Manhattan Institute

Lauren Miklos
Encounter Books



 (Encounter Books, 2009)



Nicole Gelinas and Claire Berlinski, City Journal Contributing Editor, discuss "After the Fall" on Ricochet.com's "The Ricochet Book Club"

January 15, 2011
Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"

Jason, you said: "Conservatives seem to have little trouble admitting that markets involve humans, who are greedy and often make mistakes." This remark gets us to one part of the financial-crisis debate: are markets "efficient" or not? The answer may seem academic, but it matters. If people conclude that markets aren't "efficient," they'll demand an even greater role for the government in determining where our money and labor should go. (For an example of this argument, read this Krugman magazine piece.) Some history: Over the half-century or so up until 2008, academics convinced policy folk that markets were efficient -- that is, that financial markets quickly and accurately reflect all available information . . .


January 14, 2011
Was the crisis "actually imposed by the government?"

I was going to do an original post tonight, but the questions and comments are too much of a temptation, so I'll start right in. Aodhan, you ask, "how significant was the government's inadvertent 'role' here in precipitating the crisis by pursuing the political goal of fostering home ownership?" Thomas Sowell, in The Housing Boom and Bust, has concluded that complex financial bets "went bad" only because "the government had exerted pressure over time on many lenders to make loans to the uncreditworthy" so that they could buy houses ( as you paraphrase Sowell). Financial instruments like credit-default swaps, of course, depended on those loans' performance, so they failed and brought down the financial system . . .

January 14, 2011
The Government's Role in Financial Markets

Thank you, Claire, for the invitation, and thank you, Emily, John, Michael, Bob, and others for the comments. Claire, you zoomed right in on the point of the book: what is the government's role in markets? How and when should it play that role? Where does the "market" end and government begin? I'll answer your practical point. What would have happened had Washington allowed free markets to sort out the mess starting with Lehman's collapse on 9/14/08 (my wedding day, too, btw) without extraordinary government action? Like you, I don't know what would have happened. Here is what I think . . .

Nicole Gelinas and Ira Stoll, editor and founder of FutureOfCapitalism.com, discuss Nicole's arguments pertaining to financial regulations.

December 22, 2009


Dear Nicole,

Thanks for your answer about the FDIC. I think the IndyMac example you cite is an excellent case to look at. What you don't mention, though, is that both the bank and the regulator blamed Senator Schumer for causing a run on the bank. What you seem to see as an example of how the federal government protects depositors I see as an example of how irresponsible government officials mucking around bank balance sheets can cause harm to depositors and to bank employees and shareholders. I just don t think the cause of the Great Depression was a lack of federal deposit insurance. For one thing, the depression continued for years after deposit insurance had been instituted. Your arguments about grandmothers and mom and pop needing deposit insurance are the same ones that people in Washington make about the need to expand government health insurance. Somehow, mom, pop, and grandmothers all manage to navigate the private auto insurance, homeowners insurance, and life insurance markets on their own. Those grandmothers are a lot sharper than they are given credit for, in part because a lot of them lived through the economic downturns that the younger regulators labor under the illusion that they can prevent.

More broadly, I think capitalism is durable, robust, and resilient enough to withstand downturns, not so fragile that a downturn will necessitate a big intervention of the sort that policymakers chose to implement this time around. I have less faith than you seem to in the ability of regulations or regulators to reduce the chances of these downturns. You say, Washington's negligence ensured that the economy was too weak to withstand the market correction of Wall Street's optimism without massive government intervention. Actually, we don't know what the economy would have done without massive government intervention. Maybe it would have recovered on its own. We know that in France and Germany, where there was less stimulus, there was a quicker recovery. The massive government intervention that constituted the seizure of Fannie Mae may have actually made things worse.

To answer your question about what I think government's role in finance should be, I think it should be limited to the powers enumerated in the Constitution, which include the power to coin money and to regulate commerce between the states. Beyond that, less is better than more. There should be laws against fraud and theft, and they should be enforced. The courts are important in terms of providing a reliable forum for adjudicating disputes over contracts, or corporate governance, resolving bankruptcies, and allowing claimants to defend their property rights.

