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Thursday, March 05, 2009

Don't blame Bushco or Obamaco

People accused Bushco of not having much of a clue about how to "fix" the financial meltdown.

How long until people accuse Obamaco of not having much of a clue about how to "fix" the financial meltdown?



Citi Group was trading at $1.01 when I grabbed this shot from Google finance.

Here's my take on things: there is really no sense in blaming Bushco or Obamaco because neither "side" of the aisle has much experience with this type of situation and there really is no policy prescription that is KNOWN to work. People point to Japan and say, "don't do that" but it isn't clear what "that" actually is. I have admitted before to not being a macroeconomist, nor a banking economist, but it seems that the bailouts are only going to do one thing - stave off insolvency at the expense of becoming de facto nationalized. Perhaps this is why the financial sector is taking it on the chin day after day.

In the end, being a bank is relatively simple - money comes in, money goes out, and you take your vig. It's the banks that got messed up with the exotic, now perhaps toxic, assets that are in trouble. But why did some banks get involved early on, perhaps like IndyBanc, others got involved later on, perhaps like BoA, and others chose not to play the game, perhaps like BB&T? It is easy to blame greed, but greed is always around and even the taxonomy of "good greed" versus "bad greed" doesn't really provide a satisfactory explanation.

In economics the theory of games, that is, strategic interaction has been one of the dominant models for firm interaction. The prototypical game called the prisoner's dilemma might provide some insights into why certain banks jumped in and others did not. Consider two banks sitting around looking for profit opportunities, Bank A and Bank B. The CEOs of these large banks feel pressure for ever increasing profits, perhaps more than is the at the local and regional banks. The CEOs hear of the new exotic assets and think, "hey, there's a good profit potential here." From the point of view of society, if only one bank went in for exotics, then if/when things headed South, the system would survive. However, that wasn't the case - plenty of banks got involved and when things headed South, the system couldn't survive.

What does this have to do with the prisoner's dilemma? If Bank A decided to sit the game out and Bank B and others jumped in and scored a large profit, the CEO/management of Bank A might stand to lose their job. Therefore, if Bank A sees Bank B jump in, then Bank A jumps in as well, even if overall this can lead to a bad outcome for all the Banks involved. This is a common problem with the non-cooperative outcome of the prisoner's dilemma - the non-cooperative outcome leads to a less efficient outcome than the cooperative outcome. Generally, if firms are competing in the car market, consumers stand to gain if there is more than one firm selling, say, pickup trucks and sedans, even if the firms would rather negotiate among themselves to segment the market for pickup trucks and sedans. This is one reason for antitrust laws - they ostensibly stop firms from colluding to increase profits at the expense of consumers.

Thus, many of the big banks get into the racket even if, in the end, the non-cooperative outcome is less efficient than the cooperative outcome, i.e., the outcome in which no bank goes after the exotoxicTM assets.

If the banks were stuck in a prisoners dilemma then there might be an argument for regulation. However, the regulation would have to be very prescient to stave off all possible prisoners dilemmas that might lead to the same outcome. Thus, I am suspect of regulations that are coming down the pike.

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Comments:
Ok, a similar case has been made for the idea that imperfect information, moral hazard, etc. all feed into the same sort of poor coordination that sometimes dooms markets to failure. But this is simply forensic science - don't tell me why the patient died, offer constructive ideas for how to treat the illness. Nationalization and regulation might be bad, but how do they compare to the alternative, which might be a big gaping hole where the credit and capital markets used to function. Comparing a known bad to an unknown worse, I'll take the known bad of regulation.
 
I don't think that imperfect information generally dooms markets to failure. I'd buy the claim that asymetric or imperfect information might doom certain transactions or certain individual agents to failure but not the entire system. I would say this because it is rather rare for markets to "fail" - outside of a few "bubbles" the current situation is admittedly rare. What, perhaps only four or five episodes of such "perfect storms" have occurred in relatively free markets over the past hundred years or so?

When it comes to regulation, politicians tend to go with "any policy is better than no policy" pragmatism that has numerous unintended consequences.

I think if regulation is going to be placed on the financial market, for the "greater good," that regulation should be well thought out. Unfortunately, it doesn't seem like that will be the case. Rather, the current approach seems likely to entail a politburo style regulation handed down from above and voted on without much debate. There was another episode of such legislative haste around late September, 2001, and that was roundly, and rightly, criticized.

One final point - the only banks that seemed to be in this position were those with investment banks. I am not sure, but wasn't the repeal of Glass-Steagal what allowed certain banks to enter into the investments area. Perhaps this "freedom" sufficiently changed the incentives of the managements of these banks so that they unintentionally found themselves in the prisoner's dilemma I describe.

Colleague Richard B. suggests that it might be better to think about banks that fell under Basel II - but I will have to think more about that.

My point is that there are plenty of banks that will fall under a regulatory blanket who might not "deserve" to be handcuffed the same way as others.
 
My comment about information related only to individual markets. I have no beef with that. Still, saying "regulation is bad" doesn't get us very far. And your observation about the appropriate function of banks is valid too: money comes in, money goes out. Regulation should be well thought out, but if you refer, for example to Oliver Williamson's taxonomy of behavioral assumptions in the Economic Institutions of Capitalism, markets that are prone to asymmetric information and opportunism (as opposed to strictly maximizing rationality) behavior require a mechanism design approach, i.e. regulation. As for politicians, well, they can screw anything up given the chance; even capitalism
 
As I have matured as an economist I have come off my "no regulation is better than bad regulation" hard-line stance. That said, I am not in favor of the 545 in Washington passing regulation without reading what they are voting on. I don't think that is what pro regulation economists from the Berkely or Harvard schools of thought really wanted.

Regulation, by definition, suggests that we are in a second-best world, perhaps third or fourth best. At this point, I would be happy with a loss-minimization approach to regulation rather than straight rent-seeking or self aggrandizement.
 
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