naked capitalism

There is an important study in the Archives for Internal Medicine last month, which escalates an ongoing row as to whether patient satisfaction is in any way correlated with positive medical outcomes. The answer is yes, and the correlation is negative.

This finding is of critical importance, not just in understanding why American medicine is a hopeless, costly mess, but also as a window into how easy it is for buyers of complex services to be hoodwinked by their servicer provider, whether via the provider being incorrectly confident about his ability to do a good job or having nefarious intent.

Let’s deal with health care case first. The study in question was large scale, of 52,000 patients from 2000 to 2007. This summary comes from the Emergency Physicians blog (hat tip Julie W):

Results of the study showed that patients who had the highest satisfaction ratings spent 9% more on health care and prescription medications than did patients who had the lowest satisfaction ratings. In addition, the most satisfied patients had a 26% greater risk of death compared to least satisfied patients. When patients in poor health were excluded, the risk of death for these highly-satisfied “healthy” patients increased to 44% more than their least-satisfied counterparts.

In commentary accompanying the article, Dr. Brenda Sirovich suggested that discretionary testing is likely the cause of both the increased costs and the increased mortality in highly satisfied patients. Patient perceptions, even if medically inappropriate, drive testing and treatment. Antibiotics are harmful in patients with viral infections, yet a substantial subset of patients are not satisfied without an antibiotic prescription for their colds. Large studies show no link between PSA screening and either overall survival or prostate cancer survival. However, any patient whose life has been “saved” by a PSA screen is often quite satisfied. In both scenarios, there is no perceived negative effect from treatment. Patients will recover from their colds with or without antibiotics. Patients likely would not have died from their prostate cancer even if it was left untreated.

And consider: drug research shows a fairly significant placebo effect. So one would assume that satisfied patients would show positive results merely from placebo effect. The fact that the overall results are decidedly negative doesn’t merely say that more treatment and more testing are ineffective, it suggests they actually do harm.

The article uses the PSA test as an example of ineffective screening. I’m pretty healthy, yet I’ve seen this bias to overtest and overtreat first hand, and I can’t imagine what people who are less than robust must go through.

Readers have seen me rant upon occasion in comments about mammograms. They are a terrible test. They are bad at capturing the dangerous-fast moving cancers and produce a lot of false positives (benign slow moving growths which won’t kill you even if you live to be 100) which lead to unnecessary procedures. Oh, and no one factors in the risk of annual exposure of soft tissue to radiation. Manual breast exams by an experienced examiner are far better at detecting the dangerous growths, and thermal imagining is also more accurate than mammograms and does not involve radiation. But radiologists have an installed base of equipment and will hector you if you refuse to get a mammogram.

Similarly, there are only a few knee operations (surgeries for a torn medial meniscus and torn ACLs) that have a high efficacy rate. Yet with my long-standing knee problem (which is my case is due to foot and ankle instability but the overwhelming majority of orthopedists won’t even look at my gait), the standard answer from an orthopedist is, in the absence of ANYTHING sus on an MRI: “Let me go in and have a look and I’ll clean it up.” I’m not about to let a doctor go on a fishing expedition in my knee, yet that seems to be considered acceptable.

The inherent problem of medicine American-style was set forth longer form in the Maggie Mahar book, Money Driven Medicine which shows why the market has failed. One big culprit is information asymmetry. One of the conditions for a market to function well is that buyers and sellers have perfect information. In the medical arena, there is often a lack of good data as to what constitutes optimal practice. Among the many examples are the backing and forthing on hormone replacement therapy and the above mentioned mammograms. Now condiser: these treatments have been the subject of multiple large scale studies. Most protocols haven’t been investigated this intensely. And even when there is good information, the patient is at the mercy of his medical providers, the drug companies, and device makers. He can’t challenge their views; his best hope is to shop for a better practitioner, which is a costly, time consuming, and deeply flawed process (how can he judge whether a doctor is making sound recommendations?).

The other major element of market failure is the considerable disparity in buyer and seller power. If you are very sick, you will do anything to get better, which includes spending a lot of money. And our can-do, technology-loving culture favors doing more, whether beneficial or not.

We’ve seen how resistant patients are to evidence-driven medicine, particularly when the finding is less is more. Women seemed distressed to be told that mammograms were being overadministered (the old recommendation had been to get them annually starting at age 40, the new recommendations are ex a family history of cancer, to start getting them at 50 and have them done every other year through age 74). And patient confusion was not helped by self-serving radiologists taking issue with the study conclusions. And we have drug companies expertly playing on patients’ “more must be more” bias: advertising aggressively for new drugs, when they are typically much more expensive than older ones, often with little or no improvement in efficacy. Doctors seem remarkably disinclined to argue with patients who want a particular drug (indeed, I’ve seen how trigger happy doctors are to hand out pills. Say you are tired and in NYC that’s treated as code not for a vitamin B-12 shot, but either Adderall or anti-depressants).

The bigger issue is that in many fields, customers have no real ability to judge service quality. Like the satisfied patients, they too often rely on proxies, like bedside manner or being with the “right” firm, when big firms have first and second strings, and if you aren’t an actual or prospective big ticket you are usually better served finding a good partner at a smaller shop. I’ve been more exposed to top lawyers and litigation by virtue of working on complicated deals, having some clients get involved in lawsuits, and often talking shop with some savvy lawyer friends. As a result, I’ve mainly have very good experiences the few times I have had to hire a lawyer, but even I had one stuff up. And I’ve seen too many times in client situations where they appeared not to understand that their counsel was not up to snuff for the task at hand, but it would have been close to impossible to get them displaced.

I’ve similarly seen friends make bad decisions because they trusted their advisor when they shouldn’t have. I remember a long argument with a savvy investor friend who liked and trusted her broker at Citigroup, and took his advice to buy Citigroup at $45. She wouldn’t listen to contrary information, in fact, she was convinced he had some special insight by virtue of being at the bank (as opposed to he might be getting bonus credits). We know how well that trade worked out.

And that’s one reason I’m more sympathetic with duped investors than other readers probably are. Hindsight is always 20/20. The mortgage securities market had seemed to work well for nearly two decades. Bernanke kept insisting household balance sheets were fine and there was no reason to worry about housing prices, that prices would at worst stabilize. And most people trust people they do business with. That’s a big factor that enabled looting by the securities industry. People simply don’t want to believe that someone who seemed sincere and should have an interest in keeping them as a client would fleece them.

The message, sadly, is clear: satisfaction is not always in a customer’s best interest. But most of us don’t have the time or psychic energy to be vigilant.

There has been so much news on the mortgage beat the last few weeks that I managed to neglect one of my missions, which is my personal Ben Stein watch on Adam Davidson, who operates as the Lord Haw Haw for the 1% in his column in the Sunday New York Times Magazine.

His latest piece, “Why Are Harvard Graduates in the Mailroom?” is more accurately titled “In Praise of Exploitation.” When you strip his argument down, it amounts to: “A lot of people choose to be exploited, and voluntarily take jobs where they are paid less than they deserve because they hope to be big winners.” As in really big winners. Davidson repeatedly compares the payoffs to various activities (working the the mail room at William Morris, being a low level drug dealers, acting, working in a law firm or investment bank) to a lottery.

The lottery analogy, which Davidson uses through the entire piece, is wonderfully, nails-on-the-chalkboard screechingly at odds with his claim: “That’s the spirit of meritocratic capitalism!” Lotteries involve random, blind draws of “lots”. Modern lotteries, the kind that plug holes in government deficits, are such astonishingly low odds affairs that they are described as “a tax on people who are bad at math.” So Davidson appears to be telling us that success in modern capitalism is painfully unlikely and pretty much random.

And there are ample proofs that meritocracy is a fantasy. A devastating 1992 paper by Patrick D. Larkey and Jonathan P. Caulkin, “All Above Average and Other Unintended Consequences of Performance Appraisal Systems,” declared that 100 years of dealing with performance review systems proved they were inherently unable to produce objective results. Among the reasons: the complexities of the boss-subordinate relationship, the fact that virtually all performance appraisals are subjective (even ones of salesmen should allow for who has better or worse territories), and that it is pretty much impossible to devise sensible ways to compare staff caliber across departments. When I was a young person on Wall Street, getting comp right was management’s most important job, and at Goldman, they spent the better part of six weeks of the year on it.

Or consider the example portrayed in Michael Lewis’ book Moneyball. The baseball industry has always measured players’ skill and achievements by a handful of well-known statistics. To make the most of a limited budget, Oakland A’s general manager Billy Beane relied on statistical analysis to sign low-salaried players that appeared to be dramatically undervalued. The result: The team, with one of baseball’s lowest payrolls, has placed first or second in its division for eight seasons running.

Remember: baseball is a business where the recruiting is unusually transparent, the basic rules have remained unchanged for decades, competitive encounters are in full view, and the incentives for success are high. This would seem to be the perfect environment for developing good rules for hiring and promotion, yet the entire industry was largely wrong.‘

And that’s before we get to the role of good old fashioned bias. A 1997 Nature paper by Christine Wenneras and Agnes Wold, “Nepotism and Gender Bias in Peer-Review,” determined that women seeking research grants need to be 2.5 times more productive than men to receive the same competence score. Similarly, Tom Ferguson has combed though the data sets underlying a recent study claiming that the executive ranks of large firmswere meritocratic, and the underrepresentation of “out groups was due to their lack of skills. Ferguson found that the distribution suggested otherwise: ethnic groups are in fact over-concentrated in a few pockets, when they should be scattered evenly if merit selection dominated.

And another part of the fantasy that Davidson and other status quo apologists exploit successfully is the desperate need to believe the system is fair. As Stanford neuroscience professor Ben Barres (who knows more than a bit about discrimination, having formerly been Barbara) noted, citing research:

When it comes to bias, it seems that the desire to believe in a meritocracy is so powerful that until a person has experienced sufficient career-harming bias themselves they simply do not believe it exists.

Another intelligence-insulting aspect of this article is how Davidson force fits all sorts of different jobs into the same simple-minded generalization. One of the reasons some career paths have extreme power law payoffs is lots of people are willing to do the work for no or little pay because it is creative and intrinsically enjoyable (at least for some people). Writing and the visual and performing arts fall into this category. By contrast, as Frank Partnoy’s book FIASCO made clear, highly paid derivative salesmen hated the work and all said they’d do anything else, including haul garbage, if they could make anything resembling the money they were earning.

Not that we should fell sorry for the aspiring partners or equivalents in accounting, consulting, investment banking, or the law that Davidson weirdly equates with drug dealers or mail room boys looking to leap into a professional role. Those jobs are all well paid to very well paid. The hours are typically exploitative, but the young’uns are also learning a trade, as well as how to manage clients, not just doing scut work. And unlike the mail runners who never get their break, the downside for people in banks or professional firms who don’t make it to the very top are usually very handsome. Indeed, a not trivial number opt out into better careers than if they had stayed with their firm and had made it to the top.

So Davidson misleads in suggesting that a normal organizational pyramid, or the more Darwinian “up or out” version of law, accounting, and consulting firms, is a “lottery” when the upside and downside payoffs of those career paths are very attractive, as contrasted with the typical payoffs of trying to be a professional performing artist (for instance, a woman I know who majored in dance and had gotten hired as a ballerina had to turn to stripping to pay off her school debts).

But there is one way in which Davidson’s lottery metaphor is apt. A 2008 study found that poor people spent a whopping 9% of their incomes on the lottery. I’ve read various theories as to why, most of them of the moralizing “aren’t they dumb/irresponsible” subtext. But as someone who once in a great while buys a lottery ticket (only when it is a rational bet after taxes, and that occurs very rarely when the pots are super huge, and even then, with the predictable lack of success), the explanation that seems most plausible is that the wager allows them to engage in some pleasant fantasizing, just as shelter and vacation magazines do for the more affluent (you can argue that this fantasizing comes at a high cost, but people who are poor need their pleasures too, and there are worse choices than lottery tickets).

So unintentionally, Davidson’s lottery metaphor is apt for those who aren’t on the fast track: exploiting people’s tendency to dream to get them to accept economic propositions that are hopelessly stacked against them. And his insistently cheerful tone tells us we should recognize that this is all for the best in this best of all possible worlds.

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I must report that Davidson did e-mail me after one of my salvos at him, but I chose not read his message. If he would like to take issue with one of my posts, he is free to do so in my comments section. I do correct posts pronto if I have made a mistake or misconstrued an argument or data. Felix Salmon argues, and I concur, that one of the values of the blogosphere is that participants can engage in conversations in public, and it forces everyone to sharpen their discourse.

Yves here. No one should be surprised that Bloomberg is reporting today that Goldman is aggressively lobbying for a Volcker Rule waiver for its role as a sponsor of and investors in “credit funds.” Update: Andrew Ross Sorkin predictably parrots industry talking points.

By George Bailey, who has worked in senior compliance roles at a Big Firm You’ve Heard Of and is also a member of Occupy the SEC

Today is “Volcker Day” and Paul Volcker was on a tear.

Mr Volcker added in a formal submission to regulators Monday that “proprietary trading is not an essential commercial bank service that justifies taxpayer support,” and that banks should stop “stonewalling.”