As far as the Federal Reserve, this morning's Washington Post account doesn't exactly inspire confidence. The Post quotes a speech by Ben Bernanke in May 2007 assuring bankers, we see no serious broad spillover to banks or thrift institutions from the problems in the subprime The troubled lenders, for the most part, have not been institutions with federally insured deposits. The world existed okay for thousands of years before there was a Federal Reserve bank, and if the central bank closed its doors, Americans, being ingenious folk, would probably manage to find some way to get along without it. If the Federal Reserve must exist, at the very least I wish it wouldn t use the power of the federal government to raid private mints that have the temerity to compete with the Fed by issuing their own hard currency.

Anyway, I seem to have failed to convince you (unless this last installment did it), but I have enjoyed the discussion. Thanks again for the opportunity and best of luck with the book.



Dear Ira,

We are in agreement that "capitalism is durable, robust, and resilient enough to withstand downturns." I worry, though, that capitalism faces a subtler threat.

As citizens perceive that the too-big-to-fail financial system enjoys immunity from predictable market discipline, they will lose faith in a two-tiered "free-market" system that offers bailouts to thee, but not to me. It's easy for people to perceive this bald unfairness as a market failure. And as we've seen over the past year, politicians readily will use the excuse that markets failed to justify yet more top-down interference in the economy.

But markets didn't fail; the government failed to understand its proper role in the marketplace. That role is to create a rules-based infrastructure for private-sector finance that protects the economy from predictable financial-market excesses and also allows for the orderly market discipline of financial firms and instruments, up to and including failure.

Absent such a system, no president from either major party in a democracy will allow the economy to withstand the markets' corrections of their natural excesses. Such corrections would exact too high a price on the citizenry.

Listen to the words of President George W. Bush from last autumn, six weeks after Lehman Brothers' disorderly collapse ushered in the biggest bailouts that the nation has ever seen. "We are faced with the prospect of a global meltdown," the president said. "And so we've responded with bold measures. I'm a market-oriented guy, but not when I'm faced with the prospect of a global meltdown."

Listen, too, to the Wall Street Journal's account of the thinking within the Reagan administration a quarter-century before, weeks after President Ronald Reagan's senior staff had protected lenders of the first "too-big-to-fail" bank of the modern era. "Even within an administration committed to extricating government from the financial machinery, there wasn't much of a debate. … Contemplating the failure of a large, money-center bank is 'thinking the unthinkable,' says a White House official who staunchly supports free-market principles on most issues."

If neither Ronald Reagan nor George W. Bush, each a defender of free markets, thought that he could responsibly refrain from intervening in "free" financial markets, who would?

The practical question, then is this: how can the government, in necessarily playing a role in financial markets, support them rather than undermine them?

We've seen the results of the wrong kind of government interference, including the largely invisible interference of a quarter-century's worth of "too-big-to-fail" subsidies. Another choice is available—and I hope that Washington understands the necessity of making this choice before a future financial crisis overwhelms the government's rescue efforts, harming the public's faith in free-market capitalism along the way.

I, too, have had fun doing this forum, and I'll be a regular visitor to futureofcapitalism.com. Happy 2010 to you, Ira.




December 18, 2009


I'll answer your last question first. "Why not... just not do the bailouts or seizures?... The justification the government gave at the time for trammeling the rights of the AIG and Fannie Mae stockholders - that it was necessary to protect the broader economy—is the same one you give for your capitalization rules."

But, Ira, there is a huge difference here. The government, over the past 21 months, has protected the economy from Depression by saving financial firms from market discipline. This responsibility gives the government great power: picking and choosing who should take losses and who shouldn't, and picking and choosing which companies will survive and which will die.

What the government should do instead is protect the economy by allowing it better to withstand the effects of market discipline. Washington can do so only by creating consistent, predictable rules that allow financial firms to fail without taking the economy down with them. Such a system is broad daylight compared to the nighttime of capricious bailouts that don't follow any rule of law and that further obliterate market discipline, rather than advancing it.

As for not doing the bailouts, including the much-hated TARP: in the absence of rules that protect the economy in advance from unbridled finance, letting the entire financial system fail in a disorderly fashion would protect purist free-market principles—for about half an hour.

This lesson was on full view last year. To use an example that encompasses the FDIC, which you also talk about in your response: In July 2008, when IndyMac in California failed, then—President Bush told Americans from the White House Lawn that "If you have a deposit in a commercial bank in America, your deposit is insured by the federal government up to $100,000." He said, "My hope is that people take a deep breath and realize that their deposits are protected by our government."

