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July 14, 2009

Economist's View - 5 new articles

How Should We Interpret Goldman Sach's Unexpectedly Large Earnings?

The NY Times Room for Debate is discussing how we should interpret Goldman Sach's compensation pool, which will be an $11.36 billion set aside for the first half of 2009. Here's the unedited version of my entry (you may like the shorter, edited version better):

What does the size of Goldman's compensation pool tell us? It signals several things. First, it gives some indication that the financial sector is improving, and that is good news. There's no guarantee, however, that the overall economy will follow anytime soon. Even with improvements in the financial sector, the recovery of the broader economy is likely to be a slow process.

One of the reasons I expect the recovery to be slow despite improvements in the financial sector is that the economy cannot go back to where it was before the crisis hit. The financial and housing sectors need to shrink, too many economic resources were used unproductively in support of these activities, and the automobile sector is also in transition.

And it's not just that the financial sector needs to get smaller so that resources can be used productively elsewhere, the financial sector also needs to change its ways so that risk accumulations do not threaten the financial system and the broader economy. As Robert Reich notes today, Goldman's chief financial officer tells Bloomberg News that "Our model really never changed, we've said very consistently that our business model remained the same." Thus, a second signal from Goldman's unexpectedly large earnings is that firms such as Goldman Sachs are returning to the same high-risk strategies backed by too big to fail government guarantees that got us into trouble in the first place, and that aspect of Goldman's success is worrisome. It's a signal that the excesses that led to the high incomes of financial executives have not ended.

Why aren't the profits and the bonuses paid to executives justifiable? Don't they signal the superior talents of Goldman employees, and don't those talents deserve to be rewarded by the marketplace? I think we can legitimately question whether this is a reward for superior talent. Goldman was helped by bailout funds -- there's some debate about whether it actually needed a direct infusion of funds -- but it's certainly true that Goldman benefitted when its counterparties such as AIG were bailed out. Goldman is also benefitting from its early escape from government constraints that still inhibit the ability of other firms to compete on equal - though perhaps overly slippery and risky - footing.

So Goldman's earnings are not simply the product of the superior talent of Goldman's executives, there is more to the story. In addition, the bad incentives that executive compensation structures provide was one of the factors that caused the crisis, and the size of the compensation pool tells us there is work yet to be done to fix this problem.

Other entries from William K. Black, Yves Smith, and Charles Geisst.

Enough to Help, not Enough to Cure

If the first pill doesn't cure the patient, does that mean the prescription didn't work?

Consumer Protection Elitists? Hardly

Richard Green takes on Peter Wallison's arguments against establishing a Financial Product Safety Commission:

Peter Wallison calls Consumer Protection Elitist: He writes:

Traditionally, consumer protection in the United States has focused on disclosure. It has always been assumed that with adequate disclosure all consumers -- of whatever level of sophistication -- could make rational decisions about the products and services they are offered. No more. If the administration's plan is adopted, many consumers will be told that they cannot have particular products or services because they are not sophisticated, educated or perhaps intelligent enough to understand what they have been offered. Conservatives have always argued that liberals are elitists who do not respect ordinary Americans; this legislation seems to prove it. For example, the administration's plan would allow the educated and sophisticated elites to have access to whatever financial services they want but limit the range of products available to ordinary Americans. This unprecedented result comes about because, under the proposed legislation, every provider of a financial service (a term that includes organizations as varied as banks, check-cashing services, leasing companies and payment services) is required to offer a "standard" product or service -- to be defined and approved by the proposed agency -- that will be simple and entail "lower risks" for consumers. These standard products are called "plain vanilla" in the white paper that the administration circulated in advance of the legislation.

Such protection is actually not unprecedented. For example, people must be deemed to be "accredited investors" or (for more complicated products) "qualified purchasers" in order to invest in certain types of hedge funds. And stock brokers have an obligation to make sure their clients' investments are "suitable."

