Thursday, December 16, 2010

An Unusual Approach to the Bank Bailout: Facts (Part II)

Continued from Tuesday; read the first part here

It rewarded the people who caused the problem

ARGUMENT: By bailing out these institutions and leaving management in place (at all levels), the very people who created the mess faced no real consequences and, in fact, continued to receive large salaries and bonuses.

Of all the arguments against the bailout, this is the one with which I sympathize the most. These people did screw up terribly. It would be wonderful if they could be held accountable.

But here’s the problem: this was/is an unbelievably complicated mess. I don’t claim to understand exactly what happened (which is okay as people who are far smarter than me don’t understand it either) but in essence they created a complex shell game in which risk was repackaged and repackaged, passed on and on, with the end result that no one really knew what their true exposure was. If the people responsible had been canned, who would have unwound the mess? There were plenty of other places where these people could have gone and made more money if the government had said “Listen: you need to let these people go.” Like it or not, we were stuck with them.

The government should not interfere in the market

ARGUMENT: Government should leave the market alone to sort out its own issues. By intervening aggressively, the government trampled on shareholder rights, interfered in business operations (such as by limiting pay and bonuses), and set a bad precedent. The fact that this happened in the first place goes to show that government isn’t a competent regulator and we would be better off if these institutions regulated themselves, or let the market do it for them.

I suspect how people respond to this argument depends on their philosophical beliefs. Those who follow the Chicago school of economics/Milton Friedman/Wall Street Journal editorial page approach will never accept government intervention, and will always see it as an evil that does nothing more than distort the natural course of commerce. Those of a more liberal/interventionist bent will likely want much tighter regulation of this sector – to the point of controlling the level of pay and bonuses, etc. (As for me, I don’t subscribe to a particular school of thought – unless “pragmatism” can be called a belief).

The main issue here is that the financial sector is not like any other business. It is intricately intertwined with the entire economy, to the point of unhealthy dominance. Allow the automobile industry (for example) to collapse, and there would have been pain, but (relatively) limited. (The auto industry should NOT have received government aid IMHO. Where is this sector going? What future do its products have? And are we even considering the negative aspects of the automobile-dependent society we’ve created?)

Finance is tied up in everything. Just consider the fact that thanks to the idiocy of the “geniuses” running Wall Street, people who did the right thing (saved, did not use their home as a piggy bank, did not pile up debt to keep up with the Joneses) were screwed by this: bank account interest is less than inflation; retirement accounts were hit with huge losses as the market collapsed.

Given the key role finance plays (and a history of this type of collapse affecting the entire economy), there is no choice but to have a degree of government involvement in this market.

Conclusions

First, the bank bailout should never have been needed. With a proper regulatory framework (a simple approach focused on risk, using risk-weighted capital ratios), plus a clear understanding of what would happen in the event of a meltdown (a clear path for the dissolution or government takeover of a failing institution, and no bailout), it wouldn’t have happened.

We also live in a system in which virtually any kind of profit is okay, even if, as in the case of much of the speculative activity involved in the meltdown, I seriously question whether any value is created and, in fact, feel it’s actually destroying value. (Derivatives certainly have their place. For example, fuel hedging can help transportation companies, homeowners, etc., but when 70% of the activity is by speculators with no connection to the market, then something is wrong.)

The government should have intervened, but they should have bit the bullet and taken equity stakes in these companies (as Sweden did in 1992 in what is widely regarded, at least among people without some sort of ideological agenda, the most successful bank rescue ever). As did happen, management would have stayed in place to deal with the problems, taxpayers would bee fully compensated (hopefully) over time. Unfortunately, that idea would have been called “nationalization” and would be a political non-started in this country.

We also should have a proper regulatory regime in place at the national level (which would probably require some sort of constitutional amendment), eliminating the ridiculous situation we have now in which institutions shop for regulators. (One of the main reasons AIG became such a mess is that it was regulated in all 50 states. There was no single regulator with the big picture.) I haven’t delved into the financial services reform bill that was passed, but it didn’t create the single regulator that’s so badly needed.

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