Business People and Their Assumptions

I was really struck this week by the article here from Matt Taibbi which I blogged about a few days ago.  I also sent it out to some of my favorite correspondents in the business world- I always like to see how the Wall Street Journal crowd reacts to bomb-throwers like Taibbi.

From one correpondent (we'll call him J) I got the following.  First, an exerpt from Taibbi:

FREE MONEY. Ordinary people have to borrow their money at market rates. Lloyd Blankfein and Jamie Dimon get billions of dollars for free, from the Federal Reserve. They borrow at zero and lend the same money back to the government at two or three percent, a valuable public service otherwise known as "standing in the middle and taking a gigantic cut when the government decides to lend money to itself."

Or the banks borrow billions at zero and lend mortgages to us at four percent, or credit cards at twenty or twenty-five percent. This is essentially an official government license to be rich, handed out at the expense of prudent ordinary citizens, who now no longer receive much interest on their CDs or other saved income. It is virtually impossible to not make money in banking when you have unlimited access to free money, especially when the government keeps buying its own cash back from you at market rates.

Next, the response from my correspondent:

Economics 101 tells you this can’t be true. If it were that easy to earn huge profits in the banking industry, we would see globs of new entrants and profits across the industry would come down. Barriers to entry aren’t that high.

And finally, the rant from yours truly:

Barriers to entry aren't that high????? Are you serious? Of course barriers to entry for major banks are high! There's a huge advantage to being an existing monstrously large bank. You seem to miss the whole point of this argument because you have a bedrock assumption that Finance is an Efficient Market because...... well why exactly? The whole point is that the industry is NOT efficient because we've developed into a Crony Capitalist system in which the currently powerful people set rules to make sure that they stay powerful.

Look at the banking industry- they're making record profits. Are there new entrants into the industry? Has any company replaced Lehman or Bear Stearns? Do you have a theory as to why it might be that the answer is no? Are you trying to argue that banking industry profits aren't as large as they seem? I'd really like you to clarify this- I'm staggered.

OK, J gets to respond:

The excerpt says that Blankfein and Dimon can borrow from the Fed for next to nothing and then turn around and lend it to ordinary people at high rates, pocketing obscene profits from the rate difference. Several points: (1) I never said it’s easy to become a “major bank,” so I’m not sure where you got that. Banks don’t have to be huge to get low rate loans from the Fed and then make loans to ordinary people. (2) Banks are aggressively competing with each other to get my business, and if profits from this “free money” scheme were as readily plentiful as you and the Taibbi think, then fundamental, widely accepted economic theory would say the interest rate disparity would come down, even if it were a quasi-Efficient Market. (3) The biggest profit margins for the major banks don’t come from the consumer lending anyway, but rather from investment banking. Goldman Sachs (Blankfein) isn’t even in the consumer lending business as far as I know, and JPMorgan (Dimon) has LOST money on its mortgage and credit card business while raking it in on the investment banking (http://www.reuters.com/article/2010/01/15/us-jpmorgan-idUSTRE60E1UO20100115). Look at the profit of the largest consumer lending bank, Bank of America, and you can see how highly variable it is (http://ycharts.com/companies/BAC/profit_margin).

So I maintain my position that this Free Money argument is flawed. The problem is with investment banking, not consumer banking.

Naturally I spotted the flaw in his argument:

Of course the problem is with the investment banking side.  But the solution has been to take the money from the consumer banking side, using easy money to recapitalize the banks that lost all that money on the investment banking side.

Again you talk about economic theory, claiming that it proves it just can't be that banks can make money so easily, as consumer interest rates would come down.  But again, the whole point of Taibbi's post is that those rates have not come down because of the crony capitalist nature of the whole enterprise, in which government intentionally guarantees profits to banks in order to make up for the huge losses of 2008 and keep them afloat.  In other words, the huge bank profits are a feature of federal policy, not a bug. 

On another part of the topic (J's comments in red, mine in maroon),

The alternative to bailing out a few banks was a massive meltdown and collapse far greater than we actually experienced, leading to devastating unemployment. Dodd-Frank will help ensure that the situation does not repeat itself, and that irresponsible companies will not be saved. Anyone who thinks there’s still an implicit government guarantee is deluding himself.

I agree that government had to do something. I think there's even a good argument for bailing out the banks rather than nationalizing them. But you have to admit that the solution chosen didn't force the banks to accept the pain that their businesses practices should have led to. And I hope Dodd-Frank works too, but of course the banks are fighting everything in it- that's why Taibbi is so pissed, because the same guys who caused the crisis are trying to stop the solution to the next crisis- that's why he (and I) are so mad at bankers- not so much that they brought down the economy, but more that they now see themselves as being persecuted- they should be groveling and begging forgiveness. And I think you're the one deluding yourself about the government guarantee- what makes you think a subsequent government will allow a "Too Big to Fail" institution to go belly up? You just said we were right to bail them out before- why wouldn't we do it again?