He went on to say,

“There should not be a presumption that evermore market liquidity brings a public benefit,” Volcker, 84, wrote in a letter submitted yesterday to regulators in defense of the rule curtailing banks’ bets on asset prices with their own money. “At some point, great liquidity, or the perception of it, may itself encourage more speculative trading
(See here and here for the full story.)

But then Jamie Dimon came along and slapped Tall Paul. Ouch.

“Paul Volcker by his own admission has said he doesn’t understand capital markets,” Dimon told Francis in the Fox Business interview. “He has proven that to me.”

SIFMA, on behalf of the industry, took over to explain in detail just what it is that Mr. Volcker doesn’t understand in their comment letter. They reiterate their dire warning about the devastating effects on ‘corporate liquidity‘ from the Volcker Rule. Yet surprisingly, no non-financial corporate bond issuers filed any comments to acknowledge or object to this danger. In fact, there are no comment letters from any non-financial companies. They did haul out the widely lampooned Oliver Wyman study to bolster their comment that ‘corporate’ America would suffer horribly if Volcker is enacted. But that just serves to remind us again that the corporate bond liquidity that will be affected is the liquidity in dodgy financial company ‘corporate’ bonds, like CDOs and other drek. They conclude the only solution is a rewrite. They request the rule makers go back and start all over again.

The SIFMA comment letter runs to 175 pages. I haven’t read all the other financial company letters, but the ones I’ve skimmed conform to SIFMA’s position.

The Occupy the SEC comment letter logs in at 325 pages and oddly enough draws the exact opposite conclusions to each of SIFMA’s objections. It’s an interesting contrast. For some reason (some familiarity with the subject matter and public interest primarily) the group seems to have understood and articulated Volcker’s (and the electorate’s) intent pretty effectively (because this is a large document, we suggest you download it if you’d like to peruse it).

Occupy the SEC Comment Letter on the Volcker Rule

Of the comment letters received about 90% are from financial institutions, and another 5% are from foreign governments objecting to the priority the US regulators have gifted to US traders in US Government Bonds. The remaining 5% are from ordinary folks, like Mr. Volcker, Occupy the SEC and other public interest groups.

It’s interesting that 95% of the comments reflect the views of the 1%, and the views of the 99% are embodied in the comments of the remaining 5% of commenters.

I’m confident the regulators will recognize that, for all its complexity, the rules are comprehensible and can be refined to serve the public’s demand for control over a runaway financial system.

Yves here. I hate to throw a spanner in the works, but as much as Varoufakis’ view may sound persuasive, I strongly suggest you read Andrew Dittmer’s translation of a very important paper by Claudio Borio and Piti Disyatat of the Bank of International Settlements, “Global imbalances and the financial crisis: Link or no link?”

Yanis Varoufakis is a Greek economist who currently heads the Department of Economic Policy at the University of Athens. From 2004 to 2007 he served as an economic advisor to former Greek Prime Minister George Papandreou. Yanis writes a popular blog which can be found here. His latest book ‘The Global Minotaur: America, the True Origins of the Financial Crisis and the Future of the World Economy’ is available from Amazon.

Interview conducted by Philip Pilkington

Philip Pilkington: In your book The Global Minotaur: America, The True Origins of the Financial Crisis and the Future of the World Economy you lay out the case that this ongoing economic crisis has very deep roots. You claim that while many popular accounts – from greed run rampant to regulatory capture – do explain certain features of the current crisis, they do not deal with the real underlying issue, which is the way in which the current global economy is structured. Could you briefly explain why these popular accounts come up short?

Yanis Varoufakis: It is true that, in the decades preceding the Crash of 2008, greed had become the new creed; that banks and hedge funds were bending the regulatory authorities to their iron will; that financiers believed their own rhetoric and were, thus, convinced that their financial products represented ‘riskless risk’. However, this roll call of pre-2008 era’s phenomena leaves us with the nagging feeling that we are missing something important; that, all these separate truths were mere symptoms, rather than causes, of the juggernaut that was speeding headlong to the 2008 Crash. Greed has been around since time immemorial. Bankers have always tried to bend the rules. Financiers were on the lookout for new forms of deceptive debt since the time of the Pharaohs. Why did the post-1971 era allow greed to dominate and the financial sector to dictate its terms and conditions on the rest of the global social economy? My book begins with an intention to home in on the deeper cause behind all these distinct but intertwined phenomena.

PP: Right, these trends need to be contextalised. What, then, do you find the roots of the crisis to be?

YV: They are to be found in the main ingredients of the second post-war phase that began in 1971 and the way in which these ‘ingredients’ created a major growth drive based on what Paul Volcker had described, shortly after becoming the President of the Federal Reserve, as the ‘controlled disintegration of the world economy’.

It all began when postwar US hegemony could no longer be based on America’s deft recycling of its surpluses to Europe and Asia. Why couldn’t it? Because its surpluses, by the end of the 1960s, had turned into deficits; the famous twin deficits (budget and balance of trade deficits). Around 1971, US authorities were drawn to an audacious strategic move: instead of tackling the nation’s burgeoning twin deficits, America’s top policy makers decided to do the opposite: to boost deficits. And who would pay for them? The rest of the world! How? By means of a permanent transfer of capital that rushed ceaselessly across the two great oceans to finance America’s twin deficits.

The twin deficits of the US economy, thus, operated for decades like a giant vacuum cleaner, absorbing other people’s surplus goods and capital. While that ‘arrangement’ was the embodiment of the grossest imbalance imaginable at a planetary scale (recall Paul Volcker’s apt expression), nonetheless, it did give rise to something resembling global balance; an international system of rapidly accelerating asymmetrical financial and trade flows capable of putting on a semblance of stability and steady growth.

Powered by America’s twin deficits, the world’s leading surplus economies (e.g. Germany, Japan and, later, China) kept churning out the goods while America absorbed them. Almost 70% of the profits made globally by these countries were then transferred back to the United States, in the form of capital flows to Wall Street. And what did Wall Street do with it? It turned these capital inflows into direct investments, shares, new financial instruments, new and old forms of loans etc.

It is through this prism that we can contextualise the rise of financialisation, the triumph of greed, the retreat of regulators, the domination of the Anglo-Celtic growth model; all these phenomena that typified the era suddenly appear as mere by-products of the massive capital flows necessary to feed the twin deficits of the United States.

PP: You seem to locate the turning point here at the moment when Richard Nixon took the US off the gold standard and dissolved the Bretton Woods system. Why is this to be seen as the turning point? What effect did de-pegging the dollar to gold have?

YV: It was a symbolic moment; the official announcement that the Global Plan of the New Dealers was dead and buried. At the same time it was a highly pragmatic move. For, unlike our European leaders today, who have spectacularly failed to see the writing on the wall (i.e. that the euro-system, as designed in the 1990s, has no future in the post-2008 world), the Nixon administration had the sense to recognise immediately that a Global Plan was history. Why? Because it was predicated upon the simple idea that the world economy would be governed by (a) fixed exchange rates, and (b) a Global Surplus Recycling Mechanism (GSRM) to be administered by Washington and which would be recycling to Europe and Asia the surpluses of the United States.

What Nixon and his administration recognised was that, once the US had become a deficit country, this GSRM could no longer function as designed. Paul Volcker, who was Henry Kissinger’s under-study at the time (before the latter moved to the State Department), had identified with immense clarity America’s new, stark choice: either it would have to shrink its economic and geopolitical reach (by adopting austerity measures for the purpose of reigning in the US trade deficit) or it would seek to maintain, indeed to expand, its hegemony by expanding its deficits and, at once, creating the circumstances that would allow the United States to remain the West’s Surplus Recycler, only this time it would be recycling the surpluses of the rest of the world (Germany, Japan, the oil producing states and, later, China).

The grand declaration of 15th August 1971, by President Nixon, and the message that US Treasury Secretary John Connally was soon to deliver to European leaders (“It’s our currency but it is your problem.”) was not an admission of failure. Rather, it was the foreshadowing of a new era of US hegemony, based on the reversal of trade and capital surpluses. It is for this reason that I think the Nixon declaration symbolises an important moment in postwar capitalist history.

PP: The old banking proverb: “If you owe a bank thousands, you have a problem; owe a bank millions, the bank has a problem” comes to mind. Was this, then, the end of the hegemony of the US as lender and the beginning of the hegemony of the US as borrower? And if so, does this provide us with any insights into the financial crisis of 2008?

YV: I suppose that Connally’s “It’s our currency but it is your problem” turned out to be the new version of the old banking adage that you mention. Only there is an important twist here: in the case of the banks, when they fail, there is always the Fed or some other Central Bank to stand behind them. In the case of Europe and Japan in 1971, no such support was at hand. The IMF was, let’s not forget, an organisation whose purpose was to fund countries (of the periphery mostly) that faced balance of payments deficits.

Connally’s phrase was aimed at countries that had a balance of payments surplus in relation to the United States. Additionally, when a heavily indebted person or entity tells the bank that it is the one with the problem, and not the indebted, this is usually a bargaining ploy by which to secure better terms from the bank, a partial write down on the debt etc. In the case of Connally’s trip to Europe, shortly after the Nixon announcement, the United States was not asking anything from Europeans. It was simply announcing that the game had changed: energy prices would rise faster in Europe and in Japan than in America, and relative nominal interest rates would play a major role in helping shape capital flows toward the United States.

The new hegemony was thus beginning. The hegemon would, henceforth, be recycling other people’s capital. It would expand its trade deficit and pay for it via the voluntary flows of capital into New York; flows that began in earnest especially after Paul Volcker pushed US interest rates through the roof.

PP: And this new hegemony grew almost organically out of the preeminence of the dollar as a world reserve currency that had grown up in the post-war years, right? Could you say something about this?

YV: The ‘exorbitant privilege’ of the dollar, courtesy of its reserve currency status, was one of the factors that allowed the United States to become the recycler of other people’s capital (while America was busily expanding its trade deficit). While crucial it was not the only factor. Another was the United States’ dominance of the energy sector and its geostrategic might. To attract wave upon wave of capital from Europe, Japan and the oil producing nations, the US had to ensure that the returns to capital moving to New York were superior to capital moving into Frankfurt, Paris or Tokyo. This required a few prerequisites: A lower US inflation rate, lower US price volatility, relatively lower US energy costs and lower remuneration for American workers.

The fact that the dollar was the reserve currency meant that, in a time of crisis, capital flew into Wall Street anyway (as it was to do again years later when, despite Wall Street’s collapse, foreign capital rushed into Wall Street in the Fall of 2008). However, the volume of capital flows that had to flood Wall Street (in order to keep the US trade deficit financed) would not have materialised had it not been for the capacity of the United States to precipitate a surge in the price of oil at a time when (a) US dependence on oil was lower than Japan’s or Germany’s, (b) most oil trades were channeled via US multinationals, (c) the US could suppress inflation by raising interest rates to levels that would destroy German and Japanese industries (without totally killing American companies) and (d) trades unions and social norms that prevented a ruthless suppression of real wages were far ‘softer’ in the US than in Germany or Japan.

PP: You write in the book that US officials were actually not that concerned about the rising oil prices in the 1970s, why do you say this? And do you think that the recent speculative pressures on oil and food prices – emanating from Wall Street itself – have been largely tolerated by US officials for similar reasons?

YV: The reason is in the old joke that has one economics professor asking another “How is your wife?” and receives the reply: “Relative to what?” The whole point about attracting capital and gaining competitiveness over another company or, indeed, another country, is that what matters is not absolute but relative costs and prices. Yes, the US authorities were concerned about inflation and oil prices. They did not like their increases, especially when they could not control them fully. But there was one thing that they feared more: An incapacity to finance the growing US trade deficit (that would result if the returns to capital were not improving relative to similar returns elsewhere). It was in this context that their considered opinion was that a hike in energy prices, to the extent that it boosted German and Japanese costs more than it did US costs, was their optimal choice.

As for the comparison with the recent rise in oil and, primarily, food prices, I think this is quite different. For one, I do not see what US interests are being served by the ways in which derivatives in the Chicago marker are pushing food prices to a level that threaten the Fed’s quantitative easing strategy courtesy of the inflationary pressures they are causing. Additionally, back in the early 1970s, the US government was far more in control of financial flows and speculative drives than it is today. Having allowed the genie of financialisation out of the bottle, US authorities are watching it wreak havoc almost helplessly – especially given the inherent ungovernability of the United States, with Congress and the Administration locked into mortal combat with one another. In sharp contrast, back in 1971-73, the US government had a great deal more authority over the markets now.

PP: I’d like to move on to what I think is the key point of your book: namely, that the rest of the world is funding the US’s twin deficits – that is, the rest of the world is funding both the US trade deficit and the US government deficit.

When the twin deficits began to open up in the US there was a fundamental change in the nature of the US economy. Could you talk about this a little?

YV: The change was earth-shattering for America’s social economy. The strategy of allowing the deficits to expand inexorably came hand-in-hand with a series of strategies whose purpose was, quite simply, to draw into the United States the capital flows, from the rest of the world that would finance these growing deficits. In my book I tried to detail four major strategies that proved crucial in generating the capital tsunami which kept America’s deficits satiated: (1) a global boost in energy prices that would affect disproportionately Japanese and German industries (relatively to US firms), (2) a hike in America’s real interest rate (so as to make New York a more attractive destination for foreign capital), (3) a much cheapened American labour that is, at once, greatly more productive, and (4) a drive toward Wall Street financialisation that created even greater returns for anyone sending capital to New York.