If depositors with a few thousand dollars at a big, "safe" bank had lost their money, you can bet that their relatives in other states would have panicked, and pulled their money out of other "safe" banks, precipitating a Depression. Without protection of small depositors, we would have disorderly failure, uncontrolled panic, and economic catastrophe, as we saw in the thirties.

In the end, the nation would not put up with the high unemployment and lost savings that pure market forces, with no government regulations, would require to correct themselves. To deal with the effects of full, free-market correction, we eventually would get even more government intervention, practically and politically speaking. To wit: if Washington had properly regulated financial instruments such as credit-default swaps in 2000—instead of exempting them from regulation, as Congress did—we would not have seen a $787 billion economic stimulus package in 2009. With some clear, consistent limits, financial markets could have corrected themselves without creating the socially and politically unacceptable economic chaos that the stimulus is meant to address

Which scenario do free-marketers prefer?

The FDIC does something that's elemental to free markets: it allows for market discipline of banks by creating a mechanism for orderly failure. No, mom-and-pop depositors should not bear the burden of "monitor[ing] and disciplin[ing" banks. If plumbers and doctors want to take financial risk, they can do so in the stock market. It is a social good for small depositors to feel that they have a safe place to put their money. That social good carries a cost, a collective cost the banks bear through their regular premiums to the FDIC. The benefit that healthy banks gain from shouldering that cost is that they are less vulnerable to panic—another societal benefit.

How much deposit insurance is too much? You suggest that we can't possibly figure this out, so we shouldn't bother to try. But the problem with slippery-slope arguments is that we could apply them to just about any government policy.

It's necessary to have a police force and a military, for instance, though such forces could conceivably pose grave risks to society in the wrong hands and without citizen and press oversight. And it's awfully hard to figure out the perfect amount of police protection. Maybe New York shouldn't have a police force, because nobody can figure out whether we should have 36,000 police officers or 37,000 police officers. If we have too many, of course, we're hurting the free markets because we're taking resources away from more productive investment. If we have too few officers, though, we're telling people that they're safe when they're not. Anyway, the market would protect itself if we didn't have a police force at all, through marshalling private-security forces. The fear that the government will enact and enforce rules unfairly—and sometimes just plain wrongly—doesn't mean that we shouldn't have any rules at all.

To return to deposit insurance: the limit of protection should likely fall between $100,000, the maximum FDIC protection last year, and $250,000, the new limit that we have now. Under such a limit, a middle-class to upper-middle-class family can ensure that a year's worth of its income enjoyed protection. Why expand such limited protection to small investors in money-market funds? Because practically speaking, people treat such funds as bank accounts. If Washington won't be honest and treat them as such, then the next bailout is inevitable, because Washington will never allow grandmothers to lose their meager savings in a "safe" account.

Unlike small depositors, big investors should know that they risk losses. Over the past 25 years, the problem is not that Washington has explicitly expanded deposit insurance, but that it has arbitrarily bailed out lenders who weren't protected, immunizing such lenders and the firms they lent to from the credible threat of market discipline.

Washington can't avoid these bailouts unless it creates the conditions necessary to allow for failures of financial firms and investments. What are some other rules, besides consistent borrowing limits, that would make the economy more robust to such failures?

One would be to nod to the reality that financial firms today increasingly rely on short-term, uninsured financing, which makes them more vulnerable to a panic. Washington should make the firms pay for this risk by mandating higher capital requirements proportionate to short-term borrowing. And what's the magic number? There is none - so long as the math is consistent and forces managers to associate short-term funding with a real cost.

As for your health care example: a functional health-care system driven by competition would not eliminate the need for some public funds. In several conservative proposals for health-care reform, the government would subsidize insurance for low-income, uninsured patients with high-cost chronic illnesses in "high-risk pools," creating a funding mechanism for patients who are basically uninsurable under market arrangements. This approach would obviate the need for more intrusive insurance regulations and forestall a government health plan that would compete with private insurers.

In banking, why not have a private-insurance system where, as you suggest, "when you opened a bank account, the banker could ask you if you want the deposit insurance?" But deposit insurance does not exist only to protect the individual from modest losses; it exists more significantly to protect the entire financial system from unacceptable panic and Depression. If individuals were to opt out, they would cause such panic in the next crisis, as they inevitably would withdraw their uninsured funds from banks. The economy would be left dangerously unprotected from the effects of bank failures.