But beyond the issue of precedence, there is a broader issue of safety. We reasonably forbid or require a variety of actions in the interest of safety. We require people to wear seatbelts. Be don't allow people to buy certain type of narcotics over the counter. Perhaps Mr. Wallison thinks such protections are a bad idea too, in which case he is consistent, if not also ridiculous. Mortgages can be dangerous products. Let's turn it over to Richard Thaler:

Fast forward to 2008, and the world of mortgage shopping had become a much more complicated place. Borrowers were quoted low initial "teaser" rates that would jump later to some higher level, depending on market interest rates at the time, and there were prepayment penalties for paying off the loans early. For such mortgages, an A.P.R. was no longer an adequate measure of the loan's cost. How can we help people make sense of all this? One extreme approach would be to ban complex mortgages entirely: we could just go back to the world of uniform fixed-rate mortgages. But the cost of simplicity is an end to innovation. ... A better approach is to strive for maintaining diverse options but helping consumers make smart choices and avoid the most common pitfalls. ... As the administration plan describes it, lenders could be required to offer some mortgages they call "plain vanilla," with uniform terms. There might be one vanilla 30-year, fixed-rate mortgage and one five-year, adjustable-rate mortgage. The features of these plain mortgages would be uniform, much as in a standard lease used in most rental agreements. Lenders would also be free to offer other exotic mortgages — perhaps called "rocky road" mortgages? — along with the vanilla variety, but these offerings would receive more intense scrutiny from regulators.

I am not sure what is so elitist about this, other than the fact that those who are hostile to regulations tend to like to use elitist as an epithet for their opponents. So I guess I have two questions for Mr. Wallison: (1) If I gave him an HP12C calculator, assumptions about an interest rate path, and the terms of an option-ARM mortgage, would he be able to tell me the payment on that mortgage in, say, month 62? Perhaps he could, but I don't know too many lawyers (and he is a lawyer) who could do that calculation. ... The point is ... to emphasize a fact--most of us do not have the equipment to make informed judgments about complex financial products. (2) I am curious how often Mr. Wallison hangs out with those who are not elite. Does he socialize with, say, median income people? ... Perhaps he does, in which case he is entitled to refer to "the elite" as an other. But I have my doubts.

I would be hesitant to endorse this banks weren't "free to offer other exotic mortgages," but that's not a problem.

Why make these products identical, i.e. why have a plain vanilla option? Have you ever tried to compare the price of mattresses at different stores? It's almost impossible - intentionally - to find matching model numbers and exactly identical products, so you are never quite sure which is the better deal. That uncertainty gives the stores pricing power. If stores were required to offer two or three identical mattresses, such comparison shopping would no longer be a problem and you'd expect competition to drive the price down its minimum level. There would still be exotic mattresses at each store, nobody would make you purchase the standard option, you would still have choices. But even if you aren't a mattress expert and hence have little idea if the exotic mattresses are worth the price, at least there would be two or three choices where you could be sure that the mattresses were priced fairly and that they adhered to particular quality and safety standards.

Of course, since such a proposal would take away pricing power of firms selling mattresses, and they would be opposed to such a requirement. It's no different for financial firms, and Simon Johnson doesn't think the administration is being aggressive enough in countering efforts to undermine and weaken the proposed consumer protection legislation:

Waiting For The Big Push: Selling The Consumer Protection Agency For Financial Products. by Simon Johnson: ...[T]he administration's major remaining initiative is its version of a Financial Product Safety Commission - something that would be clearly beneficial for the public. And the skepticism – and outright opposition – comes from the banking sector. ...

As far as I can see, [the administration is] not pushing this new consumer protection/safety agency hard enough. Some sources claim that Secretary Geithner is fully on board with the Agency... But there is no sign of the frenzied effort that accompanied efforts to launch the PPIP – when, for example, almost every economist in the administration seemed pressed into service to call potential critics and ask them to "give it a chance."

One symptom of this "effort gap" is that counter-arguments and disinformation about the proposed agency begin to gain the upper hand. One senior executive recently told me that this agency would have unprecedented powers to determine the design of individual products – "something not even the FDA can do."

Of course, this is nonsense. The new agency would be powerful – and thus it is feared by the industry – and presumably it would be able to prevent sufficiently toxic products from being sold. Hopefully, it will also be able to require that all financial institutions also offer some vanilla products, to make consumers' choices easier. But the idea that an agency would design the details of all products for any sector is both implausible and a malicious rumor being spread by opponents (actually, it reminds me of the pushback from meatpackers, and others, early in the 20th century).

If Treasury is so supportive of this new Agency, now is the time to launch public, high profile, and clever counterattacks. By the time the legislation is being voted on, it will be too late.

And in this context, the administration should push hard on one of the great ironies here. Financial sector executives like to stress the importance of "consumer confidence," and they urge the government to take steps to restore this confidence...