These strategies had a profound effect on American society for a variety of reasons: To keep real interest rates high, the nominal interest rate was pushed upwards at a time that the administration, and the Fed, engineered a reduction in wages. The increasing interest rates shifted capital from local industry to foreign direct investment and transferred income from workers to rentiers. The cheapening of labour, which also necessitated a wholesale attack against the trades unions, meant that American families had to work longer days for less money; a new reality that led to the breakdown of the family unit in ways which had never been experienced before. The more family values were becoming the emerging Right’s mantle, the greater their destruction at the hands of the Global Minotaur that the Right was keenly nourishing.

The loss of wage share meant, moreover, that families had to rely more greatly on their home as a cash cow (using it as collateral in order to secure more loans) thus turning a whole generation away from savings and towards house-bound leverage. A new form of global corporation was created (the Wal-Mart model) which imported everything from abroad, used cheap labour domestically for manning the warehouse like outlets, and propagated a new ideology of cheapness. Meanwhile, Wall Street was using the capital inflows from abroad to go on a frenzy of lucrative take-over and merger activity which was the breeding ground for the financialisation which followed. By combining the domestic hunger for credit (as the working class struggled to make ends meet, even though they worked longer hours and much more productively than before), a link was created between financial flows built upon (i) the humble home of the bottom 60% of society and (ii) the financial inflows of foreign capital into Wall Street. As these two torrents of capital merged, Wall Street’s power over Main Street rose exponentially. With labour losing its value as fast as regulatory authorities were losing their control over the financial sector, the United States was changing fast, losing all the values and ditching all the social conventions that had evolved out of the New Deal. The world’s greatest nation was ready for the Fall.

PP: You mentioned the Wal-Mart model just now. In the book you make a good deal out of this model. Could you explain to the readers why you do and what the significance of it is for the broader economy?

YV: Wal-Mart symbolises a significant change in the nature of oligopolistic capital. Unlike the first large corporations that created wholly new sectors by means of some invention (e.g. Edison with the light bulb, Microsoft with its Windows software, Sony with the Walkman, or Apple with the iPod/iPhone/iTunes package), or other companies that focused on building a particular brand (e.g. Coca Cola or Marlboro), Wal-Mart did something no one had ever thought of before: It packaged a new Ideology of Cheapness into a brand that was meant to appeal to the financially stressed American working and lower-middle classes. In conjunction with its fierce proscription of trades unions, it became a bulwark of keeping prices low and of extending to its long suffering working class customers a sense of satisfaction for having shared in the exploitation of the (mostly foreign) producers of the goods in their shopping basket.

In this sense, the significance of Wal-Mart for the broader economy is that it represents a new type of corporation which evolved in response to the circumstances brought on by the Global Minotaur. It reified cheapness and profited from amplifying the feedback between falling prices and falling purchasing power on the part of the American working class. It imported the Third World into American towns and regions and exported jobs to the Third World (through outsourcing). Wherever we look, even in the most technologically advanced US corporations (e.g. Apple), we cannot fail to recognise the influence of the Wal-Mart model.

PP: Finally, where do you see us headed now as we emerge from the shadow of the Global Minotaur?

YV: The Minotaur is, of course, a metaphor for the strange Global Surplus Recycling Mechanism (GSRM) that emerged in the 1970s from the ashes of Bretton Woods and succeeded in keeping global capitalism in a rapturous élan; until it broke down in 2008, under the weight of its (and especially Wall Street’s) hubris. Post-2008, the world economy is stumbling around, rudderless, in the absence of a GSRM to replace the Minotaur. The Crisis that began in 2008 mutates and migrates from one sector to another, from one continent to the next. Its legacy is generalised uncertainty, a dearth of aggregate demand, an inability to shift savings into productive investment, a failure of coordination at all levels of socio-economic life.

A world without the Minotaur, without a functioning GSRM, but one that is ruled by the Beast’s handmaidens, is an illogical, absurd place. And who are the Minotaur’s surviving handmaidens? They are Wall Street, Walmart, Germany’s provincial mercantilism, the European Union’s absurd pretence that a currency union can prosper without a surplus recycling mechanism, the growing inequities within the United States, within Europe, within China, etc., etc.

The best example of our world’s inability to come to terms with its conundrum is the way in which public debate deals with the so-called global imbalances: the systematically increasing trade surplus of some countries (Germany and China are good examples), which are mirrored in increasing trade deficits in others. All commentators are now in agreement that increasing global imbalances are a terrible thing. One would, consequently, be excused for imagining that a reduction in global imbalances would have been welcomed. But alas, the opposite is the case. When the imbalances shrink (e.g. China’s trade surplus declines) this is a sign of trouble, rather than an improvement. The reason is that the cause of the imbalance’s shrinkage is not a better, a more productive recycling of surpluses, but rather a deepening recession in the countries that used to provide the demand for someone else’s net exports. So we are in the weird situation of exorcising global imbalances, while at the same time suffering when they diminish.

The West, caught in Bankruptocracy’s poisonous web, unable to rise to the challenges of the post-2008 world, will keep stagnating, losing its grip on reality, failing to match its outcomes to its capacities or to create new ‘realities’. As for the emerging economies, bristling with people ready to transcend constraints, to spawn new ‘realities’, to expand existing horizons, they will be caught in a trap of low overall demand for their wares. Unless a new GSRM materialises soon, the future of the global economy will remain bleak. What will it take to fashion a GSRM from scratch? One thing is certain: markets will not spontaneously generate one. A new GSRM must be the result of concerted political action. Just like Bretton Woods once was.

Rod Hill and Tony Myatt are Professors of Economics at the University of New Brunswick in Saint John and Fredericton (respectively). Their new book, The Economics Anti-Textbook is available from Amazon. They also run a blog at www.economics-antitextbook.com.

Interview conducted by Philip Pilkington.

Philip Pilkington: Your book seems to me a much needed antidote to the mainstream economics textbooks and can either be read alone or together with them. I think that’s a great approach because it allows students to become familiar with what is being taught in the classroom but also allows them to take a critical perspective on this material. So, let’s start with the format of these textbooks. In the book you say that they “cloak themselves in an aura of objectivity”. You then relate this to the fact that economics is not a value-free discipline and contains necessary ideological judgements. Could you talk about this a bit?

Tony Myatt: That’s correct. We say the texts cloak themselves with an aura of objectivity while at the same time implicitly (and repeatedly) making value judgements that reflect a particular ideology. Indeed, one of our main objectives in our Anti-Textbook is to provide overwhelming evidence of that. We believe that students subjected to the mainstream textbooks sense the bias in those texts (and the courses that rely on them) and it turns them off. They realize they are being sold something. They don’t like being bamboozled. Evidence for this is provided by the recent walkout from Mankiw’s introductory economics course. Even though the students could not elaborate very clearly the nature of the bias (in the letter they wrote explaining their actions), which unfortunately made them seem quite naive, those students were correct that the bias is there. One might say they intuitively sensed it.

Delightfully for us, Mankiw replied to these students in his New York Times column, saying “I don’t view the study of economics as laden with ideology…It is a method rather than a doctrine….a technique for thinking, which helps the possessor to draw correct conclusions.” Notice the wording he uses, “correct conclusions.” If there were “correct conclusions” to be drawn from using the economic method of thinking, there would be a consensus among economists on most positive economic questions. And while the mainstream texts always claim that such a consensus exists, the evidence suggests otherwise. I’m not just talking here about the profession’s response to the financial meltdown and the ongoing economic crisis, but even more mundane questions such as the effect on unemployment of an increase in the minimum wage. So, Mankiw is simply showing his own bias by implicitly claiming a consensus, by saying there are “correct” conclusions to be drawn.

Our perspective is that there is an ideology that pervades mainstream economics, especially in the way it is currently practiced and taught. There is an important point here: that we can distinguish between neoclassical economics itself, and the mainstream practice and teaching of neoclassical economics.

The point is that it is more difficult to argue that there is a bias in neoclassical economics itself. The neoclassical paradigm is remarkably malleable. It is capable of transforming itself, of shedding many an unappealing feature in the hands of ‘this analyst’ or ‘that analyst’ or ‘this paper’ or ‘that paper’. Moreover, the boundaries of mainstream neoclassical economics are blurry. It is not clear, for example, whether recent work on ‘limited rationality’ lies within the neoclassical paradigm or is a direct assault upon it. As another example, the work on imperfect information by Joseph Stiglitz overthrows many of the neoclassical presumptions about the efficiency of otherwise competitive markets, and the harmfulness of government intervention, and we see his work as being squarely within the neoclassical paradigm. One could even use neoclassical economics to show the importance of community ties and social cohesion, even though in the normal practice and teaching of neoclassical economics these things are totally ignored.

That’s why we called our book an “Anti-Textbook”. The mainstream textbooks are remarkably uniform and do reflect a narrow range of world views. This is a much easier target to attack. And the mainstream textbooks do reflect the core beliefs of mainstream economists that inform their policy prescriptions.

Your question to us was to explain why we feel economics is not a value-free discipline and necessarily contains ideological judgements. We can answer that question. But first, to understand what we did in our book, let’s answer the easier question of why textbooks must necessarily contain ideological judgements.

The textbooks necessarily contain ideological judgements because they are necessarily selective. They must include and emphasize some things and exclude or downplay others. They ask certain questions and not others. They place some topics and questions in the forefront, and put others in the background or leave them out entirely. Those decisions reflect implicit value judgements about what is interesting and important. No ‘objective’ account is possible. For most people – including many economists – this is not a controversial claim.

So, our methodology, our way of getting around the amorphous nature of the neoclassical paradigm, is to focus on the mainstream neoclassical textbooks themselves. We point out their biases of omission and commission. We notice when claims are made without any supporting evidence, or when the so-called evidence is irrelevant or out of date. We notice when two thirds of the text assumes perfectly functioning markets which prohibits (by assumption) the importance of power.

This focus on the textbooks does not mean that we feel there is no bias in neoclassical economics itself. Far from it. Every approach has a bias just as all economists have a bias. Our perspective is that it’s best to acknowledge that fact at the outset. But I’ve said enough. Better let Rod have a turn…

PP: The issue of power is an interesting one. I think what many students who feel instinctively critical of economics courses note from the outset is that the theories taught imply some sort of level playing field. Yet, you would have to be blind not to notice divisions of class and race in even the most prosperous societies. Could you talk about this a bit?

Rod Hill: I think power is central to understanding the reality of economic life. For that reason, it’s important that it be effectively obscured in the principles texts as students are taught how to ‘think like an economist’. The texts typically manage this very well, although I’m sure their authors have no conscious intention to set out to do this. (This remarkable aspect of our propaganda system helps to make it so effective.)

The texts do indeed imply a sort of ‘level playing field’ between buyers and sellers in both markets for goods and services as well as in the labour market. This follows from the central place that’s given to the supply and demand model (which is “short-hand” for the perfectly competitive market).

There, everyone is a ‘price taker’. There is no room for businesses to use their bargaining power to squeeze workers’ wages, to prevent workers from unionizing, to force down their suppliers’ prices, or to raise their selling prices once they’ve eliminated their competition. (Think Walmart.)

But ‘market power’, the ability to push the price away from a hypothetical competitive level, is just the tip of the power iceberg. At least the texts acknowledge this form of power, even if they downplay it. If students think for themselves, they could realize the practical irrelevance of the perfectly competitive market structure. More likely, at least with those who stick with economics, they will start to see the world as composed of competitive markets, regardless of their actual structure. Indeed, some textbooks explicitly justify this by asserting that most markets are ‘competitive enough’ to be approximated by perfect competition.

Most aspects of power remain discreetly out of sight in the texts, even though, as you say, you’d have to be blind not to see them in real life. I like to paraphrase a line from Ben Bagdikian’s The Media Monopoly: the texts can’t tell you what to think, but they can tell you what to think about.

So while they focus students’ attention on these powerless markets, they say little or nothing at all about the power of the wealthy, or the businesses they own, and how they can influence the ‘rules of the game’. As Ha-Joon Chang reminds us in the first chapter of 23 Things They Don’t Tell You About Capitalism, there is no such thing as a ‘free market’: all market exchange takes place within a set of rules and institutions and those matter to market outcomes. But any serious discussion of what determines them would draw attention to the links between economic and political power. It would also provide an extra reason to be concerned about the rapid growth of economic inequality in many countries.

In the world of the texts, the managers of profit-maximizing firms allegedly spend all their time trying to hire the right combinations of labour and capital while spending no time trying to increase profits by influencing laws and regulations. In the world of reality, small armies of lobbyists and corporate lawyers work to do just that, even helpfully drafting laws for busy legislators whose political campaigns they help to finance.

Incidentally, the one notable exception to this in the texts is the discussion of regulating monopoly. The story is that regulators are often ‘captured’ by the industry they are supposed to regulate so that with government screwing up (as it often does in textbook examples) no regulation might be the better option. An ideologically convenient story!

Other aspects of power are also absent. The firm is largely treated as a black box, so authoritarian relations within it are ignored; questions of economic democracy do not arise. The analysis of trade and foreign investment ignores the effects of the relative power of different countries.

I can’t prove how all this affects students. But in my own case I feel I was effectively blinded for an embarrassingly long time to many of these obvious aspects of the world.

