naked capitalism

Actually, despite the somewhat churlish headline, the story “Bailout Helps Fuel a New Era of Wall Street Wealth,” by Graham Bowley at the New York Times, is a solid job of reporting and does not tiptoe around the issue of the big bennies that the financial services industry is enjoying and their role in creating outsized profits. It also makes a distinction, which has escaped many writers, that the firms that are doing really well are the big capital markets players, not conventional banks (or firms like Citi and Bank of America, that are capital markets firms with very substantial commercial banking operations). It was the markets that the powers that be were panicked to save (debt is now heavily intermediated on over-the-counter credit markets, vastly less on bank balance sheets than it once was). And with the subsidies directed mainly at shoring up credit markets and the firms that own and operate the crucial trading infrastructure, it should be no wonder that the players that were most deeply involved are showing the greatest gains.

The reason for the tart headline is that this view should be conventional wisdom by now (well, it is among folks who understand financial services, but not in the wider world). And it should have been widely commented on when first and second quarter bank earning came out,. Instead the meme was “isn’t it wonderful those banks we thought were dead are actually making money!” No one wanted to look to closely and ascertain that the pretty profits were the result of government props, not sounder fundamentals. The one who came closest to saying the truth was Meredith Whitney, who described the earnings as “manufactured” (recall the role of AIG swaps unwinds in 1Q results) but added that the banks could keep it up for another quarter or two.

The New York Times story warm up indicates that comparatively few are in on the role of the government support in the supercharged profits. The price provides a short recap and notes that the Federal aid is contributing to lofty bonuses:

It may come as a surprise that one of the most powerful forces driving the resurgence on Wall Street is not the banks but Washington. Many of the steps that policy makers took last year to stabilize the financial system — reducing interest rates to near zero, bolstering big banks with taxpayer money, guaranteeing billions of dollars of financial institutions’ debts — helped set the stage for this new era of Wall Street wealth.

Titans like Goldman Sachs and JPMorgan Chase are making fortunes in hot areas like trading stocks and bonds, rather than in the ho-hum business of lending people money. They also are profiting by taking risks that weaker rivals are unable or unwilling to shoulder — a benefit of less competition after the failure of some investment firms last year.

So even as big banks fight efforts in Congress to subject their industry to greater regulation — and to impose some restrictions on executive pay — Wall Street has Washington to thank in part for its latest bonanza…

Not all banks are doing so well. Giants like Citigroup and Bank of America, whose fortunes are tied to the ups-and-downs of ordinary consumers, are struggling to turn themselves around, as are many regional banks.

It is admittedly a high level treatment (for instance, it does not enumerate the various types of support, but does make clear it extends well beyond the TARP) but delivers its message in a clear, matter-of-fact, and unqualified fashion.

Some economists and bloggers have been on this theme (the extent of the subsidies and the lack of quid pro quo for the taxpayer) for quite some time, and their drumbeat continues. One salvo comes today from Jesse in “How Goldman Sachs Leveraged $70 Billion in Government Money For Record Profits.” While this is admittedly close to conspiracy theory, most investment professionals I know regard the latter phases of the stock market rally with great suspicion (too much end of day tape painting, too many heavy handed short squeezes, continued thin volume, and suspicious moves on indexes when they near levels that are significant to technicians). That of course begs the question, “If the market is being manipulated, how and by whom?” When I worked with the Japanese, it was widely known that the Japanese securities firms manipulated the markets and the politicians were tipped off early and bought stocks the brokers were about to ramp (look, if I as a mere gaijin heard about it, it was hardly secret). Yet when it came out in the Japanese media years later, it was treated as a huge scandal. I was and am perplexed that a widely-known practice could be treated as such a remarkable event. I regard much of this rally as a similar open secret, except how this is being carried out is a mystery (is this mere trader opportunism and brute force that looks like collusion, with the perps secure in the knowledge that the government won’t act against rule violations, since the outcome serves their interests, or something more deliberate?)

On the wonky/policy end of the spectrum, Willem Buiter continues to be Not Happy about the wondrously bank-friendly regimes that have been put in place. He provided some commentary from János Kornai on one of his ideas, that of soft versus hard budget constraints (Buiter had invoked the idea in a post earlier in the week).