Finally, you asked about counter-cyclicality: that is, won't capital rules cause financial firms to slow lending when their asset values decline, thus harming the economy? Yes. The government cannot eliminate economic cycles and the normal financial effects of such cycles, nor should it. When asset values decline, banks slow lending, and they always will in such cases.

But by failing to limit borrowing against debt securities that behaved more like equities in terms of their vulnerability to panic, Washington exacerbated Wall Street's excesses. It allowed Wall Street to borrow every last dollar against its own optimism—something that it hadn't allowed since the twenties. Washington's negligence ensured that the economy was too weak to withstand the market correction of Wall Street's optimism without massive government intervention.

So what do you think the government's role in finance should be? Do you think that the Federal Reserve should exist?

December 17, 2009


Dear Nicole,

I am glad you asked about deposit insurance because it seems to me to be another example of a government program that has grown out of control. What began in the 1930s as a temporary plan to cover deposits up to $2,500 now covers up to $250,000 per account holder, which is a vast increase even if you adjust for inflation. Non-interest-bearing transaction accounts are guaranteed in full, with no limits at all. Your book proposes extending the FDIC guarantee to depositors in money-market mutual funds, as well.

The fund out of which insured depositors are paid now stands at “negative $8.2 billion,” and, to replenish it, the government agency has asked banks to prepay their insurance fees by December 31 for 2010, 2011, and 2010. Imagine if your car insurance company called you up and demanded to be paid the next three years of premiums in advance by the end of this year! What’s more, some bank investors, such as John Hempton of Bronte Capital, complain that FDIC officials have acted recklessly to close banks or thrifts such as Washington Mutual that were adequately capitalized, causing losses to investors.

A Columbia Business School professor, Charles Calomiris, makes the point that deposit insurance “removes depositors’ incentives to monitor and discipline banks, that it frees bankers to take imprudent risks (especially when they have little or no remaining equity at stake, and see an advantage in ‘resurrection risk taking’); and that the absence of discipline promotes banker incompetence, which leads to unwitting risk taking.”

Could Americans handle a world without deposit insurance? The FDIC’s own Web site has some interesting data pointing out that even in pre-deposit-insurance years such as 1930 and 1931 where there were a lot of bank failures, the dollar amounts lost by depositors weren’t particularly high, either in real terms ($237,359 in total losses 1930, $390,476 in 1931), as a percentage of the deposits in the failed banks (23% both years, or a lot less than the stock market went down in 2008), or as a percentage of deposits in all commercial banks (.57% and 1.01%). The FDIC’s account reports that some of the bank runs were triggered by the news that “Great Britain abandoned the gold standard in September 1931, and some depositors feared that other countries might follow suit,” and also by rumors that FDR “would devalue the dollar.” In other words, deposit insurance is a program the government set up to cover the instability it created with irresponsible monetary policy.

It’s particularly ironic that, at a time when the Manhattan Institute is furiously campaigning against an expanded government role in health insurance, you are defending government deposit insurance and even proposing expanding it to money market funds. Why wouldn’t private insurance work for bank depositors in the same way that it does for health care, life insurance, car insurance, or homeowners insurance? When you opened a bank account, the banker could ask you if you want the deposit insurance, the same way that when you rent a car they ask if you want to buy the extra insurance.

I don’t think abolishing the FDIC should necessarily be a high priority item for free-market forces in America. There are plenty of other things that the government does that I’d prefer to be privatized first, including operating bridges, tunnels, schools, and airports and delivering the mail. Friedrich Hayek, the economist the Manhattan Institute names a lecture after, was for private issuance of currency. As far as offenses against my liberties, the existence of federal deposit insurance at the old $100,000 level rates fairly low on the list (we’ll see if the $250,000 level and the limitless protections on transaction accounts expire on schedule). But I do see federal deposit insurance as a violation of the free-market principle of allowing the bank and the customer to contract as they please. Like nearly all violations of free-market principles, it starts small, but gets bigger and bigger over time. It has distorting effects on incentives and empowers unelected bureaucrats like Sheila Bair to make arbitrary decisions. I certainly wouldn’t hold the federal deposit insurance up, as you do, as a kind of golden example of rational regulation that should be emulated.