PP: And how do you think the textbooks go about hiding these sorts of assumptions?

Rod Hill: In a way, I think the texts hide these assumptions in plain sight while using the magician’s trick of focussing the students’ attention elsewhere. When the supply and demand model is introduced, the texts don’t stress the unrealistic assumptions of the perfectly competitive model (perfect costless information, no geography so that all transactions take place on the head of a pin, no one has any power over prices, no product differentiation). In part, this is because these are deemed to be not important for the questions being asked.

Students’ attention is directed to questions where the model’s predictions seem to accord with common sense: demand goes up, prices rise; costs go up, prices rise, and so on. The student might think this looks plausible and, for much of the text and the course, it’s the only game in town.

But the model also predicts ‘no advertising’, ‘no political contributions by firms’, ‘little or no research and development spending’, ‘all sellers sell identical goods for the same price’ , and ‘people doing the same work get the same wages’ in the labour market. However, no questions about those things are asked, so the predictions are not confronted by the evidence that would refute them. Students would have to figure this out for themselves. And not coincidentally, these questions also raise issues of power: firms’ power over consumers, firms’ power in the political arena, firms’ power over their workers.

So independent-minded students could ask these questions, but (unless they stick around long enough to go to graduate seminars) they are not shown any way of thinking about them in their principles of economics class.

Tony Myatt: And I’d add to that it’s not just a question of emphasis – that the texts assume perfectly competitive markets for three quarters of the book. It’s also a question of placement and progression. The usual progression is an early chapter on methodology, which emphasizes that the realism of assumptions doesn’t matter – it’s predictive power that matters. This is followed by a section often called ‘How Markets Work’, which applies demand and supply to every conceivable type of market. If students are paying attention they might notice that the results of these applications are usually treated as facts – not predictions that need to be tested against the evidence – and certainly not treated as predictions that need to be compared against the predictions of alternative models. And this is a real irony: having sold the student on the unimportance of the realism of assumptions and the overriding importance of predictive power, the texts don’t follow their own methodology. They never take the business of comparative model testing seriously. And for practicing economists, we know that’s where the real fun begins.

Emphasizing (or assuming) perfect competition is the same as assuming away power because in this market structure there are no ‘large’ market participants who can exercise influence over either market outcomes or political outcomes. Neither buyers nor sellers have influence over prices. Sellers are small and lean, just covering their costs. On their own, they lack resources and the incentive to lobby politicians. Such firms would also lack resources to invest heavily in research and development. And this is another irony, because technological change is the one thing that you could say capitalism has done well. Yet, the texts emphasize a market structure that is incapable of explaining this exact feature!

PP: You say that no alternative models are taught in the classroom. I’ve heard this criticism raised many times before and it has always struck me as rather strange. In just about every other social sciences class it is a prerequisite that the lecturer teach the major different approaches, to do otherwise would be considered biased. In your opinions, how do economists get away with this where others cannot?

Tony Myatt: Well, we need to be careful here. Other models of market structure besides perfect competition are taught. Monopoly, monopsony, imperfect competition, and oligopoly are all taught. But they are placed towards the end of the book. Later, when we need to explain the distribution of income, or the benefits of trade, the texts return to assuming perfect competition, to the demand and supply framework, as if that intervening stuff never happened. The argument is that perfect competition is simpler, and is good enough as a first approximation to all markets. But perfect competition is actually a lot more complicated than monopoly. Why not apply monopoly as a first approximation? But that would have a huge ideological impact. It would mean that power, cronyism, and exploitation are potentially important. It would mean that the economy doesn’t necessarily operate efficiently (as a first approximation), and that unions don’t necessarily cause inefficiencies. It would mean that there is a potentially much bigger role for government regulation. And the point is, when discussing a particular topic – international trade say – the texts don’t say “if we assume perfect competition we get these predictions; if we assume imperfect competition we get these predictions; now let’s compare the predictions to the facts”. This is thought to be too complicated, too advanced. But this is a cop out, a dereliction of duty, and is inconsistent with the methodology which the textbooks purport to endorse.

So, while other models of market structure are taught, they are downplayed. On the other hand, no other paradigms are taught. The mainstream textbooks only contain information about the neo-classical paradigm. How do they get away with this?

Again, it’s a question of keeping things simple. They argue they don’t want to confuse the student. It’s hard enough to teach neoclassical concepts without further confusing students with critiques of what they are learning. There’s a nice video of Stephen Marglin addressing the Occupy Harvard movement where he discusses this. (Here’s the link http://www.youtube.com/watch?v=Pf0-E8X-GHo ). He tells how, in his “critical perspectives” introductory economics course, he begins by teaching the neoclassical theory. Then he introduces several critical perspectives. And he acknowledges that this is a huge undertaking. He acknowledges that it takes most students most of their time to get their heads around the neoclassical concepts. But he also acknowledges that in most economics departments there is never a good time for the critique. If it’s too hard for first-year economics students, it’s certainly too hard for high-school students. And then graduate students need to have a ton of maths packed into the curriculum, so there’s no time there. So, as he says, “economists are all for critical thinking, just not today…tomorrow.”

In fact in my own “critical perspectives” course I use our Anti-Textbook. I teach the mainstream material (that’s the first part of each chapter). And the students teach the Anti-Text material (the second part of each chapter). They enjoy shooting me down! So far, it seems to work well. But I’ve been fortunate to have a small class.

Rod Hill: I’d just add that the dominance of the neo-classical paradigm (at least in the English-speaking world) means that there’s less internal pressure within the profession to provide other viewpoints in a principles course than there might be in, say, sociology. Lecturers trained only in neo-classical economics are comfortable using textbooks that contain only that viewpoint.

Most students come to their undergraduate studies in economics with no knowledge of different approaches so they are not in a position to ask ‘Hey, what would ecological economics have to say about that?’ They rely on their instructors to tell them what economics is.

I remember as an undergraduate stumbling upon a copy of Galbraith’s The New Industrial State in a used book shop, reading it and finding it interesting, and wondering ‘Why have I not heard about this in my courses?’ But I rarely asked such questions and had no access to the kind of guidance that we’re trying to provide in The Economics Anti-Textbook.

By dint of news flow, we are having a private equity fest tonight. David Stockman, the former Reagan budget director, made a cogent case against the idea that being at the helm of a private equity firm has much to do with knowing how to run a business on Dylan Ratigan. I thought readers would enjoy this segment, not simply due to the content but also because Stockman is a compelling and blunt speaker.

Visit msnbc.com for breaking news, world news, and news about the economy

By Sell on News, a macro equities analyst. Cross posted from MacroBusiness

It is a measure of how un-self critical modern economics has been, that the Marxists are starting to appear to be making the most sense of the current crises. The supine acceptance that “the market is always right” — a truism only to traders and vested interests — means that there has been precious little understanding developed about how markets can go wrong. Or what is wrong, as well as right, with markets and the modern practices of capitalism. An article in the London Review of Books came to my attention recently by Benjamin Kunkel that shows how Marxist analysis is actually looking quite pertinent to the current mess.

In particular, it highlights the imbalance between capital and labour, a perennial obsession of the Marxists, of course:

The full cash value of today’s product can therefore be realised only with the assistance of money advanced against commodity values yet to be produced. ‘The surplus value created at one point requires the creation of surplus value at another point,’ as Marx put it in the Grundrisse. How are these points, separated in space and time, to be linked? In a word, through the credit system, which involves ‘the creation of what Marx calls “fictitious capital” – money that is thrown into circulation as capital without any material basis in commodities or productive activity’. Money values backed by tomorrow’s as yet unproduced goods and services, to be exchanged against those already produced today: this is credit or bank money, an anticipation of future value without which the creation of present value stalls. Realisation (or the transformation of surplus value into its money equivalent, as profit) thus depends on the ‘fictitious’.

There has certainly been an excess of “fictitious” capital created over the last two decades, far more than Marx, or anyone else, could have anticipated. Money made out of the money made out of money. $600 trillion of derivatives. High frequency trading insanity with trades reduced to micro-seconds. As Adam Curtis observes in his excellent documentary “All Watched Over by Machines of Loving Grace”, the heart of the insanity has been the belief that systems run by machines are inherently more stable than systems with humans at the centre. This has greatly skewed the system towards the egregious self interests of capital, as against labour. Curtis lays much of this greed at the feet of Ayn Rand and Alan Greenspan.

Now before I get a knock on the door from grey suited men asking me “Are you, or have you ever been, a member of the Communist Party?” I should explain that I regard Marxism as wicked, directly responsible for some of the worst horrors of the twentieth century. I have many other objections to it, which I will come to later. There is, however, a difference between Marxism and what Marx wrote. And there is a difference between Marx’s critique of capitalism, which has some prescience and relevance, and Marx’s political prescriptions and revolutionary impulses, which were riddled with contradictions and, in practice, wholly pernicious.

The value of applying what Marx wrote is an identification of an imbalance between capital and labour:

So, as The Limits to Capital implies without quite stating, the special allure and danger of an elaborate credit system lie in its relationship to class society. If more capital has been accumulated than can be realised as a profit through exchange, owing perhaps to ‘the poverty and restricted consumption of the masses’ that Marx at one point declared ‘the ultimate reason for all real crises’, this condition can be temporarily concealed, and its consequences postponed, by the confection of fictitious values in excess of any real values on the verge of production. In this way, growth and profitability in the financial system can substitute for the impaired growth and profitability of the class-ridden system of actual production. By adding over-financialisation, as it were, to his model of overaccumulation, Harvey means to show how an initial contradiction between production and realisation later ‘becomes, via the agency of the credit system, an outright antagonism’ between the financial system of fictitious values and its monetary base, founded on commodity values. This antagonism then ‘forms the rock on which accumulation ultimately founders’. In social terms, this will take the form of a contest between creditors and debtors over who is to suffer more devaluation.

This is basically what is wrong in the developed world. There needs to be a balance between wages and investment returns for the system to function well. Henry Ford paid his workers well not because he was a generous man, but because then they could buy Fords. Globalisation has, of course, undone this compact, and although it has led to some productivity improvements, it is also having the effect of gutting the middle classes in the developed world. In Europe it is seen in the shape of unemployment, in America, the same as well as in the shape of rising poverty and the evaporation of the middle class.

Now, one does not have to be a Marxist to arrive at these conclusions. But Marxism (as opposed to what Marx wrote) resulted in the demonisation of markets, a perfectly normal human activity that goes back 3,000 years, give or take a century. In response, capitalism (whatever that is exactly) felt the need to overstate the value of markets, producing the kind of market worship we now see. Each position is absurd. Marxism has largely collapsed from its own contradictions. Capitalism is on the way to doing the same because when market worship is applied to financial systems, it produces the kind of endless regresses we are now seeing.

Kunkel does point out that some more mainstream analysts have noticed the problem:

Paul Krugman, discussing Roubini’s book in the New York Review of Books, agreed with him that what Ben Bernanke called the ‘global savings glut’ lay at the heart of the crisis, behind the proximate follies of deregulation, mortgage-securitisation, excessive leverage and so on. Originating in the current account surpluses of net-exporting countries such as Germany, Japan and China, this great tide of money flooded markets in the US and Western Europe, and floated property and asset values unsustainably. Why was so much capital so badly misallocated? In the LRB of 22 April 2010, Joseph Stiglitz observed that the savings glut ‘could equally well be described as an “investment dearth”’, reflecting a scarcity of attractive investment opportunities. Stiglitz suggests that global warming mitigation or poverty reduction offers new ‘opportunities for investments with high social returns’.

The neo-Keynesians’ ‘savings glut’ can readily be seen as a case of what a more radical tradition calls overaccumulated capital. But it is the broader and more systematic Marxist perspective that ultimately and properly contains Keynesianism within it, and a crude Marxist catechism may be in order. Where does an excess of savings come from? From unpaid labour – for example, that of Chinese or German workers. And why would such funds inflate asset bubbles rather than create useful investment? Because capital pursues not ‘high social returns’, but high private returns. And why should these have proved difficult to achieve, except by financial shell-games? Keynesians complain of an insufficiency of aggregate demand, restraining investment. The Marxist will simply add that this bespeaks inadequate wages, in the index of a class struggle going the way of owners rather than workers.

One of Marx’s advantages is that his notion of labour value at least puts humans at the centre of a human system. Which is better than putting “Machines of Loving Grace” at the centre of the system, which is the habit in much neoclassical thinking. But of course investors are human as well. And removing markets, as was done in the Soviet and Chinese horrors, is to remove basic humanity.

One key is to re-establish the interests of labour, probably in some collective form. That is the message of the Occupy Wall Street movement. For some reason, greed for executives and investment bankers, is simply pursuit of the right “incentives”, whereas comparatively modest wage claims is a tyrannous lurch into socialism, to be resisted at all costs. It is hard not to see this as some kind of contemporary class war; certainly it is disgusting hypocrisy. And it is destroying the middle classes in developed economies, which will have dangerous political consequences.