There are two reasons the situation will not repeat itself. First, Dodd-Frank is increasing capitalization requirements and the “cost” of becoming a Too-Big-To-Fail (TBTF) institution. Second, I believe public sentiment is far less likely to support bailouts in the future. I have no problem with increased regulation to ensure there are fewer TBTFs or that there are protections against the risk of system-wide meltdown. But don’t make the mistake that any regulation is good regulation. I see examples in the mutual fund industry (money market funds in particular) that are purported to protect against another financial crisis, but that actually miss the mark and instead impose unnecessary burdens on the industry without improving consumer protection. If enacted, they would definitely INCREASE costs to consumers and probably INCREASE risk to the markets. To the extent specific regulations proposed for banking are similarly unhelpful, I hope the industry will resist them.

This is the theme I keep hearing from Finance guys: essentially that the cure (government regulation) is worse than the disease.  I address that issue a bit with my next correspondent below.

From another correspondent in the financial industry (I'll call him N) I got this:

One of the major issues facing our society right now is crony capitalism - which is the marriage of government and business. Business would prefer not to compete - they don't want to play fair and will use government influence and rules to tilt the playing field in their direction if they can. What we're seeing on wall street, and in the car industry and in the green tech industry, and in the farm industry is the use of government to put profits into corporations. 

You and I have different solutions to the problem. From what I understand, you believe in stricter regulation to prevent business abuses. I think that the problem is in fact the influence of government and their involvement in industry that is the cause of the problem. If the humans in government are making decisions that influence profits, then the humans running the businesses will try to influence the government, through lobbying and other less savory means. My solution is to get government out of the influence business (out of the picking winners business, out of the saving companies business) and let a robust free market control business.

It is only businesses that are forced to compete for customers that will do what is right for their customers. If they do wrong, they should fail. So I was against all of the bailouts, and I'm against more regulation because that just makes the problem worse.

Look at the industries where government is heavily involved (finance, healthcare, anything to do with the environment) - this is where things are screwed up. The healthy growing innovating industries are the ones where there is less government involvement.

A little back and forth now.  From me:

I agree that my position of increased government regulation is imperfect and open to problems with unintended consequences, stupid regulators, and all the rest. Here I paraphrase Churchill and respond that government regulation is ineffecient, prone to abuse, and loaded with unintended consequences. The only thing worse than govenrment regulation of the financial industry is: Any Other Solution you can name.

I love the moral lesson of letting the big banks all come crashing down, with lots of big stockholders losing their shirts. The problem is that it would have brought the rest of the economy down with it. In the 1930s unemployment was 25%+. And the actual people involved, the ones doing these reckless deals, would still be fine, since they've been banking money during the good times. And since the whole industry did it, most of them would get jobs again anyway, since there isn't anyone else to hire who isn't tainted. So the trouble with letting Creative Destruction do its work is that in these large financial firms the incentives for individuals aren't set up properly. I don't see how to set them up properly without government intervention- do you?

Right now the Financial System seems rigged to benefit the big players. Goldman Sachs can screw over a whole swath of investors, but these people have nowhere else to go when they want a certain kind of deal done, right? I don't see that taking government further out of the industry will do anything but make this problem worse. It's too easy to rip off people right now- we take out enforcement and it will get harder? The theory sounds good, but I don't think you can garner much evidence that capitalism actually works this way- the financial markets aren't that efficient.

Anyway, I agree Crony Capitalism is a huge problem. What's interesting is that the Tea Party and the Occupy Wall Street crowds are both angry about the government-business n exis and how it harms prosperity for all of us (especially the middle class). But the TP focuses the rage on government, while OWS focuses it on business. Maybe we should get out of this duality and look at the whole system.

His response:

How come most industries don't suffer this problem? Why doesn't Apple screw their customers? The executives have banked millions, and yet they continue to do what's right for their customers, despite this fact. BTW, I have no illusions that Apple execs any less greedy than bankers.

It's not just Apple, nor is it just technology. I can point to industry after industry where the companies serve the needs of their customers and are constantly improving their products - without any government regulation.

I will grant you that the financial services industry has a broader impact on society - but the fact that we have not let banks fail is precisely the problem. In fact, the real problem is that we have not let the bond holders lose a ton of money. People who b bank stock know they are taking a lot of risk - but they have serious upside if the stock does well. Bond holders do not have a big upside. So the real role of a bond holders is to carefully assess the risk involved in the company to who they are lending. But if a bond holder knows they will be made whole no matter what happens, what is their incentive to scrutinize the people to whom they are lending money.

By the way, what regulation would have prevented the crisis of 2008?

 

 And me:

First of all, you won't hear me complaining about "greed". It's a human condition, and we're not going to change that. The best thing about capitalism is that it's a system that can channel greed to benefit the whole society. Capitalism works tremendously well in the area of consumer electronics, and more regulation is certainly not needed.

