This Is the End


Markets, Risk and Human Interaction

January 18, 2010

Breaking the Banks

January 18, 2010
The following expresses my personal views, not those of the SEC or its staff.

A few months ago I wrote a post entitled “Why do bankers make so much money?” A corollary question is, “Why do the largest banks make so much more than other banks?”

Addressing this question can help us solve the problem the largest banks pose for systemic risk, and open a channel for demands to curb their outsized profits. Profits that, by the way, are not exactly coming from producing real goods like steel or flat screen TVs. Goldman Sachs might stand foremost in Matt Taibbi’s view as a “great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money”, but all of the largest banks are increasingly seen as machines of wealth transfer, devising ways of pulling money from your pocket into theirs.

The largest banks are different from the rest, and different in ways that make them seem to be bad citizens. Compare them to the banks that are down the line in size, say regional banks, by any of these standards:
  • Amount of risk taking
  • Supplying and pushing of derivatives and other “innovative products”
  • Complexity and opaqueness of operation
  • Incentive structure and level of compensation
  • Ability to call on government support (too-big-to-fail coupled with political weight)
It is not the case that the largest banks are the same as other banks, just bigger. The regional banks are not baby JP Morgans or Goldman Sachs. What sort of trading desks do the regional banks have? How many product specialists/salesmen/modelers designing, pumping out and trading innovative products? What type of proprietary trading desks do they have that piggyback on the bank capital, customer desk trading flow and back-up from the Fed? How many of them are paying out over fifty percent of earnings in compensation? How many have a bee-line to the Fed and Treasury when things get rough?
In the movie Sabrina the title character said, “More isn’t always better... sometimes it’s just more”. But sometimes more is more than just more.The largest banks do things the smaller banks cannot do. They behave differently. They are a separate species, qualitatively different in ways that make them problematic. In fact they aren’t even banks. They are no more like Zion’s National Bank than they are like Fox Pitt, NASDAQ, Tudor Capital or Vanguard.

Another way the largest banks are different is that they have something close to monopoly power. You might be wondering how I can assert this when we all know that there are at least six large banks. (If you want to call it oligopoly power instead, that is fine).

Well, first of all, they are not open to outside competition because there are huge barriers to entry. Second, there are limits to the supply that any one bank can provide, limits to production, so to speak, because as big as these banks are, they cannot operate efficiently if they get much bigger. And third, they promote a noncompetitive industrial organization. They do that by, among other things, creating informational asymmetries. The innovative products they promote -- both derivatives and consumer products -- give them an informational edge over their customers. The trading operations they run do the same.

So if we want to curb the risk taking, too-big-to-fail conflicts, opacity, and the creation of informational asymmetries and complexity, we need to move them down to the scope and scale of the smaller banks. We need to break them up.

If the large banks are broken up into smaller banks, the risk taking, incentive distortions, lack of transparency and too-big-to-fail mentality will drop, and drop more than proportionately. If you buy the argument that the banks can exert something like monopoly power – and with the count of large banks down from a year ago, whatever monopoly power they could exert then, it has got to be worse now – then breaking up the banks will eliminate that power. And it will reduce the barriers to entry that stifle competition.

We did something along these lines before: the Glass-Steagall Act, a.k.a. the Banking Act of 1933. But reinstating Glass-Steagall is not enough, because we will still have a small set of large banks on the one hand, and a small set of large investment banks on the other, with both groups raining down negative externalities. In addition to again separating commercial banking from trading and proprietary risk taking we need to reduce the size of the largest banks and investment banks.

January 2, 2010

Controlled-Burn Inflation

January 02, 2010
The following expresses my personal views, not those of the SEC or its staff.

Suppose all the Good Guys (Joe Consumer and Homeowner) are loaded with debt, and suppose that this debt is payable to the Bad Guys (Rich People and Foreigners).
What can you do about it? Oh, and also suppose that the debt is mostly in nominal terms. Answer: You inflate.

We cringe when inflation is mentioned. Maybe it is from the horror stories of hyperinflation; maybe it is from memories of the inflationary episode of the mid-1970s. (Remember Ford’s WIN buttons)? But I am not talking about hyperinflation, or even inflation in the double digits. Rather, a controlled burn inflation, something that is, say, in the six or seven percent range. Something that will drop the debt burden by twenty or thirty percent after a few years.

On the positive side, controlled-burn inflation will drop the real obligations we will “pass on to our children” – put that phrase into Google and see how many hits you get – for our $8 trillion of public debt. It will reduce the real effect of our nearly $1 trillion to ChinaChina being recently highlighted by Paul Krugman as a Big Problem of 2010. Not to mention the nearly equal amount we have with Japan, which Krugman does not see being as much of a problem. It will drop the real debt obligation for mortgage borrowers in terms of their principal, and, for those with fixed rate mortgages, drop the real cost of servicing their debt as well. Anyone with adjustable rate mortgages or short-term revolving debt will be running in place in terms of their debt servicing. But the real value of their principal obligation will drop for them as well.

The negative is the stickiness of wages versus prices. For those who remember the 1970’s, it seemed like wage levels were always one step behind in ratcheting up to meet the higher prices. And there were costs in making the price adjustment, both in terms of processing and informational lags. But we are in a different world today, and I wonder if the frictions of a “helicopter drop” would be anywhere near as significant. In our electronic age, prices can be adjusted with far less cost, information on prices is quickly and cheaply accessible. And I believe wages can similarly be adjusted for less cost; there are fewer institutional and processing constraints to keep wages sticky – although this is a proposition that has not had to be broadly tested because inflation has been a non-issue for a generation.

To do inflation right, you have to be a little sneaky. Especially if you don’t want your creditors feeling totally screwed and have them walk away the next time you need to borrow. Don’t announce it as a policy. Have it just happen. In fact, have it happen in spite of all of your best efforts to reign it in. So you need a controlled burn that looks like it is spontaneous. Who knows, maybe this idea actually is making the rounds.