What is becoming clear is that new limits have to be placed on capitalism and some aspects of markets:

The classical economists long ago foresaw that an economy defined by constant expansion would one day give way to what John Stuart Mill called the ‘stationary state’. The idea has gained a new currency in Marxist writing of recent years, and in its contemporary version tends to locate the limits to growth in the depletion of natural resources or in the exhaustion of productivity gains as the share of manufacturing in the world economy shrinks and that of services expands. Of course, peak oil or soil exhaustion might easily coincide with faltering productivity. Harvey doesn’t spell out why growth must have a stop, and the outlines of an ecologically stable and politically democratic future socialism remain as blurry in his later work as they do almost everywhere else. At the moment Marxism seems better prepared to interpret the world than to change it. But the first achievement is at least due wider recognition, which with the next crisis, or subsequent spasm of the present one, it may begin to receive.

I do not agree with Kunkel that Marxism may come into its own. To me, it is just the flip side of the same appalling coin. Marxism has its roots in German idealism (Hegel) which I think we safely blame for fascism as well. Its horrors were no accident.

Both Marxism and capitalist theory are deeply materialistic; which inevitably rules out the human (matter cannot explain humanness, it is just matter). So no surprise that each propose some kind of tide of history argument as being inevitable (deregulation and “free” markets in the case of capitalism).

Both are quasi scientific, and so at once intellectually hollow and subject to the kind of scientific materialism that easily leads to letting machines rule over people. Both use unfalsifiable arguments; typically circular arguments in the case of capitalist economic theory, and dialectics in the case of Marxism that result in contradictions like the claim that there is only the bourgeois and proletariat (a claim that defeats itself as soon as anything changes, given that there are only two possibilities).

A nice matching set of intellectual barbarisms, in other words. Maybe in the current crisis conditions, we might start to get some intellectual grown ups emerging. At the very least, there needs to be close attention given to the balance of labour and capital, and limits must be set on fictitious capital. Another enemy is tiredness, intellectual exhaustion, as GK Chesterton observed:

Man does not necessarily begin with despotism because he is barbarous, but very often finds his way to despotism because he is civilised. He finds it because he is experienced; or, what is often much the same thing, because he is exhausted.

I was talking to a finance academic recently who said it was virtually impossible to get anything published academically that questioned the assumptions of the system; only mathematical analyses based on the the accepted assumptions ever see the light of day. A similar monochrome uniformity is evident in the economics mainstream. It is intellectual despotism, and it arises out of exhaustion.

By Marshall Auerback and Edward Harrison

Marshall here. That was an impressive rally into the close in New York. Stocks ended up across the board. Yves Smith, who was off the grid today, asked “was there any news driving” the rally into the close or was it just tape painting. Here’s what I wrote:

No, I think it was pretty sold out. You could see that throughout the day. I think it could well go lower, but the faster this crisis intensifies, the better it actually is ultimately for the markets, because it will bring resolution and you probably want to start looking at some long ideas (which I haven’t wanted to do for a long time, I confess).

Consider this as a possibility: That Stark and Weber are now out means that the Austerians are losing ground in my view. They will have satisfied their moral hazard stance when they boot out Greece, and then they can go back to playing nice. Think Fed after they let Drexel go. You punish the guys who never should have been allowed to join the club in the first place, and then you recapitalise.

So in effect, you reverse 18 months of austerity. Now, Rob will tell you this does nothing to enhance aggregate demand, which is true, but it would alleviate a large chunk of the systemic risk.

Not saying this is THE most likely outcome, but I think we have to start opening our minds to the idea that we’re getting closer to resolution. Germany has fallen 40% from its peak. Hard to say that a lot of bad news is not being reflected in prices.

There were some weird intra-day divergences today that led me to suspect that we might get a bounce. And also, some of the higher quality high yielding stocks actually appear to have bottomed around the first week in August, and have since traded above those levels.

Straws in the wind? Perhaps. But I don’t think it’s all PPT or paint taping. I guess we’ll know in the next few days.

Edward here. I was pretty succinct in my reply to Yves, saying “there was nothing behind it all”. There were rumours about the Italians getting the Chinese to buy up their sovereign debt. But really the news flow has not been good in Euroland or in the US, where BofA is laying off 30,000 people.

On Europe, I have a similar take but different conclusions. Germany is preparing for Greek bankruptcy because the present extend and pretend policy has reached the end of the line. The contagion is just too much to handle. French banks, sovereigns in Italy and Spain are now all infected with the sovereign debt crisis bug and this has spooked policy makers into finally accepting the inevitable hard restructuring I have been saying would eventually happen.

The problem is that the contagion has spread too far and economic growth has decelerated so quickly that this is well beyond the movement policy makers and electorates in Europe are willing to make. I take a more Austerian view of the Stark resignation than Marshall. I see this in much the same way I see the Fed policy debates. Back in March when speculation about extending QE2 was rife, hawks were trying to lead the discussion the other way. I put it this way:

Hawks like Bullard, and now Hoenig, are saying the Fed should cut QE2 short in order to anchor the discussion. That’s significant. If Bullard is saying they should stop QE2, let alone not do QE3, that is going to get everyone talking about whether QE2 will meet an untimely demise. Personally, I think that’s the goal because it makes QE3 a non-starter right now. Basically, the QE2 trade is officially over and people are now thinking about its end. In a sense, that’s a good thing because it can help determine how markets behave without QE as a backstop. As you can tell from my comments above, I think low rates and QE are distortionary and will have negative consequences down the line (see my post on how quantitative easing really works).

But, Hoenig and Bullard are not in control. The centrists and doves are in control of the FOMC. Bullard is anchoring discussion but that won’t change Fed policy in my view. I do think rates will be low for an extended period. So I don’t see Hoenig’s comments or his retirement as a big deal in terms of policy.

-Hoenig says Federal Reserve is responsible for bubble

The hawks were successful in anchoring the discussion at the Fed. With Stark actually resigning at the ECB, the hawks will be even more successful in Europe. Unlimited bond purchases are out – and that means contagion will continue until we see even more austerity or defaults. This is a scenario which is negative for growth, and hence negative for stocks, high yield or other risk assets.

As the manufactured debt ceiling crisis provides an unflattering window into the reckless incompetence of pretty much all of our elected officials in DC, more and more readers have been calling for Elizabeth Warren to run for President.

The idea of punishing Obama by introducing a wild card into his stacked deck is enormously appealing. The assumption that he can abuse his everyman base as badly as he wants to because they won’t vote for someone further to the right (no matter how little further to the right that really is) after the bait and switch of his campaign is still seen as a viable strategy by most political commentators.

But discomfiting Obama isn’t a very good reason for Warren to consider throwing her hat into the ring. And as we’ve observed in past posts, the Harvard professor attracts a tremendous amount of projection. It would be hard for her, or anyone, to live up to the hopes vested in her.

We’ll take a dispassionate look at the notion of having Warren run for President. The bottom line is there is a sound case to be made for the idea, and it trumps having her run for the Senate. And if she is to go this route, she should primary Obama rather than run as a third party candidate.

What Could Warren Accomplish by Running for President?

The obvious defect of a Warren bid for the Presidency is that she won’t win. Obama is expected to raise $1 billion for his campaign, as his Republican opponent presumably will. Warren has been branded as a scourge of banks. Even though it should be common sense that selling exploding toasters is bad business, the fact that she talks repeatedly and persuasively about the need for rules to have markets work well makes her a threat to much of Corporate America. Note that their heated opposition to the idea of fair play reveals the importance of treating customers badly, looting the official coffers, or both to their business models.

So why should she bother? She has become a forceful, self appointed advocate for middle class American families. She has thrown her weight behind this objective since she worked on the Harvard Bankruptcy Project more than a decade ago (it served as the basis for her and her daughter’s book The Two Income Trap). Whether you agree with the wisdom of her choice or not, that was what motivated her to take the position as advisor to the Treasury and President and start up the Consumer Financial Protection Bureau and suffer an aggressive hazing in Congress and in the media by banking industry shills operating through the Republican party. So she is willing to take pain and less than certain bets to advance her goals (we thought she was never going to be head of the new agency, but the people who wanted her inside the tent pissing out no doubt overrepresented the odds she’d get the nod).

Her strength is that she is a Reagan-level Great Communicator. And unlike Obama, a patrician wannabe who sees Reagan as a role model, she taps into deeply rooted traditional American values, that of a just society. Obama, by contrast, exploited the intense frustration with eight years of misrule by Bush the Second, and his liberal posturing was merely a market positioning exercise, to further differentiate him from Brand Republican.

Her position, which sounds dogmatic leftie to those lacking historical perspective, would have been dead center circa the early to mid 1980s, a Javits/Rockefeller Republican or a pretty tame Democrat of that era. But she has arrived at her views not out of ideology but out of pragmatism and rock solid knowledge of the terrain. For instance, in The Two Income Trap, she identified a bidding war for homes in decent school districts, and secondarily, the shift of bank business models to target consumers they can get on a debt treadmill, as the drivers of middle class bankruptcy, which had risen to disconcertingly high levels as of 2003. Her main solutions were simple: more widely distributed aid to schools, so that parents would have more decent districts to choose from (basically increasing the supply of good public schools) and usury ceilings (set as a spread over funding costs), which would force banks to revert to older pricing/product schemes where all consumers paid for services, as opposed to non/infrequent borrowers being subsidized by the heavy users of credit.

So the logic of having her run would be to change the terms of discourse in this country. In case you have managed to miss it, ideas that might interfere with the perquisites of those at the top of the food chain and their hired hands are virtually banned from the mainstream media.

The onetime bastion of the what passes for the left in the US, the New York Times, has (relatively speaking) moved further to the right than the country as a whole (I date the change from its late 1990s decision to become a national newspaper; Michael Thomas argues it started earlier, when Pinch Sulzberger joined the board of the Met and “had to dine with people he should have been dining on”). While it is reliably pinko on domestic social issues like gay rights and abortion, it hews to the corporate Democratic party line on the real power issues in the US, namely finance and economics, and has at most only timidly questioned America’s appalling foreign policy and human rights stance.

As we’ve noted, the lack of strong voices for what used to be the middle in this country has become even more pronounced as well heeled anti-middle class operatives like the Peterson Foundation have successfully executed soft takeovers of supposedly liberal organizations like the Roosevelt Institute, and Obama has targeted and taken out progressive groups that refused to carry the Adminstration’s water.

Although it isn’t as obvious, Warren also stands for a second set of ideas, that of competence and accountability in government. Not only did she build a major organization in an impressively short period of time, but she understands the importance of what we call in the consulting world “deliverables”, that is, providing tangible evidence of progress. She got various government agencies and banks to agree on a simplified mortgage disclosure form, a “to do” on the banking officialdom’s list that had somehow been too complicated to get done until Warren took it on. And this isn’t just good for consumers, it will also lower costs to banks.

By contrast, not only did Obama make a spectacular set of campaign promises that he failed to honor, he is completely unapologetic about those lies. While there is, sadly, a certain amount of misrepresentation that is considered normal among politicians, Obama’s looks to have set a new standard.

Warren has been most effective operating outside traditional power structures (and let us stress being a professor specializing in bankruptcy is not a power position, even at Harvard Law School). She managed to persuade the Clinton Administration to reverse itself on the pro-bank bankruptcy bill that eventually did pass in 2005. The Consumer Financial Protection Bureau was her brainchild and as a de facto unpaid lobbyist operating as a one woman think tank, got in into Dodd Frank despite being considerably outmanned by the well greased financial services industry apparatus (there are now five financial services industry lobbyists for each Congressman).

By contrast, Warren has been less successful operating from the core of the system. Even by all accounts she did a very good job at the Congressional Oversight Panel, it was a role of very limited real power. What did it accomplish save proving that the Treasury broke promises regarding transparency and accountability and making Geithner squirm?

Similarly, even though she did everything she could to build a CFPB with a strong team and good internal procedures, as we’ve noted, bad leadership can destroy an organization in remarkably short order. It would not be hard for a negligent or ideologically hostile CFPB chief to undo what she created. The main outcome of her taking that position, ironically, may not be that she created a successful agency, but that she demonstrated considerable organizational and executive skills (setting up an organization, particularly a large one, is a vastly more daunting task than running one).

So the real point of a Warren run would be to give her an even bigger megaphone for broadcasting the fallen standing of the US middle class and what can and should be done about it. Australian economist John Quggin wrote in a recent post argues that, “The wealth that has accrued to those in the top 1 per cent of the US income distribution is so massive that any serious policy program must begin by clawing it back. ” He argued that an Obama primary challenge would be an important step in making that seem both possible and reasonable:

It seems to me that a good place to start would be a primary challenge to Obama…. It would be impossible for the media to ignore completely, and might get enough votes to shift the Overton window. Whether such a challenge could form the basis of a mass movement, I don’t really know, but it seems to be worth a try.

Warren’s status as an outsider, someone who is not part of the old boy network, is particularly important for primary voters (women are a big force in Democratic primaries) and in terms of her branding generally. And the fact that she has just been part of the Administration and would choose to challenge it frontally would add to media interest.

Primarying Obama trumps having Warren run as a third party candidate. Primaries get national coverage. Quixotic third party candidates by contrast have to buy media and she will never be in the Ross Perot/Michael Bloomberg spending league. And unsuccessful primary challenges can have a lasting impact. Even if you (presumably) loathe his ideas, Pat Buchanan’s failed presidential bids played a meaningful role in moving the Republican party further to the right.

How Does Running for President Compare to Her Other Options for Effecting Change?