I'm glad there's some regulation there, though- I know that my I-Phone is unlikely to cause me cancer or leak battery acid on my ear because there are government safety standards they have to meet. And if some new start-up creates a superior product, I can safely purchase it because I know it won't leak battery acid either. Basic government regulation gives new start-ups a chance to break in, since I wouldn't dare risk buying such a thing if I didn't have some guarantee against catastrophe.

You see the analogy to other industries as an argument for less regulation in Finance. But my point isn't that capitalism doesn't work- I'm a capitalist too! My point is rather that pure capitalism doesn't seem to work in some industries. Do you want to stop government food safety inspections? I don't have time to educate myself about every industry so I don't get screwed by some fly-by-night company.

Finance is a great example of this. The FDIC means I don't have to worry about my bank deposits being safe. It also limits bank profits, since my bank is paying in to the FDIC. I think that's well worth the tradeoff.

You ask a very appropriate question: what regulation would have stopped the 2008 disaster? I'm sorry to say that I don't know- I'm not in Finance, and certainly don't understand the intricacies enough to be able to say. I would guess you could fashion the answer for my side better than I could (ask me about social work! I can argue both sides there!). I would certainly hope that Dodd-Frank is promulgating reforms that would have stopped the meltdown of '08. If that's not the case, then the law doesn't go far enough. Yes, yes, of course we're fixing the last crisis, not the next one, but at least we should stop the last one from recurring. Laws put in place during the 1930s were pretty successful in staving off a similar crisis up until now.

Again, I think you're hopelessly naive about the moral hazard issue. Yes, you're quite right that because of bailouts we have an industry that socializes risk and privatizes gains, and you're right that in theory we just need to let them know there's no such thing as "too big to fail" and they'll reevaluate their risk models. But in the real world it's not going to happen- Paulson tried it when he let Lehman fail, and look what happened- huge panic, the whole industry (including banks that hadn't over-invested in mortgages) was about to go belly up, and the government stepped in to bail the rest of them out- and that was the most conservative administration of our lifetime that did it. Do you really think President Romney is going to let the financial industry crash if there's a crisis in 2014? I don't. There's just no way politicians are going to allow a Depression on their watch- politicians know what happened to the Republican party in 1932- they didn't control the presidency for 20 years and lost the House for 62 years! Bailouts are happening, and it doesn't matter what you or anyone says in advance.

 

 And from him:

Do you seriously think that the reason your phone does not leak battery acid on you is due to government regulation? So if the regulation that governed this (who know what that is) was removed, this would immediately become a concern?

Which regulation is causing the car companies to develop technologies like blind spot detection and driver awareness detection?

I'd have to look for it, but I saw a study that shows that growth, progress and technology is responsible for almost all improvement in cleanness and safety - not regulation.

Why are you assuming that allowing banks to fail would be a disaster? Do you know that well over 100 banks have failed in the past few years? BTW, the orderly management of a bank failure is a good example of the right use of government. It's just the well-connected investment banks that are "too big to fail". I think the issue of the financial institutions having a massive impact on the rest of the economy is a real problem - my solution is not to increase the regulation on these institutions - they'll always find a way around it. I would limit the ownership structures instead. These problems never happened when the institutions like Lehman and Goldman were partnerships. And if you look at firms that have stayed partnerships, they have not suffered from this excessive risk taking. That's because a significant piece of each partner's wealth is tied into a firm when there is a partnership. The problems that we're facing started then the firms started to go public.

 

 And since it's my blog, I get the last word:

As to your solution for the TBTF banks, that sounds fine to me at first blush- forcing big banks to become partnerships sure sounds like regulation though, doesn't it? It's simple regulation of course, but I'm quite open to that. Don't you think the financial industry would fight your solution hard too?

I assume that allowing TBTF banks to fail would be a disaster because when it happened in 1929-1932 it was a disaster. And now they're even bigger. And because every economist and pundit in 2008 said it would be a disaster, leading to a second Great Depression, if we didn't bail out the Financial Industry. Hey, maybe you're right and they're all wrong. I wonder what you think would have happened? You've always implied that it would have been really bad, but that it was necessary to eliminate future Moral Hazard.

As I said, consumer electronics are well-served by the free market and require very minimal regulation. And of course without regulation, safety problems would come up a little more often- then the only outlet to deal with them would be lawsuits. Are you in favor of keeping it easy to file lawsuits when corporations put out products that turn out to be dangerous? I don't think that's good enough, by the way, but many conservatives want to make it harder to file suits, AND want to lower regulation. That leaves lots of incentive to cut corners in many product areas. Remember the Chinese baby formula scandal a few years ago? That couldn't happen here very easily right now.

Of course lots of safety innovation makes money too, so car and other companies do it. You're making a straw man argument here- I don't dispute that lots of great things come from capitalist innovation. But government regulation forced seat belts to be mandatory, and improved the environment by mandating catalytic converters (conservatives are still against pollution right? Even if Global Warming is a hoax, your side still believes smog is real, right?). That wouldn't have happened from the free market alone.

 

 Congratulations if you made it all the way to the bottom of my correspondence!