The rules on leverage that you propose for financial institutions pose similar risks. Who is going to enforce these rules? Given that you concede that the SEC does “all kinds of stupid, arbitrary, investment-killing things,” how would you prevent the enforcer of your leverage rules from doing similar things? Who would make the judgment on whether a company exists, as you put it “to operate a business,” or “to engage in financial speculation”? Which category would Warren Buffett’s Berkshire Hathaway fit into? How about KKR? How would the assets of the financial firms be defined so that your capital regulations aren’t countercyclical, with declining asset values requiring banks to de-leverage at exactly the moment when maintaining economic growth requires extending more credit?

One of your main arguments I hear you making for these rules seems to be about the desire of avoiding bailouts or government takeovers—you refer to firms “requiring arbitrary bailouts” or a firm’s debt becoming “such a threat to the economy that bailing out the firm becomes inevitable for the economy’s sake.” I’m against government takeovers as much as you are—at the New York Sun, we editorialized against the takeovers of Fannie Mae and AIG, as well as the TARP—but imposing a new layer of rules just because the politicians are tempted to commit bailouts strikes me as just as Rube Goldberg a fix as imposing deposit insurance because the politicians are tempted to screw up monetary policy. Why not address the underlying issue, and just not do the bailouts or seizures? I don’t think they were as inevitable as you say they were. Polls indicate they are unpopular with the public; the House initially voted down the bailout on a 228 to 205 vote, with the opponents including a bipartisan group of 133 Republicans and 95 Democrats. Had either Senator McCain or Senator Obama joined them, things might have turned out differently. The justification the government gave at the time for trammeling the rights of the AIG and Fannie Mae shareholders—that it was necessary to protect the broader economy—is the same one you give for your capitalization rules. It seems to me that an awful lot of mischief can be done under that justification.


December 15, 2009


Just to close the circle on the compensation question—you blame “state-subsidized capitalism,” “government-subsidized finance,” and “Goldman Sachs” for driving up compensation and for competing with engineering, technology, and other industries for talent. But the compensation at Goldman Sachs is paltry compared to the precincts of Wall Street, like hedge funds, that operate without government guarantees against failure. Goldman ceo Lloyd Blankfein makes $70 million in a good year; hedge fund manager John Paulson makes $3.8 billion. I’m against state-subsidized capitalism and government-subsidized finance, too (at least we agree on something!), but I don’t think it’s a particularly strong argument against the state subsidies that they are distorting compensation upward. This New York Times article names three Goldman alums who left to start hedge funds (we could both probably name a half-dozen more), and quotes one Wall Street veteran who left to join a hedge fund as saying: “I get paid more and it’s more fun.” The compensation at Goldman isn’t driven by the government guarantees but by the need to keep people who can earn more—a lot more—at hedge funds. Please don’t say the hedge fund guys were somehow emboldened by the rescue of Long Term Capital without also dealing with the many other big hedge funds (Amaranth, Sowood) that closed without government interventions.

You cite initial public offerings as an example of “how the government can consistently, predictably regulate a financial market without micromanaging it.” In your book you cite the Securities Act of 1933 and the Securities and Exchange Commission as examples of similar reasonable or rational regulations. But both the Securities Act and the SEC impose all kinds of unpredictable, inconsistent, and micromanaging obligations on firms and individuals trying to raise capital. These laws empower and enrich a whole class of lawyers (often former SEC officials), investment bankers, and investor relations consultants who charge beleaguered entrepreneurs hefty fees to navigate the bureaucracy, write unreadable, book-length prospectuses, and advise them on what they can and can’t say. Often, the result is less-informed investors as opposed to more-informed investors. One classic example was the following statement issued by Google in 2004 in response to a Playboy interview with Larry Page and Sergey Brin that was published during the pre-IPO “quiet period”: “We do not believe that our involvement in the Playboy Magazine article constitutes a violation of Section 5 of the Securities Act of 1933. However, if our involvement were held by a court to be in violation of the Securities Act of 1933, we could be required to repurchase the shares sold to purchasers in this offering at the original purchase price for a period of one year following the date of the violation. We would contest vigorously any claim that a violation of the Securities Act occurred.” If even the geniuses behind Google got themselves ensnared in the Securities Act while advised, at great fees, by top lawyers and investment bankers, how is an ordinary entrepreneur supposed to proceed? For an example of SEC micromanaging, see this New York Sun editorial documenting the way the agency descended on at least three hedge funds in 2005 and, without a warrant, demanded to see a month’s worth of their ceo’s email. Another example was the treatment of Mark Cuban. Another was the SEC press release that highlighted Raj Rajaratnam's supposed status as a "billionaire." Wouldn’t your proposed “reasonable” regulations spawn similar unreasonable red tape and flawed enforcement?

