I have always flattered myself that I would someday die either in prison or with a rope around my neck. So I was excited when The Epicurean Dealmaker invited me to write about financial regulation and crosspost at a site called The New Decembrists. But my views on the topic have grown both more vehement and more distant from the terms of the current debate (such as it is), and I’m having a hard time expressing myself. So I’ll ask readers’ indulgence, go slowly, and start from the beginning. This will be the first long post of a series.

Banks are not financial intermediaries. Their role is not, as the storybooks pretend, to serve as a nexus between savers with capital and entrepreneurs in need of capital for economically valuable projects. Savers do transfer funds to banks, and banks do transfer funds to borrowers. But transfers of funds are related to the provision of capital like nightfall is related to lovemaking. Passion and moonlight are often found together, yes, and there are reasons for that. But the two are very distinct phenomena. They are connected more by coincidence than essence.

The essence of capital provision is bearing economic risk. The flow of funds is like the flow of urine: important, even essential, as one learns when the prostate malfunctions. But “liquidity”, as they say, takes care of itself when the body is healthy. In financial arrangements, whenever capital is amply provided — whenever there is a party clearly both willing and able to bear the risks of an enterprise — there is no trouble getting cash from people who can be certain of its repayment. Always when people claim there is a dearth of “liquidity”, they are really pointing to an absence of capital and expressing disagreement with potential funders about the risks of a venture. Before the Fed swooped in to provide, 2007-vintage CDOs were “illiquid” because the private parties asked to make markets in them or lend against them perceived those activities as horribly risky at the prices their owners desired. There was never an absence of money. There was an absence of willingness to bear risk, an absence of capital for very questionable projects.

No economic risk is borne by insured bank depositors. We have recently learned that very little economic risk is borne by the allegedly uninsured creditors of large banks, and even equityholders — preferred and common — have much of the risk of ownership blunted for them in a crisis by terrified governments. The vast, vast majority of bank capital is therefore provided by the state. Prior to last September, uninsured creditors of US banks were providing some capital. Though they relied upon and profited from a “too big to fail” option when buying bonds of megabanks, there was some uncertainty about whether the government would come ultimately come through. So creditors bore some risk. During the crisis, private creditors wanted out of bearing any of the risk of large banks. Banks were illiquid because private parties viewed them as very probably insolvent, and were unsure that the state would save them.

The US banking system was recapitalized by precisely three words: “no more Lehmans”. All the money we shelled out, the TARP, the Fed’s exploding balance sheet, the offered-but-untapped “Capital Assistance Program”, mattered only insofar as they made the three magic words credible. At this moment the Fed and the Treasury are crowing about how banks are now able to “raise private capital” and about “how TARP is being repaid” and “losses on TARP investments will be much less than anticipated”. That is all subterfuge and sleight-of-hand, flows of urine while the beast lumbers on. The US government has persuaded markets that it stands behind its large banks, that despite no legal right to such protection, all creditors will be made whole and equityholders will live to fluctuate another day. Banks have raised almost no private capital, in an economic sense. They have attracted liquidity on the understanding that the government continues to bear the downside risk.

It’s unfair to say that the government now supplies all large bank capital. Stockholders still suffer price volatility and there is some uncertainty that the government will remain politically capable of being so generous. But the vast majority of large-bank economic capital is now supplied by the state, regardless of the private identities and legal forms associated with bank funding arrangements. So long as the political consensus to support them is strong, American megabanks are in fact exceedingly well capitalized, as the US dollar risk-bearing capacity of their public guarantors is infinite. But that is not a good thing.

No iron law of economics ensures that those who bear the risk of an enterprise enjoy the fruit of its successes. Governments have the power to absorb the downside of formally private enterprises (and the libertarian so principled as to refuse a bail-out is very rare indeed). But they have no automatic ability to collect profits or capture gains from organizations that they economically capitalize, but do not legally own. Bearing the downside risk of a project with no claim on the upside is the circumstance of the writer of an option. Private parties who write options, either explicitly or implicitly via credit arrangements, demand to be paid handsomely for accepting one-sided risk. Governments do not. Banks pay deposit insurance premia, but only on a fraction of the liabilities the government guarantees and in a manner that does not discriminate between the prudent and reckless (which creates a public subsidy to recklessness). When governments have lent to banks during the crisis, they have lent at well below the rates even untroubled, creditworthy nonfinancial borrowers could obtain on the market, so that the implicit option premia embedded in credit spreads were somewhere between negligible and negative. Governments paid banks for the privilege of insuring their risks, or to put it more accurately, they acknowledged that they had already insured bank risks and found ways of paying out claims via subsidies sufficiently hidden as to be politically palatable.

As we think about how to regulate banks going forward, we must first be clear about what we are doing. We are negotiating the terms of options that the government will offer to bank stakeholders. It is important to understand that, for both practical and philosophical reasons. As long as the state substantially bears the downside risks of the financial system, by virtue of explicit legal arrangements or de facto political realities, philosophical arguments for deregulation are incoherent. Deregulation is equivalent to a blank check from the state. If you are philosophically in favor of free market capitalism, you must be in favor of very radical changes in the structure of banking, towards a system under which the state would have no obligation to intervene, and would in fact not intervene, to support bank stakeholders even when their enterprise threaten to collapse. The “resolution regimes” currently proposed do not restore “free market” incentives, because those proposals codify rather than forbid state assumption of risk and losses in the event of a crisis. A free market resolution regime would allocate losses among private stakeholders only, and prevent any loss-shifting to the government. For the moment, such a regime, and the structural changes to the banking system that would be required to make it credible, are politically beyond the pale.

So, the options written by government to bank stakeholders will remain in place. All that remains, then, is to negotiate the terms of those options. Framing bank regulation in terms of option contracts underlines a reality that is tragic but true: options are zero-sum games. One party’s benefit is another party’s cost. Very deeply, there is no confluence of interest we can seek between our best and brightest financiers and the public good. Terms that are good for banks are bad for taxpayers. Negotiating the terms of an option with a wealth-seeking counterparty is an inherently adversarial affair. When President Obama is on the phone with Jamie Dimon, do you think he keeps that in mind? A fact of life that our President seems not to enjoy is that while sometimes there are miscommunications that can be resolved via open exchange, sometimes there are genuine conflicts of interest that must simply be fought out. Bank regulation, alas, is much more the latter.

There are indirect as well as direct effects of option contracts, so maybe I’ve framed things too harshly. After all, we allow and encourage formal derivatives exchanges because, even though the derivative contracts themselves are zero-sum, they permit businesses to insure against risks, and that insurance can enable real wealth creation that might not have otherwise occurred. We claim that derivatives markets make indirect positive contributions to the real economy, despite the fact that their direct effect is simply to shuffle money between participants. Banking also just shuffles money around, but we generally think that it enables important business activity. So one might argue that banks and the public have a common interest after all, and smart regulation to evolve could from a more consensual process. But, one would be wrong. We all have a stake in the existence of a payments system, and banks provide one, but managing that is a largely riskless activity, conceptually separable from the lending and investing function of banks. We would also like our economic capital to be allocated productively. But the effect of writing a more bank-friendly options contract is to reduce the penalties for poor capital allocation while enhancing the payoffs to big, long-shot risks. Banks destroy Main Street wealth and create Wall Street crises by making foolish and indiscriminate use of the capital entrusted to them. If we desire a better banking system, we must limit the degree to which private stakeholders can expect to be made whole by the state. With respect to regulation, what’s good for Goldman Sachs is quite opposed to what is good for America. The point of regulating is to align public and private interests by imposing costly limitations on how banks can behave. Indirect considerations of public welfare reinforce rather than reduce the degree to which bank regulation is zero-sum, a fight that pits the health of the real economy against the distributional interests of bank stakeholders.

