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April 22, 2009

Economist's View - 3 new articles

Using Anti-Trust Law to Break Up Banks that are Too Big to Fail

Simon Johnson wants to apply anti-trust laws to financial markets and use it to break up banks that are too big too fail. More vigorous enforcement of anti-trust laws is something I've been pushing here for a long time, and as I explain below I agree with this idea, but as I understand it, current anti-trust law is inadequate for this task (particularly on dimensions such as connectedness and systemic risk). So it will likely take Congressional action before we can proceed.

The reason for bringing this up is that I want to amend remarks I made in the past. I have said that there is no single villain in this crisis, no one person, not one change in the law, etc., that caused this. It was a combination of things. But as I think about it more and more, I'm not so sure. The reason? According to the story I've been telling about why the crisis happened, there were incentive failures at just about every step in the process. Homeowners had no recourse loans giving them one way bets on home values, real estate agents are paid in a way that causes them to maximize the value of sales, mortgage brokers faced no long-run consequences from bad loans, real estate appraisers had incentives to validate sales, ratings agencies were paid by the people whose assets were being rated, CEOs and upper level management had incentives to maximize something other than shareholder value, there was a lack of transparency giving insiders an advantage, it goes on and on.There is not a single step in the process that wasn't compromised by an incentive or market failure of some type.

Looking at this at first, I concluded that it was all of these things, and more, that caused the crisis, and that it could have been stopped at any one of these steps. Had anyone at any one of the steps from the sale of the house to the complex securities traded in the shadow banking system said no, we're not doing that, the money could not have kept flowing through the system and blowing up the bubble. For example, if the mortgage brokers would have taken personal losses on mortgages that later went bad, they might have refused to finance them, and the money could not have been passed upwards to the shadow banking system where it caused such big problems. But instead, the brokers simply passed the contracts along, sliced and diced as necessary, to the next person in the finance chain.

But what should we make of the fact that every singe step in the process is compromised? Every market that was supposed to self-regulate failed? Does every single market in the chain fail at the same time through some highly unlikely coincidence? What are the chances that, on their own, independently, each and every step in the chain would have been subject to a market failure that just happened to let the bubble keep inflating? Whatever it took to keep the money flowing through the system seems to have come to pass.

So more and more I'm starting to thing there may be a single explanation after all, that the regulators of these markets were captured by powerful forces that wanted the game to continue. The power of regulators, and the will to enforce the regulations, must match - in fact exceed - the will and power of those being regulated to resist having constraints placed on their behavior. I've talked about why ideology may have eroded the will of regulators, but their will is partly a function of their power. So long as we allow huge, clearly over-sized financial institutions to exist, this problem will potentially be present.

Therefore, if the current anti-trust legislation is adequate to the task, then yes, let's give regulators the power to enforce it, and ensure we have people in place with the will to do so. But as I said above, I think current law may have glaring legal holes that need to be closed before we can use this section of the law effectively. If so, then it's time to get started crafting new legislation that is up to the task, and I hope Simon Johnson is successful in getting movement in this direction. He has my support.


Sachs: Paying for Government's Expanded Economic Role

Jeff Sachs says the government will need to find new sources of tax revenue:

The Costs of Expanding the Government's Economic Role [Extended version], by Jeffrey D. Sachs, Scientific American: The 10-year budget framework that President Barack Obama released ... is as much a philosophy of government as a fiscal action plan. Gone is the Ronald Reagan view that "government is not a solution to our problem; government is the problem." Obama rightly sees an expanded role for government in allocating society's resources as vital to meeting the 21st century challenge of sustainable development.

The scientific discipline known as public economics describes why government is needed alongside markets to allocate resources. These reasons include: the protection of the poor through a social safety net; the correction of externalities...; the provision of "merit goods" such as health care and education that society deems to be essential for all of its members; and the financing of scientific and technological research that cannot be efficiently captured by private investors. In all these circumstances, the free-market system tends to underprovide the resource in question...

Obama's budget plan properly focuses on areas that public economics identifies as priorities and where the U.S. discernibly lags behind many parts of Europe: health..., education..., public infrastructure... and research and development... The emphasis is on public-private partnerships (PPP), combining public financing and private sector delivery. ...

Obama's vision of an expanded federal role is on-target and transformative, but the financing will be tricky. This year's deficit will reach an astounding $1.75 trillion, or 12 percent of GDP...

Obama's budget plan aims to reduce the deficit to 3 percent of GNP by 2013, and to level off till 2019..., but ... that target will be very difficult to achieve and sustain as planned. ...[T]he plan is to cut the deficit mainly through higher taxes on the rich, reduced military outlays for Iraq and Afghanistan, new revenues from auctioning carbon-emission permits and, finally, a squeeze on non-defense discretionary spending... Such a squeeze on non-defense spending seems unlikely—and indeed undesirable—at a time when government is launching several much-needed programs in education, health, energy and infrastructure.

The truth is that the U.S. ... will probably have to raise new revenues ... to carry out its vital roles in protecting the poor, promoting health and education and building a modern infrastructure with ... sustainable technology. Ending the Bush-era tax cuts on the rich certainly is merited, but further taxing the rich much beyond that will come up against political and practical limits. Within a few years, we'll probably see the need for new broader-based taxes, perhaps a national sales or value-added tax such as those widely used in other high-income countries. If we continue to assume that we can have the expanded government that we need but without the tax revenues to pay for it, the unacceptable build-up of public debt will threaten the well-being of our children and our children's children. ...

I doubt will see any major changes in the tax structure anytime soon, but if we do, value added taxes are regressive, but in countries where they are used, they're an important source of revenue for highly progressive tax-and-transfer systems (but not without problems). So the characteristic of these taxes overall depends upon their implementation, i.e. how the extra revenue from the tax is used.


links for 2009-04-22

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