The problem is that the concept is important, but this (established) turn of phrase does not slip swimmingly off the tongue. A hard budget constraint means when you run out of something (dough, usually, but it could be other scarce resources) you are stuck. No magic fairy dust to rescue you. Kornai explains:

To simplify matters, a contrast is often made between the soft and the hard budget constraint. In fact there are grades between these two extremes. The budget constraint that corporate decision-makers sense may be very soft, moderately soft, quite hard and so on, depending on their subjective awareness of the probability of rescue….

Let us turn for a minute to the dawn of capitalism. A debtor unable to pay was threatened by the debtors’ prison. Business failure in the early period of capitalism was more than a fatal material blow, for it ruined the bankrupt’s moral reputation. The budget constraint in those days was still absolutely hard. The perilous results of loss and indebtedness forced entrepreneurs to be extremely cautious.

But the historical development of property relations and the credit system gradually brought essential changes. The principle of limited liability became legitimated, and joint stock companies based on that new principle appeared. At the same time, the hitherto close connection between the material and moral position of decision-makers and the financial state of their companies became weaker.

As property and management separated, so the relation weakened between the individual destiny, income and reputation of the managers making the practical business decisions on the one hand, and the presence or absence of financial destinies of their companies, on the other. Successive legislation on business failure provided some protection for firms caught up in a spiral of debt. These changes and others not mentioned here contributed to a steady softening of the budget constraint….Early capitalism rewarded success richly and punished failure fiercely. As time went by, the rewards not only remained, but in several countries increased dramatically, while the penalties became lighter. That disproportional change has weakened the incentive for business to pursue efficiency and adaptability to change. It encourages irresponsible decisions on borrowing, investment and expansion.

The one bit I find troubling with Kornai’s discussion is he conflates soft budget constraints with socialistic regimes, namely the sort he saw in Hungary in the late 1960s, when companies were urged to adopt “market socialism” but that meant that if the manager did well, the company got a bonus, but if the company produced a loss, no matter, the state would fund the shortfall.

But this is not a function of socialist systems per se; it took place in all the examples that George Akerlof and Paul Romer cited in their classic 1994 paper on looting, and included the Chicago School free market experiment in Pinochet’s Chile, which resulted in a plutocratic land grab. To put it more simply, “socialized losses” can occur under a socialist system (where the goal is to preserve employment), in looting (where lax regulation and accounting allow companies to report largely bogus profits and syphon out funds, either directly to the owners/managers, or to affiliated companies), or in Mussolini-style corpocracy.

Note that Korzai stresses that rescues per se are not bad things, provided they are made judiciously and infrequently:

Softness of the budget constraint cannot yet be said to apply in a singular case where a firm in deep financial trouble is bailed out. The syndrome appears if such rescues occur frequently, if managers can begin to count on being rescued. We face here a mental phenomenon, an expectation in decision-makers’ minds that strongly influences their behaviour.

It isn’t hard to imagine that with a clear “no more Lehmans” policy in force in the US, UK, and EU, that banks are very well conditioned by now to expect a rescue if they screw up.

Separately, even the Times manages to undercut the pointed message of its story on source of bank profits with another story today: “All This Anger Against the Rich May Be Unhealthy.” A cultural aside: since the early 1800s in England, there was a distinction between the deserving and undeserving poor. Someone who was able to work but didn’t was undeserving (there were other ways the line might be drawn, but that was one of the most consistent). We see that carried through today (when talking about those over their heads in debt, some readers like to demonize them all as profligate, while others jump in and point out how, for instance, medical expenses can push a lot of people who had lived reasonably within their means into debt pronto. Again, it’s a “deserving v. undeserving” distinction.

Given the row over the suspect level of pay in certain areas of finance, it may be time to apply that notion to the upper end of the food chain more formally. Most people have no problem with self made men and women making a lot of money; heck, that’s the American dream. The fact that the “if you are rich, you must be deserving” Calvinist assumption is beginning to be questioned is positive; we just need to be careful not to replace old stereotypes with new ones.