However, there is some light in the bleakness. Once we understand that we are negotiating option contracts, we can look to some guidance from the private sector. Option-like private contracts are negotiated all the time, and the issues that surround managing them are well understood. A compare-and-contrast of public sector bank regulation and private sector contracts will prove informative. That will be the subject of our next installment.

Acknowledgments: To be acknowledged by me is like being kissed by a putrescent semi-decapitated halitotic zombie creature. Nevertheless, I failed to weave many links into the above, and my thinking on these issues owes a lot to a bunch of people who are smarter and better smelling than me, so I feel duty bound to mention them. In particular, it was Winterspeak and Mencius Moldbug who fully disabused me of the notion that banks are intermediaries between private parties, which pushed me to think more deeply about the meaning of bank capital, and capital in general. Others who have the misfortune of having influenced my thinking on these issues include supercommenter JKH, Economics of Contempt, Wonkess, The Epicurean Dealmaker, James Kwak, Mike Konczal, and John Hempton. (I’m sure there are more I’ve missed: count yourselves lucky!) But the views expressed above are my own, and all of the people I’ve mentioned are far too sensible lend them any credence.

Felix Salmon has been on a tear lately. If you haven’t already, go read his fantastic post on the appalling double standard whereunder human creditors are morally bound to repay all loans while business debtors have a duty to default whenever they find advantage in doing so.

In another great post, Felix quotes commenter Dan, who argues that rather than “lend to a nearly bankrupt and profligate entity” (he means the US Treasury), investors might “learn basics of business and investing and carefully loan out [funds] to local small businesses.”

I love the idea of small business investing, in theory. But I don’t do it, because, in practice, it is time consuming and fraught with economic, legal, and interpersonal risks. One of the sad ironies of our pseudocapitalmarkets is that it is easy for small investors to supply funds to firms that are large and distant, about which we have little unusual insight. But it is difficult to build a diverse portfolio out of local firms we know intimately and have a personal stake in. This is an area where regulation is more a part of the problem than part of the solution: it is prohibitively expensive for the brilliantly run café down the way to meet all the requirements of selling public equity via pink sheets, let alone getting listed on Nasdaq SmallCap and doing an IPO.

In any case, common stock is a poor vehicle for small business investing, because it is nearly impossible to value even with the most elaborate financial reporting, and offers minority investors so weak a claim that thieves and charlatans flock to provide. There is no easier business than selling empty promises for good money. So, in the world-as-it-is, only investors willing to actively participate in a small business (or at least to actively supervise) take equity stakes, while more distant third parties prefer debt, with its promise to pay on time, or else.

But those choices are too stark. Small entrepreneurs would like outside investors to share the risk of building and running a firm in this dangerously uncertain world. They’d like outside investors to make their enterprise more robust. But debt financing magnifies the risks of a living firm. Entrepreneurs share burdens with debt investors only via bankruptcy, or via painful negotiations to forestall bankruptcy.

Outside investors who are enthusiastic about a small business might well be willing to provide the flexibility that entrepreneurs would want, in exchange for a bit of upside. But again, common equity is a nonstarter for passive investors in very small firms. Conventional preferred equity doesn’t work either: preferred investors tend to view nonpayment of dividends as default, and the lack of a legal ability to enforce doesn’t make them happier. Entrepreneurs therefore find preferred equity expensive to raise (especially given the tax disadvantage! see here and here and here and here and here). Since investor expectations of payment don’t correlate with business success, it doesn’t really diminish entrepreneurs’ cash flow risk. Psychologically, since there is unlikely to be liquid secondary markets for microbiz preferred equity, investors won’t perceive much upside in small business preferred: the base case is that dividends are paid on time and as promised, the downside is dividends are skipped and/or the business fails, leaving them screwed. One could try to sell convertible preferred to create upside, but that’s complicated to value, especially given the deficiencies of small business common stock.

If someone devised an equity instrument that would offer stronger, easier-to-value promises than common equity, that would effectively disperse entrepreneurs’ risks while offering investors an upside, that could be efficiently offered in modest chunks small investors could incorporate into diverse portfolios, I think that would be a fantastic financial innovation.

And it wouldn’t even be hard to do. For all the billions Wall Street poured into “financial innovation” over the last decade, investment bankers simply never bothered to try to solve this problem. Keep doing God’s work, Lloyd.

Here’s a sketch, one of many possible ways this circle might be squared. We’ll propose a kind of variable-maturity zero coupon bond. (Zero coupon preferred, really.) Imagine that every dollar of a small business’ operating cash inflow were indexed. That first dollar bill that gets framed and placed on the wall? That’s dollar number one. By the end of the first night of business at the new pub ‘n grub, maybe dollar number 2000 would have slid through the register.

Suppose businesses sold numbered dollars. Dollar number 420,167 has just been rung in. How much would you pay for dollar number 600,000? If you pay 91¢ for that dollar and it takes a year for the business to bring the next ~$180K, you’ve earned a 10% return. If business is great, and it only takes 6 months reach that sales level, then you earn a 20% annualized return. ROI is dependent only on the briskness of sales, something that is tangible and observable, something that customer/investors can understand and estimate. These claims would confer no control rights upon their holders (except potentially when they are in arrears), so entrepreneurs, the residual claimants, would price their goods and services to maximize profits, not revenue. Holders of fixed income / variable term claims would be along for the ride. Assuming a non-wimpy business owner, investors’ best strategy for maximizing the value of their claims is to drum up business, which is a win/win for the entrepreneur and the investor. Investor repayments would naturally correlate with business success: when business is slow, few payments to investors would come due. When business is brisk, lots of claims would mature.

This is the sort of instrument a financial technology start-up could invent and popularize. There’d be lots to think about: you’d want to provide a standardized and trustworthy accounting system to count operating cash flow, you’d want entrepreneurs to state and the system to enforce limits on the “density” of claims that entrepreneurs could sell (to keep incentives intact), you might want to provide (opt-in or opt-out) automatic reinvestment of maturing claims. A firm might permit claims to be redeemed in services rather than in cash on favorable terms, at investors’ option. Etc. At least initially, this kind of scheme would supplement, not replace traditional forms of financing. Businesses would want backup credit lines in case redemptions exceed reinvestment leaving the business starved of capital. But selling dollars of future revenue is simple enough for retail investors, for customers and clients, to understand. It could be implemented cheaply, in a standardized way, that would allow individuals to build diversified portfolios out of small exposures in the businesses they know and patronize. For entrepreneurs, it would offer a means both of raising risk-bearing capital and inspiring customer activism on behalf of the business.

Maybe this is a workable idea. Maybe not. But I am sure that the problem it tries to address is not intractible, or even that hard. If the brilliant minds behind the structured finance revolution would devote one or two percent of their synapses to inventing alternative forms of small business finance, we might find that the self-induced catastrophes of the legacy banking system needn’t translate into depressions for entrepreneurs and small businesses and all the people they employ.

Welcome to interfluidity at its new home. Hopefully I’ll have a substantive post soon. In the meantime, I’d appreciate any feedback in the comments on how the new site looks and works for you. Also, if you had subscribed, does your subscription to interfluidity‘s RSS feed still work? (Were you notified of this post without having to resubscribe?)

Hello!

Sadly, interfluidity‘s host, American Powerblogs is shutting down. Over the next few days, I’ll be migrating the site to a new provider. Hopefully, when all is said and done, everything will switch over fairly seamlessly, including the full archives, comments, etc. I’m trying really hard to avoid breaking links. But this’ll be an improvised do-it-yourself transition. I’m sure that visitors will find some oddities over the next few days.

The last thing I’m going to worry about is getting the graphic design reconstructed, so expect the site to look pretty generic for a while. Also, older posts and comments will not show up on the new front page. I’ll add a post with a link to recent past posts.

I’d like not to disturb RSS subscriptions, and will try to reproduce the feed at the same URL on the new site. But I’m not positive that will work. So, if you do want to stay subscribed to interfluidity, please double check the site directly in a few days. I’ll post a “hello world!” kind of thing when it seems like I’m up and running again. If you see that in your feed, that’ll be a good sign.