Warren has spent the better part of the last two years in high pressure, high visibility roles in DC. She may quite reasonably prefer to return to some semblance of her prior life. Nevertheless, two things are clear. First, that if she does want to return to the political arena, running for President is a far better option for her than running for Senate. Second, she can advance her agenda without campaigning for office.

As we have discussed in earlier posts, having Warren run for Senate might be a nice idea for the Democratic party, but it certainly isn’t a very good idea for her. If you had any doubts, the spectacle of the last few weeks should serve as proof of the Senate as “America’s Most Ineffective Body“, in the words of Marcy Wheeler. As Matt Stoller points out, Martha Coakley should count herself lucky to have lost:

Had Coakley beaten Scott Brown, she wouldn’t have been able to resist the banks as AG. She would have been in the Senate, fruitlessly whining.

For Warren to go to the Senate is simply to hobble her. Congress is dominated by a pay to play system described by Tom Ferguson in a recent Financial Times comment:

…tired recitations of astronomical campaign finance spending totals miss the bigger picture. For a tidal wave of cash has structurally transformed Congress, sweeping away the old seniority system that governed leadership selection and committee assignments. In its place, the major political parties borrowed a practice from big box retailers like Walmart, Best Buy or Target.

Uniquely among legislatures in the developed world, US congressional parties now post prices for key slots in the lawmaking process….

The practice makes cash flow the basic determinant of the very structure of lawmaking. Instead of possibly buffering Congress from at least some outside forces, committees and leadership posts reflect the shape of political money. Outside investors and interest groups become decisive in resolving leadership struggles within the parties…

The real rub is the way the system now centralises power in the hands of top congressional leaders….The leadership’s hold over the swelling coffers of the national party campaign committees, along with the huge fixed investments in polling, research, and media capabilities these committees maintain, provide them with the extra resources they need to cajole and threaten candidates to toe the party line.

In addition, freshman Senators are supposed to maintain a low profile and any member of Congress is expected to support a President that hails from his party most of the time. Not playing ball with the party apparatus means having pretty zero change of getting any support for your own initiatives. And it isn’t as if Warren is the only candidate the Democrats could field against Scott Brown. Both Martha Coakley and Rachel Maddow poll better.

If Warren were to decide against running for a national office, there are plenty of things she could do to keep pressing for a better deal for middle class families. One would be to see if she could get a television show or a regular guest feature that would focus on middle class finances and discus a mix of pragmatic and policy issues, ideally with it including ordinary people.

Another idea would be to form a shadow CFPB to keep the real one honest. Warren built the CFPB to have a strong research function, so it would have a firm grasp of the actual practices of financial services players and their impact on consumers. She could replicate a good bit of that at Harvard by forming a not for profit that would draw on students as the backbone of its research team. They could design web-based tools that would allow consumers to upload contracts, correspondence, and add notes and call logs. This would enable the investigators to look at examples of questionable bank behavior and they could engage in outreach to other consumer groups to determine whether these cases were outliers or were examples of broad-based conduct. Warren’s profile and her strong relationships with the media would enable her group to publicize any adverse findings and pressure (or at least embarrass) regulators, in particular the CFPB if it goes asleep at the switch.

Dangers of Projection

As we noted in March:

The reactions to Warren, both on the right and left, are becoming divorced from reality. She has assumed iconic status as a lone mediagenic figure in the officialdom who reliably speaks out for the average person, a Joan of Arc for the little guy. And she drives the right crazy because she is rock solid competent and plays their game better than they do. She sticks to simple, compelling soundbites and images without the benefit of Roger Ailes and Madison Avenue packaging, and she speaks to an even broader constituency, Americans done wrong by the banks, than they target. No wonder they want to burn her at the stake.

If anything, the efforts to sanctify Warren have grown. She is treated as the last, best hope of the tattered progressives, when it isn’t even clear how much she supports their agenda. She would presumably promote policies that would stem or reverse the concentration of income and wealth in the top 1%, but her view on other issues is unclear. What is her stand on our military commitments? On gay marriage? On immigration? On our broken health care system? On out of control college costs that result in most new graduates being debt slaves? On climate change? On China? She’s a formidable policy wonk and no doubt a quick study, but even smart people who step outside their areas of expertise can become hostage to bad orthodox thinking or its ugly cousin, leading edge conventional wisdom. And well advised or not, Warren may not be as liberal as her fans like to believe.

But even if she fails to be the Great Liberal Hope, she is an influential counterweight on the most pressing battleground, that of the rearchitecting of our political and economic structures to assure and extend rent extraction by the top 1% (indeed, the top 0.1%).

The other open question is whether she can be a successful candidate. Even though Warren has done remarkably well every time she has been thrown in the deep end of the pool, this is yet another new realm, one where a lot of battlefield judgments are required (like how to respond to swiftboating).

These are gambles a large number of Americans would like to see Warren take on their behalf. She said in March in a Huffington Post interview, “My first choice is a strong consumer agency…My second choice is no agency at all and plenty of blood and teeth left on the floor.”

Perhaps Warren has since come to realize that her pugnacious impulse was right. No consumer agency or any effort that threatens the banks and plutocrats can succeed unless the fundamental terms of political discourse in this country change. Warren may be able to give that effort the impetus it desperately needs.

I don’t know about you, but I’m suffering from debt ceiling/Eurozone mess fatigue and thought readers might enjoy a wee respite. This engaging presentation by Kevin Slavin provides some useful food for thought about how the use of algorithms are coming to literally reshape our world. Hat tip reader Thomas B:

Lordie, I can’t believe someone who professes to understand markets has written, at length, that caution, no, “excess of overcaution,” was a major contributor to the criss. Or has Felix Salmon been spending too much time with lobbyists from ISDA and SIFMA?

I hate seeming rude, but Felix has a habit of tearing into Gretchen Morgenson for errors much less significant than the one he made in a post today. He wrote, apropos this chart, which comes from FT Alphaville:

The big-picture thing to remember when looking at this chart is something which I’ve said many times before — that it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution, with an attendant surge in demand for triple-A-rated bonds. On a micro level, triple-A securities are safer than any other securities. But on a macro level, they’re much more dangerous, precisely because they’re considered risk-free. They breed complacency and regulatory arbitrage, and they are a key ingredient in the cause of all big crises, which is leverage….

Then look at the green line. Triple-A debt wasn’t a huge part of the bond market back in the early 90s, but for the past decade it has invariably accounted for somewhere between 50% and 60% of total global fixed income issuance. That’s possibly the most horrifying bit of all: it simply defies credulity for anybody to be asked to believe that more than half the bonds issued in any given year are essentially free of any credit risk.

Now anyone who had read the Financial Times in 2006-early 2007 or was in the credit markets then would know that this statement, “it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution” is demonstrably counterfactual. All you had to do was look at the spreads for risky assets. There was a simply astonishing compression between the yields of perceived-to-be-risk-free assets, such as Treasuries and their toxic counterfeits, the AAA rated tranches of CDOs and CLOs, and risky assets, like the lower-rated tranches of the same bonds, as well as junk bonds. If there was “overcaution” you would have seen a wide spread between AAA bonds and lesser-rated bonds.

But to Felix’s point, demand for AAA paper was robust. But that was not the result of caution; two big drivers of demand (particularly for “manufactured” AAA paper, the kind created by structured credit legerdemain, was as repo to serve as collateral for OTC derivatives positions, and for bonus gaming. In the 1980s, the ONLY acceptable collateral for repo was Treasuries; that started expanding as time went on to other AAA rated assets (and even lower rated assets, but the haircuts were significant). We described both in ECONNED. First on the explosion of OTC derivatives stoked demand for AAA instruments:

Brokers and traders often need to post collateral for derivatives as a way of assuring performance on derivatives contracts…

Due to the strength of this demand, as early as 2001, there was evidence of a shortage of collateral. The Bank for International Settlements warned that the scarcity was likely to result in “appreciable substitution into collateral having relatively higher issuer and liquidity risk.”

That is code for “dealers will probably start accepting lower-quality collateral for repos.” And they did, with that collateral including complex securitized products that banks were obligingly creating.

As time went on, repos grew much faster than the economy overall. While there are no official figures on the size of the market, repos by primary dealers, the banks and securities firms that can bid for Treasury securities at auctions, rose from roughly $1.8 trillion in 1996 to $7 trillion in 2008. Experts estimate that adding in repos by other financial firms would increase the total to $10 trillion, although that somewhat exaggerates the amount of credit extended through this mechanism, since repos and reverse repos may be double counted. The assets of the traditional regulated deposit-taking U.S. banks are also roughly $10 trillion, and there is also double counting in that total (financial firms lend to each other).

In other words, this largely unregulated credit market was becoming nearly as important a funding source as traditional banking.21 By 2004, it had become the largest market in the world, surpassing the bond, equity, and foreign exchange markets.

Now I must confess I have not tried to update the BIS chart. But I have a sneaking suspicion that while derivatives outstandings took a hit in the crisis, between a rise in risk aversion and a concerted effort in credit default swaps land to reduce the notional amount outstanding by netting out offsetting positions, that the old pattern of derivatives outstanding growing more rapidly than the economy has resumed. And now that no one is terribly interested in using AAA rated CDOs as collateral for repo, Treasuries are probably even more important as repo collateral than they were before the meltdown.

A second, significant demand for AAA rated paper was structured credit product creators uncharacteristically eating their own cooking because it enabled them to game their firms’ bonus systems. If you hedged an AAA instrument with a credit default swap from a high rated counterparty, Basel II allowed firms to treat it as having no capital requirement (and there was considerable latitude in the rules as to how much or little hedging was necessary to achieve this happy outcome). US banks in theory had analogous capital weightings, but their higher funding costs for this sort of activity and less permissive treatment of the hedges meant they didn’t do this sort of trade in anywhere near the same volume (save at Merrill, which engaged in accounting chicanery).

The net effect of these so-called negative basis trades were to allow the trading desks to credit FUTURE income (often years into the future), namely, the yield on the instrument less the funging and hedge costs, discounted to the present and was credited to the desk’s P&L. Nothin’ like getting paid on income never to be earned.

Now how significant was this activity? Again, from ECONNED:

J.P. Morgan estimated that Merrill and other major CDO vendors like Citigroup, UBS, and Deutsche Bank wound up keeping roughly two-thirds of the top-rated tranches of the 2006 and 2007 deals, which accounted for the bulk of the value of a transaction, typically 65% to 80%.

Read that again. 2/3 of the AAA CDO tranches were retained by the issuers. These were most assuredly NOT “overcautious”. Has s Felix forgotten some of the pre-crisis dismissals of caution, like US investment banks hoovering up subprime originators and servicers in late 2006 and early 2007? Or how about former Citigroup CEO Chuck Prince’s famously ill-timed expression of optimism in a Financial Times, right before the crisis began in earnest (early July 2007):

Chuck Prince on Monday dismissed fears that the music was about to stop for the cheap credit-fuelled buy-out boom, saying Citigroup was “still dancing”.

The Citigroup chief executive told the Financial Times that the party would end at some point but there was so much liquidity it would not be disrupted by the turmoil in the US subprime mortgage market.

It’s alarming that someone like Felix, who not merely lived through the crisis but also chronicled it in some detail, seems so keen to engage in revisionist history.

By Douglas K. Smith, author of On Value and Values: Thinking Differently About We In An Age Of Me

We face severe and growing income inequality with negative effects on people and the economy. Yet, no surprise, the ‘can’t do’ right wing continues a scorched earth campaign against the minimum wage. These self-promoting haters actually prefer no wages and indentured servitude – for example using prisoners to replace employees and cheerfully promoting ‘internships’ for the unemployed.

They glory in income inequality and wish it to expand instead of contract. Enough of that. They are destroyers of the American Dream.

But people who seek to shrink income inequality — to insure life, liberty and the pursuit of happiness for all and not just some — must now focus as much on the maximum wage as the minimum wage.

So, be it proposed:

“That any enterprise receiving taxpayer funds shall not compensate that enterprise’s highest paid person in an amount greater than twenty-five times what the lowest compensated person receives.”

First, note that this proposal would not apply to enterprises that do not receive any taxpayer funds.

For those, however, receiving bailouts, deposit insurance, government guarantees, tax breaks, tax credits, other forms of public financing, government contracts of any sort – and so on – the top paid person cannot receive more than twenty-five times the bottom paid person. This ratio, by the way, is what business visionary Peter Drucker recommended as most effective for organization performance as well as society. It also echoes Jim Collins who, in his book Good To Great, found that the most effective top leaders are paid more modestly than unsuccessful ones. And, critically, it is a ratio that is in line with various European and other nations that have dramatically lower income inequality than the United States.

Note, second, that this identifies the top paid person – not the CEO. Even though outrageous CEO pay and its ill effects on severe income inequality is much in the news, CEOs are not always the highest paid person.

Third, the proposal uses a ratio – 25-to-1 – instead of an absolute dollar figure. If a taxpayer funded enterprise wishes to pay the top person, say, $50 million, they can do so: just as long as the lowest paid person receives $2 million. In other words, instead of today’s limitless top wage being supported by taxpayer money – that is, socialism for the rich and only the rich — this proposal is equitable toward all.

Fourth, the choice of compensation is made by the enterprise – not by government officials.

