Crony Capitalism and the Current Economic Crisis

Marginal Revolution sums up Russ Roberts's new paper, "Gambling with Other People's Money," on what caused the current crisis in six points.  The first and last point of their blog illuminate key points in his paper:

1. It isn't "too big to fail" that's the problem, it's the rescue of creditors going back to 1984, encouraged imprudent lending and allowed large financial institutions to become highly leveraged.

6. The increased demand for housing resulting from Fanne and Freddie's expansion pushed up the price of housing and helped make subprime attractive to banks. But the ultimate driver of destruction was leverage. Either lenders were irrationally exuberant or were lulled into that exuberance by the persistent rescues of the previous three decades.

But what they seem to primarily miss is Roberts' main point on why the bailouts and favorable regulation (or deregulation, depending on your view) occurred:  Crony capitalism. Roberts writes:

The most culpable policy has been the systematic encouragement of imprudent borrowing and lending. That encouragement came not from capitalism or markets, but from crony capitalism, the mutual aid society where Washington takes care of Wall Street and Wall Street returns the favor.9 Over the last three decades, public policy has systematically reduced the risk of making bad loans to risky investors. Over the last three decades, when large financial institutions have gotten into trouble, the government has almost always rescued their bondholders and creditors. These policies have created incentives both to borrow and to lend recklessly.

When large financial institutions get in trouble, equity holders are typically wiped out or made to suffer significant losses when share values plummet. The punishment of equity holders is usually thought to reduce the moral hazard created by the rescue of creditors. But it does not. It merely masks the role of creditor rescues in creating perverse incentives for risk taking.

The expectation by creditors that they might be rescued allows financial institutions to substitute borrowed money for their own capital even as they make riskier and riskier investments. Because of the large amounts of leverage—the use of debt rather than equity—executives can more easily generate short-term profits that justify large compensation. While executives endure some of the pain if short-term gains become losses in the long run, the downside risk to the decision-makers turns out to be surprisingly small, while the upside gains can be enormous. Taxpayers ultimately bear much of the downside risk. Until we recognize the pernicious incentives created by the persistent rescue of creditors, no regulatory reform is likely to succeed.

He explains the creditors' role in a simple analogy of a poker game that I summarize here: You, the creditor, is asked to lend $ to your friend, a poker player. He asks you to lend $100 for every $3 of his own money, and will pay you back a favorable rate of interest. While that may seem like a high risk, you go along with it for  awhile since your friend is a very skilled poker player. But you will keep an eye on him because you want him to stay solvent so he can pay back his debt. However the gambler will take a big risk if he thinks he can score a major win.  After all, he has only put up $3. As long as he's winning, everyone's happy. But at some point if he becomes increasingly reckless, asking to borrow more and becoming highly overleveraged, you will start reining him in by charging a higher rate of interest, or asking for collateral. That's what normally happens...until Uncle Sam enters the room. Everyone in the room knows Uncle Sam is very rich, and helps write the rules of the game, at times, intervening. They've also seen him cover the debts when everyone goes broke.  Uncle Sam's mere presence in that room changes the incentives for everybody. If you think there's a good chance Uncle Sam will bail out your player, you will keep less of an eye on him and just keep lending $. Why shouldn't your friend take more risk? Why shouldn't you if you know rich Uncle Sam is going to bail you all out of if things go sour? Now enter the moral hazard of Fannie and Freddie, and their implicit government backing.    

I don't believe regulation or deregulation as an end to itself; that confuses process with purpose.  There clearly needs to be some regulation of capitalism; it's a matter of striking the right balance between maximizing capitalism's benefits for society at large and attempting to prevent it from bringing the economy to a halt, or systematically fleecing little guy.  As such, I tend to believe the crisis was caused by a confluence of several factors: what Roberts' describe as both Republican and Democratic presidential administrations' desires to make everyone in America a homeowner, a global savings glut that decreased the Fed's ability to use monetary policy to cool off the housing sector, exotic financial instruments created by Wall Street that were traded opaquely, and the lack of will of the government to regulate or bring transparency to such instruments (except of course, for Brooksley Born at the CFTC). Crony capitalism is a recurring theme in all this.  I also think that as unfortunate as TARP was, it had to be done because Wall Street's implosion would have badly hurt Main Street (how it was executed though, as well as the bailout of automakers, is another story).

In a somewhat similar vein, the Atlantic published an article a year ago called: "The Quiet Coup: How the Bankers Seized America" by former chief economist of IMF Chief, Simon Johnson, who describes the typical incestuous relationship between the financial oligarchy and the government in developing countries, and their striking similarities to our current situation. Johnson comes down on the side of deregulation and too big to fail but views these symptoms as stemming from crony capitalism.  He sums up the financial sector's historical importance to the economy:

From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.  

So the key thing to watch as the details of the Senate financial regulation bill gets debated is to ask what penalty do the creditors pay if a firm is deemed a systematic risk and on the edge of insolvency? Will they get a better deal through resolution than if the firm had to go through standard bankruptcy? Remember, Goldman Sachs as creditor to AIG got 100 cents on the dollar (why now Secretary Geitner may find himself under investigation since he arranged the deal as head of the NY Fed, and the NY Fed's actions are being closed looked at by the TARP Special Inspector General). Are there any preferred players in the bill?  This will tell us whether the government is serious about ending crony capitalism, or merely perpetuating it.