I’d like to thank American Powerblogs for a great run. They’ve been wonderful, and I’ve loved the platform and the software. I’m sure that whatever I’m moving to will feel like a big step down.

An enduring truth about financial regulation is this: Given the discretion to do so, financial regulators will always do the wrong thing.

It’s easy to explain why. In good times, regulators have every incentive to take banks at their optimistic word on asset valuations, and therefore on bank capitalization. It is almost impossible for bank regulators to be “tough” in good times, for the same reason it is almost impossible for mutual fund managers to be bearish through a bubble. A “conservative” bank examiner who lowballs valuation estimates will inevitably face angry pushback from the regulated bank. Moreover, the examiner will be “proven wrong”, again and again, until she loses her job. Her fuddyduddy theories about cash flow and credit analysis will not withstand empirical scrutiny, as crappy credits continually perform while asset prices rise. Valuations can remain irrational much longer than a regulator can remain employed.

Bad times, unfortunately, follow good times, and regulatory incentives are to do the wrong thing yet again. When bad times come, overoptimistic valuations have been widely tolerated. In fact, they will have become very common. Overvaluation of assets leads to overstatement of capital. Overstatement of capital permits banks to increase the scale of their lending, which directly increases reported profitability. Banks that overvalue wildly thrive in good times. Fuddyduddy banks lag and their CEOs are ousted and The Economist runs snarky stories about what schlubs they are. The miracle of competition ensures that many of the most important and successful banks will have balance sheets like helium balloons at the end of a boom. Then, like a pin from outer space, somebody somewhere fails to repay a loan.

When this happens, bankers beg forbearance. They argue that the rain of pins will eventually pass and most of their assets will turn out to be fine. They ask regulators to allow them to write down assets gently, slowly, so that they can let ongoing earnings support or increase their regulatory capital. If that doesn’t work, they suggest that capitalization thresholds be temporarily lowered, since what good is having a buffer against bad times if you can’t actually use it in bad times? Knowing, and they do know, that their assets are crap and that they are on a glide path to visible insolvency, they use any forbearance they extract to “gamble for redemption”, to make speculative investments that will yield returns high enough to save them, if things work out. If they don’t, the bankers were going to lose their banks anyway. The additional losses that fall to taxpayers and creditors needn’t concern them.

Here, wouldn’t regulators draw the line? When the trouble is with just a few small banks, the answer is yes, absolutely. Regulators understand that the costs of closing a troubled bank early are much less than the costs after a delay. If a small bank is in trouble, they swoop in like superheroes and “resolve” it with extreme prejudice.

But when very large banks, or a very large number of banks are in trouble, the incentives change. Resolving banks, under this circumstance, will prove very expensive in terms of taxpayer dollars, political ill-will, and operational complexity. It will reveal regulators to have been asleep at the wheel, anger the public, and alienate nice people whom they’ve worked closely with, whom they like, who might otherwise offer them very nice jobs down the line. When a “systemic” banking crisis occurs, regulators’ incentives are suddenly aligned with bankers: to deny and underplay, to offer forbearance, to allow the troubled banks to try “earn” their way out of the crisis. Regulators, in fact, can go a step further. Bankers can only “gamble for redemption”, but regulators can rig the tables to ensure that banks are likely to win. And they do. A central bank might drop short-term interest rates very low to steepen the yield curve. It might purchase or lend against iffy assets with new money, propping up prices and ratifying balance sheets. It might pay interest to banks on that new money, creating de novo a revenue stream based on no economic activity at all. Regulators might bail out prominent creditors and counterparties of the banks, suddenly transforming bad bank assets into government gold. Directly or via those bailed out firms, regulators might engage in “open market transactions” with banks, entering or unwinding positions without driving hard bargains, leaving taxpayer money on the table as charity for the troubled institutions. They might even redefine the meaning of financial contracts in a subtle ways that increase bank revenues at the expense of consumers.

If all that stuff works out, regulators might be able to claim that they didn’t do such a bad job after all, that the crisis was just a “panic”, that their errors prior to the crisis were moderate and manageable and it was only the irrational skittishness of investors and the taunts of mean bloggers that made things seem so awful for a while. Regulators, like bankers, have everything to gain and little to lose by papering things over. And so they do. Besides, things here weren’t nearly as bad as in Europe.

There was nothing new or different about the recent financial crisis, other than its scale. Yes, the names of the overvalued financial instruments have changed and newfangled derivatives made it all confusing about who owed what to whom and what would explode where. But things have always blown up unaccountably during banking crises. We have seen this movie before, the story I’ve just told you is old hat, and the ending is always the same. We enact “reform”. The last time around, we enacted particularly smart reform, FDICIA, which was painstakingly mindful of regulators’ incentives, and tried to break the cycle. It mandated in very strong terms that FDIC take “prompt corrective action” with respect to potentially troubled banks.

The theory of “prompt corrective action” was and is very sensible. It’s pretty clear that the social costs increase and the likelihood of an equitable resolution to problems decreases the longer banks are permitted to downplay weakness, the more regulatory forbearance banks are granted, or the more public capital banks are given. (An “equitable resolution”, in this context, means giving the shaft to bank managers, shareholders, and unsecured creditors to minimize costs to taxpayers and to sharpen the incentives of bank stakeholders to invest well. “Regulatory forbearance” and “public capital injection” are redundant: Under current banking practice, regulatory forbearance is economically equivalent to an uncompensated injection of public capital, like TARP but without the messy politics and with no upside for taxpayers. Make sure you understand why.)

So FDICIA tried to short-circuit our woeful tale by telling regulators they should have a twitchy trigger finger. If regulators intervene early and aggressively, the costs of the crisis will be moderate, and since the costs of the crisis are moderate, it should actually be plausible for regulators to intervene early and aggressively rather than playing the world’s most expensive game of CYA. It was a great idea. Except it didn’t work.

We’ve already told the story of why it doesn’t work. Bank health and safety is a function of capitalization, capitalization is a function of bank asset valuation, and there is no objective measure of asset valuation. During good times “conservative” valuations are demonstrably mistaken and totally unsupportable as grounds for confiscating the property of respected, connected, and wealthy businesspeople. Regulators simply fail to take prompt corrective action until it is far too late.

As you read through the roughly 1400 pages of currently proposed regulatory reform, ask yourself what, if anything, would interfere with the (uncontroversial and long-understood) dynamic that I’ve described. Giving regulators more power doesn’t help, when regulators have repeatedly failed to use the powers they had. Putting more bank-like institutions and activities under a regulatory umbrella seems sensible, as does eliminating opportunities for firms to choose among several regulators and shop for the most permissive. But even our most vigilant and competent regulator (hi FDIC!) was totally snowed by this and the previous two banking crises. It has become fashionable to suggest that the idea of “systemic risk” is novel, and that just having some sort of high-level, blue ribbon council explicitly charged with worrying about financial catastrophes will change everything. But financial meltdowns are not new, Timothy Geithner was giving smart, widely discussed speeches about systemic risk in 2006, exactly as the current crisis was building.

There is, unfortunately, almost no correlation between the degree to which an institution or sector is supervised by regulators and behavior or misbehavior during a financial crisis. Commercial banks, GSEs, and bond insurers were intimately regulated and are now toast. Mortgage originators, boutique securitizers, ratings agencies, and CDS markets were largely unregulated. They also clearly failed. The one trainwreck that the current round of proposals might have forestalled is AIGFP, whose unhedged, uncollateralized CDS exposure would make even the most lackadaisical regulator blush. But it is not at all plausible, especially in the US, that AIG was the linchpin without which the late troubles would not have occurred. If we had to refight the last war under all the regulations now proposed, we might have won one battle. But we’d very definitely have lost the war. Deregulation won’t solve the problem. But neither will the sort of regulation now proposed by Barney Frank or Chris Dodd.