Fifth, this approach to the maximum wage dramatically benefits the economy through some blend of more job-creating investment by the enterprise (through deploying higher retained earnings), and/or more consumer spending, savings and investment because of increased take home pay (and/or shareholder dividends) for the many instead of the few. It would, for example, immediately provide stimulus to restart our heavily consumer-driven economy.

Sixth, this proposal is competitively neutral: all enterprises using taxpayer funds must abide by the same 25-to-1 ratio of top-to-bottom compensation. In most industries, competitors respond to opportunities similarly; that is, if there are government opportunities, all try to take them and, if there are no such arrangements, none do. Nothing changes except the uses to which taxpayer funds get deployed as compensation. The new maximum wage rule levels the playing field for all competitors.

Nor, seventh, would this proposal have any adverse effect on the market for talent. Again, all enterprises are subject to the same rules. Moreover, there’s never been any – zero, zilch, nada – evidence that top pay correlates with sustained enterprise performance. Indeed, quite the reverse. Which, again, is why Drucker, Collins and others all note that talent and performance are not correlated to income inequality-levels of executive pay. The more likely result is the opposite: the maximum wage ratio will put enterprises using taxpayer funds on a better, sounder path to performance than those who don’t use taxpayer funds!! Meaning, of course, that such enterprises will attract the talent they need – not the talent they do not need.

Eighth, this proposal can and should be enacted by all federal, state and local jurisdictions that provide taxpayer funds to enterprise. And, of course, with the appropriate inclusive definitions of ‘compensation’ (salary, wages, bonuses etc) and “person’ to avoid cheating and evasion.

Ninth, enforcement will be inexpensive. Enterprises would be required to submit just two numbers to the appropriate tax authority: the highest and lowest compensation figures. If the ratio is in excess of 25-to-1, the offending enterprise will be given a simple choice: claw back the top earner’s compensation to the appropriate level; or, within, say, 30 to 45 days, pay all of the lowest earners the required amount; or, a combination of the same steps needed to bring the enterprise in line with the maximum wage rule. (If deemed necessary, generous rewards to anonymous whistleblowers could support monitoring and compliance efforts).

Tenth, and finally, remember that we’re talking about OUR MONEY. It’s not the ‘government’s money”. It’s OUR MONEY. And we insist that enterprises wishing to be funded and/or compensated and/or insured and/or tax advantaged with OUR MONEY abide by the maximum wage in order to reduce destructive, economy killing and unhealthy income inequality. When publicly funded companies operate within the 25-to1 maximum wage band, we all benefit.

It is the free choice of free enterprise whether or not to use OUR MONEY. If you are part of an enterprise and wish to pay anyone, including yourself, more than today’s all-too typical extreme, greater than 300 times the lowest wage earner, go ahead.

But do not use OUR MONEY.

Something very peculiar is afoot. Well after the bank regulatory reform debate was supposedly settled, central bankers seem to be reopening that discussion. It’s puzzling because the very reason the banks won so decisively was that central bankers were not prepared to get all that tough with their charges.

I’m not clear what has led central bankers to get a bit of religion. Is it the spectacle of the Bank of England talking about breaking up the banks (they won’t get their way thanks to bank lobbyist working over the Independent Banking Commission, but no one doubted their sincerity)? Or the Swiss National Bank imposing 19% capital requirements, which as we discussed, is likely to lead to the investment banking are of UBS being domiciled elsewhere (assuming a country capable of bailing it out will have it)? Or perhaps it is central bankers being forced to recognize that their Plan A of extend and pretend and super low interest rates simply won’t lead banks getting to meaningfully higher capital levels when the staff continues to take egregious amounts out in compensation? Or have they realized how bad bank balance sheets are in the Eurozone and how tight the linkages still are among the major capital markets players, and they belatedly realize they need them to be much more shock resistant?

The bottom line is that various central bankers have taken the surprising step of insisting their banks meet more stringent requirements for the biggest banks than those originally planned to be to be included in Basel III. Per Bloomberg:

The Basel Committee on Banking Supervision is considering extra capital requirements of as much as 3.5 percentage points that the largest banks may face if they grow bigger, according to two people familiar with the talks.

The so-called surcharge would take the form of a boost to capital the banks must hold and would apply to financial institutions whose collapse would harm the global economy. A list of such banks hasn’t been disclosed.

Draft plans circulated before a meeting next week would subject banks to a sliding scale depending on their size and links to other lenders, said the people, who declined to be identified because the proposals aren’t public. Banks wouldn’t initially face the highest surcharge, which is intended as a deterrent to expansion, one person said. The largest banks may face a 3 percentage point levy at their current sizes

Predictably, banks who have been conditioned to throw temper tantrums to get their way are now howling at the prospect of being asked to hold more capital. But to me, the most important element here is that being exposed to other banks, or “tightly coupled” is being discouraged. As we have discussed in other posts, following the work of the Bank of England’s Andrew Haldane, there are two approaches to companies that produce externalities, like pollution and financial crises: taxation or prohibition. Which is appropriate depends on the level of private costs versus social costs. When social costs are high relative to private costs, prohibition makes more sense. Haldane did a back of the envelope calculation that showed that taxation was grossly inadequate as a remedy (we’ve cited this quote repeatedly precisely because we think it’s critically important):

….these losses are multiples of the static costs, lying anywhere between one and
five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. As Nobel-prize winning physicist Richard Feynman observed, to call these numbers “astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy. “Economical” might be a better description.

It is clear that banks would not have deep enough pockets to foot this bill. Assuming that a crisis occurs every 20 years, the systemic levy needed to recoup these crisis costs would be in excess of $1.5 trillion per year. The total market capitalisation of the largest global banks is currently only around $1.2 trillion. Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs, with the levy playing the role of the meteorite.

Yves here. So a banking industry that creates global crises is negative value added from a societal standpoint. It is purely extractive. That means that taxation (and capital charges are effectively a form of taxation, in that they are meant to change the economics of the business so as to discourage certain behaviors) is an inadequate remedy and far more aggressive measures are warranted.

That view is confirmed by another way of thinking about the problem. The TBTF banks are tightly coupled, which means when Something Bad happens, problems propagate through the system so rapidly that it is well nigh impossible to interrupt the process. It’s like a badly designed electrical grid where a bolt of lightening hitting one transformer would take the entire eastern half of the US down.

In tightly coupled systems, you need to undo the tight coupling first. That’s why remedies like exchanges and clearing houses are in theory improvements, since they create contained points of failure (but in practice, the derivatives clearinghouses mandated in Dodd Frank may wind up being inadequately margined due to the unwillingness to require sufficient margin on credit default swaps since they would render the product uneconomical, and not sufficiently independent of the big banks to achieve the desired risk reduction). But the most important measure, that of breaking up the big banks and requiring firms to be more specialized (say investment banks, retail banks, and asset managers) and subject to sector-specific rules, is off the table.

If the excessive integration is not alleviated, measures intended to reduce risk typically make matters worse. This was a discussion from reader Lune on March 17, 2008. Notice how many elements of the forecast, the stresses on Fannie and Freddie becoming untenable and the mortgage market continuing to be a mess, have come to pass:

We’ve already seen the law of unintended consequences so far:

1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.

2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can’t access the new credit facility. Mortgage markets remain frozen.

Lune also provided a forecast that in many respects was prescient. And that was because, just as you’d expect in a tightly coupled system, the more you try to do, the worse things get.

And not only has Basel III not addressed why our financial system is so disaster prone, but it also falls short on other fronts. Our Richard Smith provided very informative write-ups (see here, here and here)

The bizarre bit here is the sudden gear shift by central bankers. Basel III was correctly criticized on a number of fronts: ridiculously attenuated phase in (the new capital rules aren’t fully in effect until 2019), preserving the concept of risk weighted assets (when as London Banker scathingly pointed out, hasn’t fared too well), and a failure to address liability side issues (particularly as relating to derivatives; they were a major culprit in why Lehman’s leak turned out to instead be a black hole). This is Richard Smith’s drive-by shooting:

Here are my main gripes:

Valuation: the capital ratios mean nothing if the assets are overvalued. Waldman is always going on about this. It ends up as quite a radical critique: capital ratios without valuation reform = cart before horse.

Accounting: there is still no harmonization of accounting practices on all the shadow banking apparatus: for instance, special purpose vehicles, derivative netting and repos. Actually, of course, when you come across things like Repo 105, or BoA’s quarter end balance sheet manipulations, there don’t seem to be any relevant reputable accounting practices at all; even if you think Lehman’s liquidity pool probably is an outlier, some of this stuff really, really needs fixing. And do we think that under Basel III there will be more accounting dodges that will cross the line from ‘asset sweating’ to ‘accounting manipulation’?  Not Basel III’s fault, but I rather think we do expect exactly that.

Regulatory risk weightings are still a mess, with the ratings agencies still ensconced as the arbiters of credit quality.

Then of course there is shadow banking, which Basel III largely dances around. One particularly glaring example is the whole custody/client money/asset segregation/rehypothecation/title mess in London. There’s not a peep, burble or whisper here in the UK about the sort of legal reforms (somewhat in the manner of the US’s 1934 Securities Act, perhaps, plus a UK version of SIPC) that would sort this out. Recent Lehman-related rulings on Client Money actually mess the situation up even more. Of course, our obligingly vague 17th century line on “who owns what” works very capital-efficiently for Prime Brokerages. Which is a big part of why Mayfair now houses a $4 Trillion shadow banking system. Push from Basel III would have helped get more of a grip.

I have nothing to say about enforcement; it’s been such a long time since I’ve seen any that I’ve forgotten what it is.

So it should not be at all surprising that former Kansas City Fed chief Thomas Hoenig gives a very strongly worded diss to what passes for financial reform in the US. His point of departure was the idea that UBS might decide to move its investment banking operations to the US. Hoenig dismissed that idea because our regulations are too weak and we should not be allowing new big players to be in a position to fail on our taxpayer nickel. As Hoenig wrote in the Financial Times:

Some argue that both the US Dodd-Frank Act and Basel III capital requirements have now ended US bail-outs. But these efforts do not solve the fundamental flaw in the system: there are highly complex and opaque banking organisations engaged in a variety of non-core, high-risk activities while backed by a public safety net. The problem is not that banks take risk, but that some are too complex for anyone to assess and control that risk.

These new regulatory changes actually extend, or make more complicated, what we have tried to do before. For example, Dodd-Frank requires enhanced prudential supervision and regulation that increases incrementally with the systemic risk of the largest financial companies. Yet that design simply cannot be effective if the risk cannot be monitored or assessed.

Similarly, the new Financial Stability Oversight Council is to look for evolving systemic risk and take appropriate actions – an impossible task because problems are only obvious after the fact. There are many examples over the past 20 years, but one need look no further than the recent housing bubble. I applaud the Swiss for requiring significantly higher capital ratios, but if that were enough, Swiss authorities would be more interested in having UBS retain its investment banking activities.

Hoenig outlined his own proposal, which is presented in longer form at the Kansas City Fed website. It goes considerably in the direction of prohibition, such as limiting the activities of banks to socially useful activities and restricting the access of shadow banks to wholesale funding markets. One can quibble with the particulars of Hoenig’s proposals, but that is the direction we need to go in if we are to have any hope of preventing another large scale financial crisis.

There’s a great post up, “Human Complexity: The Strategic Game of ? and ?,” by Richard Bookstaber, former risk manager, author of the book A Demon of Our Own Design and currently an advisor to the Financial Stability Oversight Council. As insightful as it is, Bookstaber does not draw out some obvious implications, perhaps because they might not be well received by his current clients: that the current preferred profit path for the major capital markets firms is inherently destructive.

I suggest you read the post in its entirety. Bookstaber sets out to define what sort of complexity is relevant in financial markets:

The measurement of complexity in physics, engineering, and computer science falls into one of three camps: The amount of information content, the effect of non-linearity, and the connectedness of components.

Information theory takes the concept of “entropy” as a starting point: essentially, the minimal amount of information required to describe a system. Related to this is a measure called thermodynamic depth, which looks at the energy or informational resources required to construct the systemic. The idea is that a more complex system will be harder to describe or to reconstruct, though this is problematic because it will look at random processes as complex; for example, by these sorts of measures a shattered crystal is complex….

Non-linear systems are complex because a change in one component can propagate through the system to lead to surprising and apparently disproportionate effect elsewhere, e.g. the famous “butterfly effect”….

Connectedness measures how one action can affect other elements of a system. A simple example of connectedness is the effect of a failure of one critical node on the hub-and-spoke network of airlines. Dynamic systems also emerge from the actions and feedback of interacting components….

The definition you use depends on the purpose to which you want to apply complexity. For finance, several of these measures of complexity come into play. There are non-linearities due to derivatives. Connectedness comes from at least two sources: the web of counterparties and common exposures. Exacerbating all of these is the speed with which decisions must be made.

So far, so good. Then we get to this:

Also, because economics and finance deal with human-based rather than machine-based systems, our tendency to operate based on context will invariably lead the conventional tools used to solve complex physical systems to miss the mark.

I’m not at all certain that context is the most important driver. What seems to be germane is limited cognitive capacity. Herbert Simon (who Bookstaber invokes elsewhere in this piece, but not on this issue) was keenly interested in the limitations of human intellectual capabilities: that we could only consider a limited number of issues at the same time, that it takes a certain amount of time to access long-term memory, etc. As a consequence, humans are inherently severely reductivist in the way we approach reality. We are strongly disposed towards storytelling as a way to organize information; models are another compensatory device.