But the same people completely reject the idea that consumers will feel more confident about financial products if there is finally some serious consumer protection around those products. Whenever people learn – or just fear – that a particular food product is unsafe, they stop buying it. When the stock market ripped people off in the late 1920s, it took legislation with real teeth to rebuild investor confidence – take a look at, for example, the Securities Exchange Act of 1934. ...

If Treasury and the administration really wants a Consumer Protection/Safety Agency for finance, they need to kick their support campaign into much higher gear immediately.

Consumers have a big information disadvantage when it comes to mortgages and understanding which product fits their needs without exposing them to unnecessary risk, and in some cases they may not even be presented with the full spectrum of mortgage products that are available when they apply for a loan. And though it's better than it used to be, it's also difficult to shop around due to the transactions costs involved. The information problem combined with the difficulty in comparison shopping give brokers the opportunity to steer people toward products that are more profitable, but not as good a fit for the borrower. Having a few common options that are available across brokers makes comparison shopping easier and helps to overcome the information problem.

Update: More at Rortybomb.

Update: Tim Fernholz disagrees with Simon Johnson:

Simon Johnson writes that the administration isn't supporting the proposed Consumer Financial Products Agency enough. Since I wrote a piece arguing the exact opposite last week, I thought I'd respond, though I do agree with Simon in so far as he administration could never do too much to support the creation of the agency.

links for 2009-07-14


Dani Rodrik says "mercantilism deserves a rethink":

Mercantilism Reconsidered, by Dani Rodrik, Commentary, Project Syndicate: A businessman walks into a government minister's office and says he needs help. What should the minister do? Invite him in for a cup of coffee and ask how the government can be of help? Or throw him out, on the principle that government should not be handing out favors to business?

This question constitutes a Rorschach test for policymakers and economists. On one side are free-market enthusiasts and neo-classical economists, who believe in a stark separation between state and business. In their view, the government's role is to establish clear rules and regulations and then let businesses sink or swim on their own. ... This view reflects a venerable tradition that goes back to Adam Smith...

On the other side are what we may call corporatists or neo-mercantilists, who view an alliance between government and business as critical to good economic performance and social harmony. In this model, the economy needs a state that eagerly lends an ear to business, and, when necessary, greases the wheels of commerce by providing incentives, subsidies, and other discretionary benefits. Because investment and job creation ensure economic prosperity, the objective of government policy should be to make producers happy. ... This view reflects an even older tradition that goes back to the mercantilist practices of the seventeenth century. ...

Adam Smith and his followers decisively won the intellectual battle between these two models of capitalism. But the facts on the ground tell a more ambiguous story.

The growth champions of the past few decades - Japan..., South Korea..., and China... - have all had activist governments collaborating closely with large business. ... China's pursuit of a high-saving, large-trade-surplus economy in recent years embodies mercantilist teachings.

Early mercantilism deserves a rethink too. It is doubtful that the great expansion of intercontinental trade in the sixteenth and seventeenth centuries would have been possible without the incentives that states provided, such as monopoly charters. As many economic historians argue, the trade networks and profits that mercantilism provided for Britain may have been critical in launching the country's industrial revolution...

None of this is to idealize mercantilist practices... Governments can too easily end up in the pockets of business, resulting in cronyism and rent-seeking instead of economic growth. ... The pursuit of trade surpluses inevitably triggers conflicts with trade partners...

Nonetheless, the mercantilist mindset provides policymakers with some important advantages: better feedback about the constraints and opportunities that private economic activity faces, and the ability to create a sense of national purpose around economic goals. There is much that liberals can learn from it.

Indeed, the inability to see the advantages of close state-business relations is the blind spot of modern economic liberalism. ...Just look at how the search for the causes of the financial crisis has played out in the US. Current conventional wisdom places the blame squarely on the close ties that developed between policymakers and the financial industry in recent decades. For textbook liberals, the state should have kept its distance...

But the problem is not that government listened too much to Wall Street; rather, the problem is that it didn't listen enough to Main Street, where the real producers and innovators were. That is how untested economic theories about efficient markets and self-regulation could substitute for common sense, enabling financial interests to gain hegemony, while leaving everyone else, including governments, to pick up the pieces.

If policymakers had listened just as much as before to Wall Street, somehow listening to Main Street would have saved the day and we would have avoided the financial crisis? I'd like to hear a bit more about how that would have happened since exactly how listening to Main Street would have prevented the crisis is left unexplained, and it's not at all clear to me how that would have avoided the problems in the financial sector. (And aren't there examples of countries that followed these types of polices, but still had some sort of financial meltdown?)

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