described as a kind of victim to the banks. If the entire system has beome very much risk averse, isn't it expected that the huge demand for risk-free assets will kill their return?

Dave Backus said...

Nice post. Rajan's a wonderfully thoughtful economist, as are many at Chicago. Which is why the premise of Cassidy's interviews (Chicago = monolithic free market dogma) strikes me as dumb. Pretty much all economists, at Chicago and elsewhere, understand that markets operate in an institutional environment, and that the institutions are important. Nowhere more so than in finance, where the costs of getting it wrong -- or even not quite right -- are obvious.

On the second para -- or rather the whole thing, since they're all connected: we need to separate two things. One is punishment. I understand the emotional -- and political -- demand for this response, but that horse is out of the barn. The other -- more important -- one is setting up rules and regulations that make it harder to suffer similar damage in the future. It's an incredibly complex exercise, but that's the goal. The details are really a distraction.

One issue that I think is very important is the ability of our political system to do the right thing. If we're honest, much of the weak regulation that facilitated the crisis can be traced to political leaders of both parties. There's more than a little irony in Congress's current investigation of what went wrong. A topic for future discussion: how US political processes compare to (say) China's.

David Coughlin said...

I have a quick question. Is the implication of your last paragraph that we of limited mental means would be able to grasp the righteousness of the record bonuses if we were smarter? Or is it that we can't grasp it because it is smoke and mirrors.

Keith Power said...

"There is a lot of organizational and relationship capital embedded in the banks. If you let them go, it is very hard to start them up [again]."

What exactly is that capital worth ?

There is a prevailing assumption that the bigger institutions must not be allowed to fail but I would like to see evidence to back this assumption. I would like to know both the cost and distribution of cost for letting the banks fail vs bailing them out. Obviously in the latter case the cost is distributed among the tax-payers which makes it quite attractive to politicians and big finance.

LondonYoung said...

Sigh ...

First point - paying bonuses in equity is idiotic. The systemic risk is banks defaulting on their counterparties. Equity investors are prepared for a loss - because they are in it for the upside. Paying bonuses in equity encourages risk-taking - you get both upside and downside. Paying in deferred debt aligns the employees with the system - avoid risk, there is no upside! At all the blown-up shops the key players were all loaded up with equity. It is very frustrating to me that this obvious point is missed.

Second point - yes, making the banks have more capital is a great idea. There are clear metrics for capital and it would be trivial to regulate that the banks need to hold more. The failure of our government to do so is straightforward proof that the administration is purely political. What is the downside to asking all banks to have a 15% common capital ratio? Answer: none.

LondonYoung said...

and Keith Power - I agree with you, I would LOVE to see evidence of the harm in allowing big institutions to fail. IMHO, there is actually very little harm in allowing institutions to fail given that we have a fiat money system. I could see the case in the gold standard days, but not anymore ...

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