Back to Bookstaber:

But another important point for finance which makes complexity differ from its physical counterparts is that in finance complexity is often created for its own sake rather than as a side-effect of engineering or societal progress. It is created because it can give a competitive advantage.

‘
This is arguably true but is actually far too kind to financial firms. “Competitive advantage” implies that they need to offer newer, better, fancier gizmos just as cell phone makers have sought to meet or better yet leapfrog the iPhone. But “better” in terms of market share and appeal to customer, would in many cases imply simpler rather than more complex.

As we wrote in ECONNED:

But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.

Complexity is central to financial services firm rent seeking. And it is pervasive. It’s not just CDOs or customized derivatives. A credit card agreement in 1980 was one pretty understandable page. With all the relevant sections, they are now thirty often incomprehensible pages.

And the reason complexity is bad is that system-wide, it creates unknown unknowns:

A complex system is one that is difficult to understand and model; as complexity increases, so do the odds of something unanticipated going wrong. This is the driving characteristic of complexity that is most important for finance and economics: complexity generates surprises, unanticipated risk. “Unanticipated” is the key word: it is not simply that more complexity means more risk — we can create risk by walking on a high wire or playing roulette. Rather, it is that complexity increases risk of the “unknown unknowns” variety. And the risks that really hurt us are these risks, the ones that catch us unaware, the ones we cannot anticipate, monitor or arm ourselves against. Simply put, a system is complex if you cannot delinate all of its states. You may think you have the system figured out, and you might have it figured out most of the time, but every now and then something happens that leaves you scratching your head. This is an epistemological interpretation of complexity. It defines complexity as creating limits to our knowledge. Neoclassical economics does not admit such complexity.

If the states in a system can be determined in a sufficiently short time frame, it is not complex, even though doing this may require more analytics and computer power. So complexity is measured by the increased risk of surprising modes of failure and propagation. This means a complex system can be defined as one that cannot be solved, whose effects under stress cannot be anticipated….

We cannot think about complexity without reference to time frame. A problem might be complex if we only have a few seconds to respond, but not complex if our time frame is one or two months. If we have enough time to solve a problem and understand and anticipate all of its possible outcomes, then it is no longer complex even though, to restate the point, it might be costly to solve and monitor, it might have random results (random but where we can know all of the possible states and assign probabilities to each one), but it no longer can lead to surprises.

This importance of time frame is the reason we have to look at complexity and tight coupling jointly. Tight coupling means that a process moves forward more quickly than we can analyze and react….

A second characteristic for complexity in economics, and finance in particular, is that it is not exogenous, simply sitting out there as part of the world. We create it ourselves, indeed often create it deliberately, and create it expressly to harvest the attendant unanticipated risks.

Bookstaber goes from this to argue that game theory is inadequate to describe the resulting interactions because games always have rules, whereas in markets, participants often break rules or understandings (insider trading, securitization sponsors failing to adhere to the terms of pooling and servicing agreements, major banks giving big institutional investors crappy execution on foreign exchange transactions, to barely scratch the surface). He contends that the best model is warfare, which of course appeals to the macho self image that most Wall Street denizens harbor.

But what are the characteristics of war? Unless the engagement is via proxies or a mere skirmish, it involves a serious commitment by both parties, usually so substantial that neither side can readily withdraw (both that it has put its prestige at risk, so that the usual “sunk cost” analyses are put aside, or that withdrawal is tantamount to capitulation and allows the enemy to inflict additional costs (via conquest or a punitive peach treaty) which could be catastrophic, at least as far as the leaders are concerned. War by its nature is potentially a test to destruction. And that is precisely how the banks have played it. And they can escalate their degree of commitment and the damage ultimately done, by virtue of having state guarantees.

So Bookstaber’s analysis provides further confirmation for what we have long said: the only way to allow banks to have their activities backstopped is to have their risktaking severely constrained. They need to be operated like utilities, with extensive regulation and oversight, and excess profits should be seen as probable evidence of rule breaking and investigated. You don’t want a terribly efficient financial system; highly efficient systems are prone to breakdown. Formula One cars only run one (at most) race, and reader vlade reminded us that cheetahs have the same problem:

You’re the fastest meanest thing on earth (and with the least fat), but if you don’t eat for three days, you die.

If a kick from your next meal breaks your leg, you die (of hunger). If you run for too long, you die (of overheating). If you run and can’t rest afterwards, you die (of overheating). If (a lot of things goes here) you die.

Cheetah is sexy, hyena isn’t – but if I was to bet on a long-term survival of one, I’d back hyenas (in fact, a cheetah will give up its kill to a hyena, because it cannot afford any injury in a fight)

The people who are close to the problem, like Bookstaber, keep providing compelling information that we need radically different approaches to managing financial firms than the ones we have now. But it is pretty clear that the officialdom has decided the time for action has past (except in the UK, where an epic battle is underway, much to the consternation of banksters). We can only hope in the wake of the next crisis (because crisis is the inevitable result of the current model) that the nation’s leaders have the will to leash and collar the banks.

Yves here. I normally let VoxEU articles stand on their own, but this topic, of whether the bank PR that bigger banks are essential stands up to scrutiny, is near and dear to my heart.

Note that the authors point to a 1990s study that finds that a $25 billion in assets bank was the optimal size. There were a fair number of studies done then of bank size versus efficiency. I’m a bit surprised that this is the one that is most often cited, since it also came up with the biggest size threshold at which a negative cost curve kicked in (meaning the bank became more costly to run). One study found that the slightly negative cost curve started at $100 million in assets (!); more typical was somewhere between $1 and $5 billion. And remember, these studies were done in the days when banks returned checks, and check processing was believed to have strong scale economies (ie, if check processing was a bigger proportion of total costs then than now, it could arguably have increased scale economies).

Some academics were frustrated with these results. I recall reading a paper where the author argued that there were theoretical cost savings to being bigger (duh) and basically contended that the empirical data had to be wrong.

This article does make an important contribution in parsing out the impact of absolute versus relative size. And it mentions that bank executives have incentives to make banks bigger (an issue we have discussed) as opposed to safer.

However, a big frustration is that this piece treats all large banks as being of a muchness. There is a considerable difference between being a large and largely traditional bank, versus being one with large capital market operations (like Citibank, Goldman, Deutsche, SocGen, UBS, Barclays). The dealer banks are systemically risk due to the counterparty exposures and opaqueness (as in when one gets in trouble, others with a similar profile are assumed to be on the ropes too). For instance, Lehman, Goldman, and Morgan Stanley are not considered to be of “systemic size” in this study’s parameters.

Another methodological problem in looking at big bank efficiency is that a lot of supposedly off balance sheet exposures of large banks really aren’t. Examples include credit card securitizations (banks have stepped in repeatedly to shore up credit card deals gone sour), the famed structured investment vehicles, and to a degree, mortgage securitizations via putback liability. That means the asset of banks particularly active in these businesses, which of course are the biggest banks, are understated. Grossing them up would be precisely wrong but approximately more correct, and would also lower the size advantage of large banks.

By Asli Demirgüç-Kunt and Harry Huizinga. Cross posted from VoxEU

Today’s big banks are enormous. By 2008, 12 banks worldwide had liabilities exceeding $1 trillion. This column, using data on banks from 80 countries over the years 1991-2009, provides new evidence on how large banks differ in terms of their risk and return outcomes and investigates how market perceptions of bank risk are affected by bank size. It concludes that policies should reward bank managers for keeping their banks safe rather than for making them big.

In recent years, many banks have reached enormous size both in absolute terms and relative to their national economies. By 2008:

12 banks worldwide had liabilities exceeding $1 trillion, and
30 banks had a ratio of liabilities to national GDP higher than 0.5.

Large banks tend to be too big to fail, as their failure would have hugely negative repercussions for the overall economy.

Saving oversized banks, however, may ruin a country’s public finances (Gros and Micossi 2008).

Take the example of Ireland; this country provided extensive financial support to its large banks and subsequently had to seek financial assistance from the EU and the IMF in 2010. The public finance risks posed by systemically large banks suggest that such banks should be reduced in size.
Further evidence against big banks can be found from studies on banking technologies. Berger and Mester (1997) estimate the returns to scale in US banking using data from the 1990s, to find that a bank’s optimal size, consistent with lowest average costs, would be for a bank with around $25 billion in assets. Amel et al. (2004) similarly report that commercial banks in North America with assets in excess of $50 billion have higher operating costs than smaller banks. These findings together suggest that today’s large banks, with assets in some instances exceeding $ 1 trillion, are well beyond the technologically optimal scale.

The public finance risks of large banks and findings on banking cost structures together present a strong case against large banks. All the same, further evidence on how large banks perform relative to small banks is warranted to inform the debate on bank size. Additional insight is useful before one passes judgment on whether systemically large banks should be regulated or taxed out of existence.

Big banks vs. small banks: New evidence

In recent research (Demirgüç-Kunt and Huizinga 2011), we provide empirical evidence on two additional aspects of the debate on big banks vs. small banks.

First, we examine how large banks perform differently in terms of their risk and return outcomes.

For this, indices of bank risk and return based on accounting data are used.

Second, we investigate how market perceptions of bank risk, as reflected in a bank’s interest expenses, are affected by bank size.

Large banks may be perceived to be less risky on account of too-big-to-fail benefits, yielding lower funding costs for sizeable banks (see Carbó-Valverde et al. 2011 for example estimates). Alternatively, large banks are seen as more risky if they are too big to save, giving rise to higher interest rates.

These aspects of bank size are investigated for an international sample of banks from 80 countries over the years 1991-2009. These international data allow us to distinguish between a bank’s absolute size (as measured by the logarithm of its total assets) and its “systemic” size (i.e. how risky a bank is as measured by the ratio of bank liabilities to national GDP). The correlation between these proxies for a bank’s absolute and its systemic size is positive, but low at 0.1. Thus, it is meaningful to separately consider bank absolute size and systemic size.

Size matters, but is it absolute or systemic size?

The distinction between bank absolute and systemic size turns out to be important for explaining bank performance regarding bank risk and return. A bank with larger absolute size on average realizes a higher return on assets. This higher return, however, comes at a cost of higher bank riskiness. A bank’s absolute size thus implies a trade-off between bank risk and return.

The impact of systemic bank size on risk and return is very different. Systemically larger banks on average have lower returns on assets, but there is no discernible impact on bank riskiness.

Systemic size is thus a liability, as it lowers return without an offsetting reduction in risk.

In practice, expanding banks see their absolute and systemic size increase simultaneously. Banks located in smaller countries, however, see their systemic size increase relatively more, with negative implications for risk and return outcomes.

Next, we investigate how a bank’s interest expenses are affected by bank systemic size. Systemically large banks, defined as banks with a ratio of liabilities to GDP exceeding 0.1, on average are found to pay interest rates that are 40 basis points higher, suggesting a “too-big-to-save” effect. Furthermore, the interest expenses of systemically important banks are more sensitive to the bank capitalisation ratio as a proxy for bank risk. This also suggests that systemically important banks are too big to save, and that they are subject to market discipline by bank liability holders.

This new evidence of market discipline of systemically large banks contrasts with earlier evidence, mostly for the US, that absolute bank size pays off. In particular, Kane (2002) and Penas and Unal (2004) report that large bank mergers create value for bank shareholders and bond holders, respectively, as larger bank size increases too-big-to-fail subsidies. In our broader international sample, we do not find any impact of a bank’s absolute size on its interest costs, but we confirm earlier evidence that absolute size reduces market discipline by a bank’s debt holders for a sample of just US banks.

Market discipline of systemically important banks, while it exists, has been ineffective in preventing the emergence of systemically huge banks worldwide. A main reason for this may be that bank managers, rather than bank shareholders, in practice devise and implement bank growth strategies. Bank managers may well benefit from bank asset growth through higher pay and stature, even when continued bank growth is not in the interest of bank shareholders. The phenomenal growth at individual banks that we have witnessed over the last several decades may thus be a reflection of inadequate corporate governance at banks failing to align the interests of bank managers and bank shareholders.

Policy implications

In the absence of effective market discipline on bank systemic size, public policy in the form of regulation or taxation is required to bring down bank systemic size (see Goldstein and Véron 2011 for a discussion).

Regulation can take the form of quantitative limits on bank size, or of other regulations such as capital adequacy and liquidity requirements that are biased against systemically large banks.

Taxation can similarly take the form of, say, levies on bank liabilities that are especially geared towards systemically large banks.

In the US, the Wall Street Reform and Consumer Protection Act (or Dodd-Frank Act) passed in July 2010 prohibits bank mergers that result in a bank with total liabilities exceeding 10% of the aggregate consolidated liabilities of all financial companies, but an earlier proposal by the Obama administration to institute a levy on the liabilities of large bank failed to be enacted. In Europe, the European Commission (2010) is proposing bank levies to finance national bank resolution funds. Such levies could easily be slanted towards large banks, at the national or EU level.

Evidence that market discipline on bank systemic size is ineffective suggests that bank levies on oversised banks by themselves are not enough to reduce bank size.

Corporate governance reform in the banking sector is also needed to ensure that market discipline and taxation can be effective.

In particular, bank managers should be rewarded for keeping their banks safe rather than for making them systemically large.