But what about Bernie Sanders? Is “too big to fail” the problem? Yes and no. Unsustainable bank-funded asset price booms can and do occur even among small banks. But systemic crises are more likely in a world with big banks, as only one or two need totter to take down the world. Chopping up banks reduces the frequency of major crises. Also, “prompt corrective action” does sometimes work for small banks. For big banks, PCA is just a joke — Citibank is and always will be perfectly healthy until it is totally a basket case. But regulators do stage early interventions in smaller banks, even during relatively quiet times, and that does help. Crises among small banks can lead to large fiscal costs (c.f. the S&L bailout). But even during serious crises, many small banks turn out to have been prudent, and small banks tend not to be so interconnected that a cascade of failures leaves us without a financial system. Small-bank-based systems fail gracefully. (See Felix Salmon.) Crises among small banks are less corrosive to incentives for careful capital allocation, and less offensive to distributive justice, than large bank crises, because regulators are willing to force preferred equityholders and unsecured creditors of smaller banks to bear losses while they hesitate to do so for big banks. Also managers of smaller banks can be perfunctorily defenestrated, while managers of megabanks somehow survive (and even when they don’t, they are too wealthy to have to care). Again, one hates to be mean, but treating the managers of trouble-causing banks roughly is important both to get the incentives right and out of regard for justice.

We should insist upon a market structure in which financial institutions are universally small. But smallness cannot be defined by balance-sheet assets alone. We need to manage the degree of interconnectedness and the scale of total exposures (including off-balance sheet exposures arising from derivative market participation). Further, we need to ensure that no market participants are indispensable by virtue of controlling some essential market infrastructure. Clearing and payments systems, securities and derivatives exchanges, etc should be multiple and redundant if privately owned, or publicly managed if efficiency demands a monopoly provider. Essential infrastructure should be held by entities that are bankruptcy remote from firms that bear unrelated risks, although the stakeholders needn’t be bankruptcy remote from the critical infrastructure. (For example, if the owner of a derivative exchange goes under, the exchange must be immune from liability, but if the exchange suffers losses due to insufficient collateral requirements, the owner could still be liable.)

Fundamentally (and a bit radically), for financial reform to be effective, regulators must actively target market structure. Financial systems are public/private partnerships, not purely private enterprises. It is perfectly reasonable for the state as the ultimate provider of funds and bearer of risk to insist on a robust and heterogeneous network of delegates. Regulators needn’t (and really cannot) architect the breakup of today’s destructive behemoths. All they need to do is identify dimensions along which firms become indispensable or threatening to financial stability as they grow, and tax measures of those attributes at progressively steeper rates. The taxes could be slowly phased in over a few years, to give existing firms time to arrange efficient deconglomerations. Importantly, legislators should characterize the target market structure, and empower regulators to define and alter tax schedules as necessary to achieve that target, rather than specifying them in law, to counter gaming by nimble financiers. (For example, a tax on balance sheet assets would lead to rapturous innovation in tricks to keep stuff off-balance-sheet.) Taxes should always be imposed in a nondiscriminatory way across the industry. (If you are not concerned about the role of political influence and favoratism in regulatory action, you haven’t been paying attention.) “Taxes” could take the form of increased regulatory burdens, such as capitalization or reserve requirements (though the effectiveness of the latter is diminished if central banks pay interest on reserves).

Variations of these ideas are actually in both Frank and Dodd’s proposed legislation. Regulators would have a fair amount of discretion, under the new laws, to do the right thing. They could ignore the terrifying shrieks of our banking overlords and force the monsters to break apart. But we come back to the first and most ancient law of banking regulation. Given discretion, banking regulators will always, always do the wrong thing. Only if Congress defines a verifiable target market structure and periodically audits the regulators for compliance will we eliminate “too-big-and-mean-and-rich-and-scary-and-interconnected-and-sexy-to-fail”.

But what about the much vaunted “resolution authority”. Doesn’t that change the deadly dynamic of banking regulation described above? Sure, it will still be true that during booms, banks will make dumb mistakes and regulators will be unable to point out that the Swiss cheese they’re calling assets is chock full of holes. But, you might argue, when the cycle turns, they’ll no longer be helplessly forced to resort to CYA-and-pray! They’ll have the tools to wind down bad banks ASAP!

Maybe. Resolution authority might be helpful. But I’m not optimistic. During the current crisis, there are two accounts of why we guaranteed and bailed existing banks — including creditors, managment, preferred shareholders, and financial counterparties — rather than resolving the banks and forcing losses onto the private parties who made bad bets. One account emphasizes legal constraints: we had laws that foresaw the orderly resolution of commercial banks, but not investment banks or bank-holding conglomerates. According to this view, regulators’ only options were to permit Lehman like uncontrolled liquidations of financial firms or else make whole every creditor to prevent a formal bankruptcy. If this is what you think then, yes, resolution authority might change everything.

But another view — my view — suggests that despite the limitations of preexisting legislation, regulators throughout this crisis have had the capacity to drive much harder bargains, and have chosen not to. Despite having no legal authority to do so, the government “resolved” Bear Stearns over a weekend in almost precisely the same manner that FDIC resolves your average small town bank. Secretary Paulson could at that point have gone to Congress with a proposal for resolution authority to institutionalize the powers he clearly required. Instead, he had Treasury staff prepare the first version of TARP and put it on a shelf until an emergency sufficient to blackmail Congress arose. Whatever the legal prearrangements, regulators have always had sufficient leverage, over firms and firm managers, to push through any structural changes they deemed necessary and to create bargaining power for firms to insist on loss sharing. Finally, earlier this year, when bank nationalization was an active debate, opponents did not because they could not claim that authority would not be found if the administration decided nationalization was the way to go. Harsh measures towards banks would have been extremely popular. What authority the administration did not have by virtue of existing powers and informal leverage they could have achieved by purchasing common shares instead of preferred during “capital injections”, or, in a pinch, by asking Congress for help. In my view, legal niceties were never the issue. Regulators opted to guarantee the banking system and bail out creditors because given the terrifying scale of the problem, the operational complexities and investor uncertainty associated with resolutions or nationalizations, the power of the banks and regulators’ personal connections to them — our leaders simply opted not to pursue more hardball resolutions. If we don’t change the structure of the financial industry, there’s no reason to think that next time around regulators won’t use the proposed resolution authority to do exactly what they opted to do this time. They won’t even need to go to Congress for a new TARP, as Frank’s proposal gives the executive branch carte blanche to provide financial firms unlimited guarantees and support. (I haven’t read the text of Dodd’s bill.)

Yes, I know that “living wills” are supposed to diminish the operational complexity and uncertainty associated with taking a harder line, and that, in theory, might encourage different choices. I also understand that some sort of industry-funded slush fund is supposed to bear future bail-out costs. My sense is that during a gut-wrenching financial crisis, hypothetical funeral plans will provide little comfort to terrified regulators, prepaid slush funds will prove to be laughably inadequate, and commitments to make firms pay for the mess ex post will be waived in order to shore up struggling bank balance sheets. These proposals are about providing the political cover necessary to get legislation passed, but they will prove to be utterly without substance when the next crisis occurs.

I’ll end where I started. The one rule that you can rely on with respect to banking regulation is that whenever regulators have discretion, they do exactly the wrong thing. For very predictable reasons and despite the best of intentions, they screw up. Besides messing around with intragovernmental organization charts, the main proposals before Congress give regulators more power and more discretion. That just won’t work.

Afterthoughts: It is really worth considering this excellent piece by Matt Yglesias, ht Mike Konczal.

I almost always disagree with Economic of Contempt on these issues. But despite being wrong, he is very smart, and a gentleman too. You should read this piece, which gets everything right, within the confines of supervisory regulation. We need structural changes most of all, but supervisory regulation won’t be going away, and there his points are dead on. Also check out his very creative defense of Too Big Too Fail banks. I happen to think liquidity is as often vice as virtue, so I’m not persuaded. (Assets that are difficult to value should be illiquid. Otherwise investors fall prey to delusions of safety and rely upon risk-management by exit, which never works out well.) So EoC is wrong. But he’s wrong in clever ways, and always worth reading.

Go Paul Kanjorski!

On Monday, I was among a group of eight bloggers who attended a discussion with “senior Treasury officials” in Washington. Several nice accounts of that meeting have already been posted (see roundup below). Here’s mine.

First, I’d like to thank the “senior Treasury officials” for taking the time to meet with us, and for being very gracious hosts. Whatever disagreements one might have, in statistical if not moral terms it was an extreme privilege to sit across a conference table and have a chance to speak with these people. And despite the limitations of the event, I’d rather there be more of this kind of thing than less. So a sincere tip o’the hat to all of our hosts. Thank you for having us.

The second thing I’d like to discuss is corruption. Not, I hasten to add, the corruption of senior Treasury officials, but my own. As a slime mold with a cable modem, it was very flattering to be invited to a meeting at the US Treasury. A tour guide came through with two visitors before the meeting began, and chattily announced that the table I was sitting at had belonged to FDR. It very clearly was not the purpose of the meeting for policymakers to pick our brains. The e-mail invitation we received came from the Treasury’s department of Public Affairs. Treasury’s goal in meeting with us was to inform the public discussion of their past and continuing policies. (Note that I use the word “inform” in the sense outlined in a previous post. It is not about true or false, but about shaping behavior.)

Nevertheless, vanity outshines reason, and I could not help but hope that someone in the bowels of power had read my effluent and decided I should be part of the brain trust. The mere invitation made me more favorably disposed to policymakers. Further, sitting across a table transforms a television talking head into a human being, and cordial conversation with a human being creates a relationship. Most corrupt acts don’t take the form of clearly immoral choices. People fight those. Corruption thrives where there is a tension between institutional and interpersonal ethics. There is “the right thing” in abstract, but there are also very human impulses towards empathy, kindness, and reciprocity that result from relationships with flesh and blood people. That, aside from “cognitive capture”, is why we should be wary of senior Treasury officials spending too much time with Jamie Dimon. It is also why bloggers might think twice about sharing a conference table with masters of the universe, public or private. Although the format of our meeting did not lend itself to forging deep relationships, I was flattered and grateful for the meeting and left with more sympathy for the people I spoke to than I came in with. In other words, I have been corrupted, a little.

I’ve been asked, so I’ll mention that no one was flown in to attend the meeting. Many participants came from within driving distance of DC. The rest of us flew or took a train on our own dimes. We were offered a tray of cookies at the meeting, from which I abstained on principle. Those of you who think that’s silly have no idea how much I like cookies.

The content of the meeting was not very exciting. Treasury officials clearly had some points they wanted to communicate. Okay, then. I offer myself as stenographer to power:

• It worked! Officials pointed to a lot of good news in terms of visible cash flows associated with TARP and the various assistance programs. They claimed that since the Obama administration has taken office, more money has come back than has been put into the financial system (although what programs are included in that calculus I don’t know). They pointed out that the blanket money market guarantee and TGLP (for new issues) had already or soon would come to an end, and that a bunch of the post-Bear programs offered by the Fed have wound down naturally, through disuse.

• The stress tests were real. Treasury had no idea what they would show when they announced them, the tests were conducted diligently, the results were not subject to negotiation as widely reported, only errors of fact were corrected. The sole purpose of the tests was to offer a fair accounting of the state of the banks. Treasury did intend to reassure capital markets not by fudging the stress tests, but via the Capital Assistance Program under which Treasury stood by to invest to cover any capital deficiency if funds couldn’t be raised privately. Once sunlight had poured in to reveal banks’ actual condition, however, private capital was forthcoming, so government assistance was unnecessary, except for one particularly troubled institution (GMAC).

• The stress tests were not overly optimistic along the most important dimensions. Yes, unemployment, housing prices, and GDP were worse than even the “more adverse” scenario. But bank revenue and capitalization levels have exceeded stress-test projections. One official pointed out that unemployment is a poor predictor of mortgage defaults. Overall, outcomes are evolving much better than they would have hoped.

• The regulatory reform proposals Treasury is developing are for real, they are substantive, they will make a big difference and deserve our support.

• Policymakers at Treasury are sincere and working hard in the public interest. They are not resting on their laurels, and worry more than any of the rest of us possibly could about what might go wrong. Despite the positive developments thus far, they still anticipate a difficult road ahead, but are working capably to manage whatever may yet come.

• However bad our problems were, they were small compared to what European countries allowed to develop, on a relative-to-GDP basis.

Despite all the flattery and cookies, the senior Treasury officials did get quite a bit of pushback. I noted that a lot of the “on-balance-sheet” good news is a function of large contingent liabilities assumed by the government, the sort of “tail risk” that eventually did in the banks. Michael Panzner and Kid Dynamite pointed out that financial statement values are questionable, and threw out terms like “extend and pretend” and “ponzi scheme”. David Merkel, a brilliant man with a very gentle demeanor, brought the conversation back to cash flows, reminding us that valuation is uncertain but cash flows never lie. Neither side of the argument had much to say to that, since no one knows how the cash flows on financial assets built up during the credit boom will actually evolve. Yves Smith pushed back very adamantly on officials’ characterization of the stress tests, pointing out that Treasury didn’t employ enough examiner man-hours for the tests to be credible, given past precedent with much smaller institutions holding much simpler positions. She also derided the proposed derivatives reform bill as containing loopholes wide enough to drive a truck through. Accrued Interest expressed skepticism about financial regulatory reform. He’s a free-markets guy who dislikes and distrusts intrusive regulatory regimes. He wants to see an end to “too-big-to-fail” by creating a credible resolution regime that would let private risks be borne privately. Tyler Cowen asked about the stimulus funds given to states, whether it’d be difficult to wean them going forward, whether states would be in a position to game the Federal government. In person as in writing, Tyler is a master at synthesizing diverse strands. At a certain point, he took control of the meeting, and teased out what was common to our often conflicting comments — skepticism that unsustainable aspects of the financial system that preceded the crisis were actually being changed, a sense that problems were being papered over or accommodated rather than solved. John Jansen asked a series of incredibly ballsy questions about the Treasury’s specific funding plans, in terms of maturity of future bond issues. (His questions were not answered, but they had me musing about whether Reg FD would apply to “senior Treasury officials”.)

Aside from the bit about contingent liabilities, my main schtick was regulatory reform. Accrued Interest and I made for kind of an odd couple, in that we stood across a great ideological divide (he prefers a minimalist regime, while I want a very active one), but shared the same bottom line: It should always be possible for a financial institution to fail. A Treasury official pointed out that eliminating “too big to fail” doesn’t solve the problem, since institutions can be systemically important because of their interconnections and roles along a wide variety of dimensions. I responded that “too-big-to-fail is too stupid a criterion”, but pointed out that it would be possible to progressively tax several of the various markers of criticality so that it becomes uneconomic for an institution to remain indispensable. AI quipped that I was proposing Pigouvian taxes on being important. He didn’t like the idea, mumbling something about central planning of market structure, but his coinage was very insightful. My mantra, which I tried to push ad nauseam, is that we should prefer structural rather than supervisory approaches to bank regulation.

I also asked about the role of the financial system in terms of allocating capital, whether it troubled officials that real resources were badly misallocated prior to the overt crisis, and how reform should address that issue. They answered that it did trouble them, but surprisingly (to me) emphasized that misallocations were often related to real estate, where a wide array of government policies led to distortions. I think that lets bankers off the hook way too easily. Financial institutions created, sold, and owned investments that performed terribly even with all the subsidies and guarantees offered by the government, so we have no reason to think they’d not have found some other outlet for malinvestment if real estate hadn’t been convenient. In this context, the subject of global financial imbalances briefly came up. I mentioned that there is such a thing as capital controls. A Treasury official answered flatly that capital controls are outside the range of plausible policy options.

Anyway, it’s unsurprising that a bunch of bloggers would mouth off over a wide range of issues, and the things we mouthed off about shouldn’t be very surprising to people who read our blogs. The most interesting aspect of the meeting was anthropological, getting a look at how senior Treasury officials behaved, how they interacted with us and what kind of a thing this was to them. It was a two hour meeting, but different groups of officials came at us in shifts, and stayed with us for 20 to 40 minutes. The tone of the meeting was open, earnest, and informal. But somehow, it never felt like we connected, like there was a lot of actual communication occurring. There were eight bloggers, and although some of us spoke more than others, we were all aware that “air time” (as Yves put it) was scarce, and we limited followups to make sure there was time for others. The officials, on the other hand, didn’t seem to perceive the time as precious. One spoke very deliberately, very slowly. Others were quick to pick up on and run with funny tangents, anything that could serve as a focal point for harmless banter. (The name of Michael Panzner’s blog, “Financial Armageddon” played that role a lot, so perhaps “harmless” is not quite the word.) This is just my impression, and I may be mistaken, but I got the sense that they do this kind of thing frequently, these rolling meetings with some group of people whom it is important to treat as important, but whose conversation they don’t necessarily value all that much — people who are there to be “brought into the tent”. (It reminded me of when, a long time ago, I had to do technology demos for an endless stream of corporate backers.) I felt like, aside from the talking points above, their openness, earnestness, and sincerity were the core of what they were trying to convey. The trenchant verbiage back and forth was just something that had to be endured while sustaining the appropriate attitude. I don’t blame them for this. In fact I may be projecting, describing how I myself would behave if I had an important policy job with this sort of “public affairs” meeting as a frequent interruption. Nevertheless it was my impression.

In that vein, I thought there were certain tricks, rhetorical techniques employed, that I enjoyed. In response to a several difficult questions, one official enthused that what the interlocutor had brought up was an important concern, something he really cared about, but then quickly went on to assert that, in his judgment, it was unlikely to be the pivotal or most challenging problem. I thought this a very effective trick to sweep an issue aside, a kind of jujitsu by which the official would render very sharp comments harmless by moving with rather than fighting against the questioner. After this move, the only possible disagreement is a judgment call about which of many problems is most pressing, and whose judgment would be better than that of a senior official immersed daily in the practicalities of policy? Twice Treasury officials commented on how uncommon a group we were, how we asked particularly pointed questions or were unusually bright. To borrow a cliché, I’ll bet they say that to all the groups. One official made use of an expletive early in his discussion, which had the effect of making us feel like insiders, like this was not the sort of canned, guarded conversation one might see on CNN. The same official was quick to address us by first name when responding to questions. That wasn’t hard, since our names were in front of us, written on placards in large letters. But it was still effective. Being addressed so familiarly makes you feel important, like you are someone powerful people deem worth their while to know. Obviously, the reality distortion field wears off when you leave, once you think it over. But these guys are pretty good at what they do.

There was one time, and only one time during the meeting, when I felt completely stonewalled. Ironically, it was not a Treasury official, but one of my fellow bloggers, who did the deed. Accrued Interest’s trademark style is to weave Star Wars mythology into sharp disquisitions about the bond markets. Early in the meeting I asked AI what the appropriate Star Wars metaphor was for the event we were attending. He took a moment to think, then his face lit up with a smile. But all he said was that he thought it best he didn’t say. I don’t think any force in the galaxy could have pried it out of him.

Other bloggers’ impressions

• Kid Dynamite — A Sit Down With Senior Treasury Officials – Part I
• Accrued Interest — Financial Regulation: How would you have it work?
• John Jansen — Bond Market Opening November 03 2009
• John Jansen — Bond Market Opening November 04 2009
• David Merkel — My Visit to the US Treasury, Part 1
• David Merkel — My Visit to the US Treasury, Part 2
• Michael Panzner — A Few Observations of My Own
• Yves Smith — Curious Meeting at Treasury Department

Commenter “reason” asks a question:

…it is not clear to me that it is well understood why inflation sometimes can be seen in consumer goods and sometimes is manifested in “asset price inflation”. Do you have any ideas on this mechanism? I know some people deny there is such a thing as “asset price inflation”. Do you have a theoretical basis for your ideas in this area?

I have a very simple answer to this question: Follow the money. Whether an economy generates asset price inflation or consumer price inflation depends on the details of to whom cash flows. In particular, cash flows to the relatively wealthy lead to asset price inflation, while cash-flows to the relatively poor lead to consumer price inflation.

Why? In Keynesian terms, poorer people have a higher marginal propensity to consume. The relatively poor include people who are cash-flow constrained — that is they cannot purchase what they wish to purchase for lack of green, so their marginal dollar gets immediately applied to the shopping list. Also, poorer people may be different, there may be a correlation between poverty and disorganization, lack of impulse control, inability to defer gratification etc. Think of Greg Mankiw’s Spenders/Savers model.

Except when the world seems very risky, no one holds cash for very long. Poorer people disproportionately use their cash to purchase goods, while richer people disproportionately “save” by purchasing financial assets. If the supply of both goods and financial assets is not perfectly elastic, then increases in demand will be associated with increases in price. If relative demand for goods and financial assets is a function of the distribution of cash, what price changes occur will be a function of who gets what. [1]

This tale of two inflations helps to explain how we arrived at the unequal, credit-centric economy we have today. Central bankers are notoriously allergic to “wage pressure” as a harbinger of rising prices. Wages have two distressing properties: First, they are sticky. They represent repeated and persistent cash flows that cannot be downward adjusted en masse except during a serious crisis or dislocation. Second, a substantial fraction of wages goes to lower quintiles of the income distribution, who have a high marginal propensity to consume. Central bankers are not evil scrooges — they have nothing against consumption by poor people. But funding that consumption by wages limits the effectiveness of monetary policy. They’d prefer that the marginal dollar bound for consumption flow from a more malleable source.

During the “Great Moderation” in the US a variety of structural changes helped to increase the potency of monetary policy:

1. The wage share of GDP decreased significantly over the 1970s and 80s. Compensation did not decrease as much, but much of nonwage compensation is retirement savings that is saved rather than consumed.

2. Wage inequality increased, such that a growing fraction of wages went to “savers” rather than “spenders”, limiting the direct impact of wage growth on consumption.

3. The growth and “democratization” of consumer credit provided consumers with an alternative source of purchasing power that was sensitive to monetary policy.

Prior to the Great Moderation, central bankers had to provoke recessions in order to control inflation. Broad-based wage growth led to increases in nominal cashflows by “spenders” that could only be tempered by creating unemployment or other conditions under which workers would accept wage concessions. In the post-Reagan world, growth in the sticky component of disposable income shifted to the wealthy, who tend to save rather than spend their raises. The marginal dollar of consumer expenditure switched from wages to borrowed money. The great thing about consumption funded by credit expansion, from a central banker’s point of view, is that it is not sticky downward — no one who gets a loan today assumes that she will be able to expand her borrowing by the same amount every year. Credit-based consumption is susceptible to monetary policy with far less impact on employment than wage-based consumption. (One of Ben Bernanke’s many claims to fame is his characterization of the credit channel of monetary policy transmission.)

By the middle 2000s, the credit economy was the air we breathed, and conventional wisdom held (and continues to hold) that economic growth and credit expansion are synonymous. We had those peculiar debates about the difference between “consumption equality” and “income equality”, and which mattered more, since middle-class consumption had become significantly credit-financed. But from central bankers’ perspective, we had stumbled into a good place, one where output growth was channeled into asset price inflation, but provoked consumer price inflation only indirectly and via a channel policymakers could regulate. This benign regime faced two threats, however. First, asset price inflation is unstable — while on any given day, price moves are determined by the flow of funds into assets, over time prices can become so unreasonable relative to the the asset’s cash or service flows that arbitrageurs and nervous fundamentalists appear, creating the potential for a collapse. Second, credit expansion is unstable, as chronic borrowers may become unable to service existing debt, let alone borrow more to sustain aggregate demand. Unnervingly, sustaining consumption has required a secular downtrend in the policy interest rate, and eventually you hit that zero-bound. [2]

The Greenspan/Bernanke doctrine can be summed up by three familiar words, “Yes We Can!” Greenspan famously concluded that we can “mop up” asset price bubbles after they burst, rather than interfering with the dynamic whereby asset price inflation substitutes for consumer price inflation. Bernanke devoted his life to studying the role of credit in monetary policy and the hazards of deflation and credit collapse, and he famously concluded that we have the technology to prevent “it” from happening here. We are watching his experiment play out, in real time and from inside the maze. The outcome is not yet known.

I have my own normative view of “the great moderation”, and it is not positive. I do not hope to see a return to the “good old days” of the 1990s and mid-2000s. But that isn’t because the moderation dynamic cannot work, in principle. In principle, we can periodically reset the stage with a money-funded jubilee. It’d go like this: When credit expansion reaches its natural limit, let the debtors default, but make creditors whole with new money. “Moral hazard”, rather than a problem, is the goal of the operation: Low marginal-propensity-to-consume “savers” are rewarded and encouraged to continue pouring their incomes into domestic financial assets, where any effect on goods price inflation is muted. Over several years, the balance sheets of debtors can be cured via some combination of bankruptcy, loan modifications, austerity, and youth. In the meantime, the Federal government adopts the role of consumer of last resort, in order to sustain nondeflationary levels of aggregate demand and limit unemployment. I think this is our current strategy. We are groping and stumbling towards the status quo ante, and it is not impossible that we will find it within a few years.

So what’s the problem? First, in exchange for apparent stability, the central-bank-backstopped “great moderation” has rendered asset prices unreliable as guides to real investment. I think the United States has made terrible aggregate investment decisions over the last 30 years, and will continue to do so as long as a “ride the bubble then hide in banks” strategy pays off. Under the moderation dynamic, resource allocation is managed alternately by compromised capital markets and fiscal stimulators, neither of which make remotely good choices. Second, by relying on credit rather than wages to fund middle-class consumption, the moderation dynamic causes great harm in the form of stress from unwanted financial risk, loss of freedom to pursue nonremunerative activities, and unnecessary catastrophes for isolated families. Finally, maintaining the dynamic requires active use of policy instruments to sustain an inequitable distribution of wealth and income in a manner that I view as unjust. In “good times”, central bankers actively suppress the median wage (while applauding increases in the mean wages driven by the upper tail). During the reset phase, policymakers bail out creditors. There is nothing “natural” or “efficient” about these choices.

The great moderation made aggregate GDP and employment numbers look good, and central bankers sincerely believed they were doing a good job. They were wrong. We need to build a system where changes in asset prices reflect the quality of real economic decisions, and where the playing field isn’t tilted against the poor and disorganized in the name of promoting price stability.

Suppose that the Federal government were to offer sizable loan guarantees for any and all “green energy” companies. Any firm, including new entrants, would be eligible. The government would do some cursory due diligence, only to establish that the company in question would actually spend the capital it raised on real projects colorably linked to green energy (as opposed to, say, buying New Zealand dollars in a carry trade).

Wouldn’t such a program constitute a stimulus to the economy? If sufficient leverage is allowed, it would lead in short order to a bunch of entrepreneurs founding companies on just a shoestring of equity and a whole lot of cheap, guaranteed debt. Firms with even a small likelihood of success would constitute real options worth more than the sliver of private capital at risk, so arbitrageurs would rush to create them.

Such a program would be a pretty direct form of fiscal stimulus. Although politicians and financiers enjoy pretending otherwise, contingent liabilities are still liabilities, and offering loan guarantees to all comers for risky projects is, ex ante, just a way of financing a government expenditure equivalent to the expected losses of the program. We shouldn’t be surprised that an oddly financed stimulus would function as a stimulus.

But note that if, by good fortune, the artificially spurred new firms do surprisingly well and very few guarantees are actually paid, that wouldn’t eliminate the ex ante stimulus effect of the program. It is not the actual transfer of Federal money that serves as the stimulus. The stimulus comes only and precisely form the certainty the program provides to investors that capital spent will be repaid, with interest.

So, suppose that the government does nothing, but “the market” becomes certain (correctly or not) that green energy companies are a sure thing. As long as the cost of capital to such firms falls sufficiently, precisely the same dynamic would take hold. We’ve just watched it happen, twice. When capital became very cheap to internet firms, entrepreneurs understood (and discussed quite openly) that there was an attractive lottery on offer, so why not get in? During the structured credit bubble, the market became convinced that some classes of debt yielding more than the “risk-free” interest rate were certain to be repaid. Entrepreneurs (both speculative borrowers and financial engineers) saw the arbitrage, and found ways of offering those classes of debt. In both cases, if the market had been right, everyone would have been happy. But when the market was wrong, it was someone else’s cost. Many entrepreneurs walked away rich and happy. Others lost, but only a small amount relative to what they’d have made if things worked out differently. It was a good gamble for them ex ante.

Responding to Arnold Kling’s “recalculation theory“, Paul Krugman asks (as he has asked many times)

why [doesn’t], say, a housing boom — which requires shifting resources into housing — …produce the same kind of unemployment as a housing bust that shifts resources out of housing.

A housing boom, any kind of boom, is attended by an increase in certainty. Information is stimulus, confusion is contraction. A bust occurs when the market is unsure of everything, when market participants perceive better risk-adjusted return in holding government securities (or supply-inelastic commodities) than in financing real investment. Sectoral shifts per se have no clear implication with respect to variables like employment and output. But “hangovers” do happen, because powerful booms are periods when market participants make consequential decisions with great swagger and confidence, and busts are when we learn that despite their certainty, they were wrong. They are left not only impoverished and burdened by debt, but bereft of confidence in their ability to evaluate new opportunities. The best way to avoid the hangover is not to err so terribly in the first place. Easier said than done, perhaps, but that’s no reason to cop out. We can build a better financial system, one in which degrees of certainty are attached and removed from economic propositions dexterously, rather than clinging like giddy leeches until a collapse.

Information is stimulus. As markets become more informed, money will be created and lent into the economy as surely as if the government printed and spent it. And stimulus is information, since governments do not spend randomly but do so in accordance with their own revealed certainties, which may or may not turn out to be wise. Poorly chosen stimulus and asset price bubbles are covert twins — only the identities of the people making bad decisions are different. Conversely good economic choices by governments can lead to outcomes as salutary as a healthy market. (See this very nice post by Bryan Caplan, and the articles cited.)

Information is a behavioral attribute, not an attribute of the external phenomena to which it may ostensibly refer. To say that an agent is informed means she behaves differently than an uninformed agent. Her behavior is less random, more predictable. To be informed does not imply ones information is accurate. (In general, accuracy is unknowable, both ex ante and ex post.) Information increases the volatility of outcomes, because it provokes larger and more concentrated bets than uncertain agents would take, creating large gains and losses depending on how adaptive the informed behavior turns out to be. It is often better, as a behavioral matter, to be uninformed than to be poorly informed.

But we do not always have the option of remaining uninformed. We cannot afford to hedge all of our bets. Whether via a great mis-recalculator in the sky or a political establishment largely captured by certain interests, new information will be manufactured. (I think it probable that government stimulus will substitute for market-generated information in the near term, as chastened capital market participants are more conscious of the hazards of certainty than policymakers are.) We will be spurred to take some actions and eschew others, and the structure of the economy will shift accordingly. Let’s hope those choices are good, and do our best to help make them that way.

Update: While I was writing… Arnold Kling offers related and excellent “Thoughts on Probability and Uncertainty.”

Note: I use the word “state” in this post to mean “the state”, government generally, not state as opposed to federal government in the US. Thanks to Richard Serlin for pointing out the ambiguity.

Tyler Cowen writes

Now it’s dead, everyone else has been blogging it…

The first thing to note is that vanilla is not dead. State-defined vanilla products are not an idea narrowly applicable to this moment’s consumer finance challenges. They are, or could become, an important part of the regulatory arsenal in a wide variety of contexts. They are a tool whose development people with libertarian impulses (including, though you may not believe it, me) should view with cautious enthusiasm. At its core, the purpose of defining a vanilla option is to offer an additional choice, a well-understood default that helps consumers to weigh the purported benefits of exotic alternatives against the uncertainty costs they carry. Libertarians might reasonably object to a requirement that private enterprises offer vanilla products (although the objection is less compelling for industries that are and will continue to be state subsidized and regulated). But first and foremost, vanilla products are about cajoling into existence products that, despite their complexity, can be credibly certified as functional and nontoxic. The idea is in the “libertarian paternalism” / “nudge” tradition of not-exactly-regulation which, however objectionable, is less objectionable than the unqualified paternalism that may result from continued dysfunction and crisis. (Tyler might note a familiar form to this argument.)

The crucial question is whether governments could deploy vanilla products well. Both Tyler and Ezra Klein make the usual sad-but-true public-choice argument that, while vanilla might be a good idea in theory, what compromised politicians and bureaucracies actually offer might, in practice, not be so great.

They are undoubtedly right to be worried. But public choice concerns should always be the beginning, not the end, of a conversation. It’s both incorrect and intellectually lazy to frame the argument as many “pro-market” commentators do (not Tyler or Ezra!), that sure, markets make mistakes, but politician-run governments make “worse” mistakes, so we are better off letting imperfect markets have free reign.

Governments and markets are dissimilar in the form and causes of their mistakes, and the badness of their errors is not uniformly rankable. Imagine that “what is to be done” is a radio signal being sent over two channels, both subject to maddening (but nonidentical) interference. A dumb strategy for extracting the signal would be to just decide that one channel is cleaner, and then throw away the other signal. Smarter strategies combine the information from both signals, and using information from each signal to help correct the errors of the other. There are domains where history and reason suggests that even terribly flawed markets provide a better signal than government. There are other domains where terribly flawed political processes generate a better signal than status quo markets. We should weight the different signals accordingly. But we should always be alert for opportunities to exploit the different strengths and weaknesses of markets and governments to produce better results than either could alone. How to do so, in real life rather than radioland, is an art. But vanilla products have the potential to be a masterpiece of the form. We have to insist on just one point.

A vanilla product must be defined by a uniform contract that regulators write and publish and that varies in a single dimension.

Of course regulators would consult with industry and consumer groups, and of course industry lobbyists would struggle to capture the process and embed their spicy “tricks and traps” into our vanilla creme. But they’ll have a hard time doing so, as long as authorship and responsibility for the terms of the contract and its evolution over time rest with the regulatory agency.

Here’s why. If the contract is written by the regulator, when consumers get screwed, they get screwed by the regulator as much as by the firm that sold them the product. Think about the politics of that. Suppose Struggling-Mom-Of-Four finds her credit card interest rate skyrocket because she missed a phone bill, and the industry had slipped a universal default provision in the “vanilla” credit card terms. When that story gets on the local news channel, it’s no longer a just a story about megacorp screwing ordinary family. It’s a story of the government screwing Mom-Of-Four, directly and on behalf of megacorp. When megacorp screws someone via a private arrangement, the populist “do something!” impulse is blunted by concerns about liberty and contract and personal responsibility. Citizens are genuinely divided about when government interference in private affairs is justifiable, so politicians get conflicting signals from their constituents, and unconflicted signals from megacorp not to interfere.

But citizens are not at all conflicted that the government should intervene to prevent the government from screwing people. If a contract written and owned by regulators has not-well-understood characteristics that leave consumers surprised and unhappy, representatives’ “constitutent services” lines will ring off the hooks. Politicians that refuse to intervene against well-publicized injustices will be quite vulnerable, since they’ll lack the usual philosophical justifications to defend inaction. So politicians will act. State ownership of vanilla contracts provide dispersed consumers a means to challenge concentrated industries for ownership of regulators, by virtue of the hypersensitivity of elected representatives to charges that they fail protect their constituents from rapacious government.

Another benefit of a uniform, regulator-owned contract has to do with the legal system. Every contractual arrangement is attended by legal uncertainty. A freshly written contract is quantum mechanical — words imbue a probability distribution that collapses to determinacy only when observed at the tip of a judge’s gavel. (Usually no cats are killed.) Vanilla contracts offer an economy of scale in dispelling legal uncertainty. Disputes over vanilla arrangements would be quickly adjudicated, by public courts, not private arbitrators (binding arbitration would be a political nonstarter). Since there would only be one contract, legal precedents would be portable across providers. The characteristics of vanilla contacts would quickly become well-settled and widely known.

Vanilla contracts may or may not be dead this cycle, with respect to regulation of financial products. There are many other policy domains where vanilla contracts might be useful. I’d like a bit of vanilla with my health care, thank you very much. The Washington Post has an an excellent article about the too-little-discussed problem of tacit cherrypicking by insurers despite a formal “community rating” requirement (ht Dean Baker). This bit caught my eye:

A straightforward way to reduce gamesmanship is to standardize benefit packages, Precht wrote in a July report. One issue lawmakers must resolve is how much latitude to leave insurers over what they cover and how.

Sound familiar?

Extra vanilla

I realize I’m on time-delay, and that this is all so very last week. (When I am only a week behind, it’s like living in the future.) Anyway, here’s my RSS reader’s dump of vanilla related links, in reverse chronologil-ish order. As always, if I’ve missed you, that’s my lameness, not yours:

• Dupe Deluxe: The Sucker’s Market for Financial Innovation — Rob Horning
• Financial Innovation as a Tax — Karl Smith
• The plain vanilla option for financial competition — Tyler Cowen
• Confusing Disclosure and Information — Ezra Klein
• Vanilla — Robert Waldmann
• Commodities, Buying the Future — Mike Konczal
• Good-Bye, Vanilla Option — James Kwak
• Vanilla Option, Extra Scoop — Mike Konczal
• Assume You Don’t Have a Can Opener — Ezra Klein
• Don’t believe the hype! Credit card sharks still hate the taste of plain vanilla — Dan Geldon
• While we weren’t looking, Barney Frank sold us out on the Consumer Financial Protection Agency — lambert
• On Vanilla Products — David Merkel
• Why the vanilla option is necessary — Felix Salmon
• Vanilla Iced — Kady Liang
• And now for something completely different — The Epicurean Dealmaker
• Vanilla is a commodity — me
• Frankly I’m with Frank — Robert Waldmann
• Vanilla, iced — Ryan Avent (Free Exchange)
• Is There Any Consumer Protection Issue Blue Dogs Support? — masaccio (firedoglake)
• Vanilla fudge — Alyssa Katz
• Plain Vanilla — Kevin Drum
• Consumer Financial Protection Agency Gets Watered Down — Chris Walters
• Vanilla Products, Eulogy — Mike Konczal
• Financial Reform Already Takes A Hit — dday
• Obama caves to pressure on consumer financial protection — Edward Harrison
• The beginning of the end of meaningful regulatory reform — Felix Salmon
• Frank Waters Down Consumer Protection Proposal — Daniel Indiviglio

For the econgeeky, be sure to check out Karl Smith’s piece (via Mike Konczal), which describes the costs of tutti-frutti into familar microecon diagrams, and this very nice paper by Gabaix and Laibson, that formally models much of the problem vanilla products are intended to solve (via Mike Konczal, via Tyler Cowen, via Christopher Shea who outlines the argument in accessible terms).