I fear that your suggestion of limits on borrowing is just more of the same government-knows best approach: “If Washington had required a 20 percent down payment for the purchase of a home—a consistent limit on borrowing against a speculative asset…” Why not 21%? Or 19%? Or 19.5%? Why should some congressman or bureaucrat set the borrowing limit rather than the free market choices of a willing lender and a willing borrower? Shouldn’t those parties have a right to make a contract without interference from Washington? My guess is that, just as you use the bailouts as a rationale for more regulating of the banks, you use the federal mortgage guarantees as justifications of the limits. But if someone is willing to forego the guarantees, shouldn’t they be able to escape the limits, even by paying a higher rate, as a borrower does with a jumbo or nonconforming loan?

One last question, to stay with your recommended solution of limits on borrowing or leverage but to return to the technology sector. Sometimes heavily leveraged borrowers default. But sometimes they are leveraged highly because they believe in their investment, and sometimes it works out well for them. I was reminded of this the other day reading a Gretchen Morgenson article from the February 7, 2001 New York Times that ran under the headline “A Lehman Bond Analyst Paints a No-Nonsense Portrait of Amazon.” It reports that “an influential convertible bond analyst at Lehman Brothers” had “published a report arguing that this may be the year in which both time and money run out for Amazon.” The article went on to note that the online retailer had $2 billion in debt and working capital of $386 million. Are you advocating that the government set rules that would have limited Amazon’s ability to borrow? A share of Amazon stock that sold for $15 in 2001 is now worth $135, which by my rough math is a 900% return. Lehman Brothers, of course, is the bankrupt one. Amazon.com is a pretty amazing company, allowing people to buy your book and lots of other things, too, without even having to leave their desks. Anyway, this is just really an informational question, not a rhetorical one—would your leverage restrictions apply only to financial companies, or to tech companies like Amazon, too, and would the application of your rule have killed Amazon prematurely in 2001 or before without allowing the company to survive and become the success that it is today? And, again, in Amazon's case as in that of the person borrowing to buy a home, what is the justification for allowing the government to interpose itself to block a transaction between a willing borrower and a willing lender?



Dear Ira,

I will address your point about "unpredictable" and "inconsistent" regulations first, since it gets to the core of my argument. As the world has seen over the past two years, the absence of proper rules does not make for freer markets. Instead, it leads to nationalization, as society will not accept the full consequences of intense free-market corrections. Yes, the SEC and other regulators do all kinds of stupid, arbitrary, investment-killing things, which I don't support. The answer is not to get rid of financial rules altogether, any more than the answer to government's many errors is to have no government at all.

What are the right rules? Ones that create a level playing field for private-sector competition and free-market discipline, rather than picking winners and losers. As you say correctly about today's inconsistent, micro-managerial regulations, "if even the geniuses behind Google got themselves ensnared in the Securities Act while advised, at great fees, by top lawyers and investment bankers, how is an ordinary entrepreneur supposed to proceed?" What President Obama and Congress are proposing, through their "Wall Street Reform and Consumer Protection Act of 2009," would place "ordinary entrepreneurs" at an even greater disadvantage. The act would give "systemically important" financial firms certain privileges, including the right to a bailout in a crisis, that other firms don't have.

The right rules, too, make the economy as a whole more robust and better able to withstand financial firms' and instruments' failures. To this end, instead of institutionalizing certain firms as too big to fail, Washington should craft rules that set consistent limits on borrowing. With such limits in place, failure of even a big firm won't leave so much unpaid debt behind that it bankrupts the entire system, requiring arbitrary bailouts.

As for your point about what the "perfect" percentage of cash down for any asset class under such limits would be: there is none. Margin requirements on stocks—that is, limits on borrowing—are currently 50 percent; they could be 40 percent or 55 percent. It's the consistency that matters. Predictable application of rules allows markets to innovate while offering protection to the broader economy.

An illustration of what not to do: for decades, Washington allowed investors in AAA-rated, mortgage-backed securities to hold just one-fifth of the capital normally required for debt securities. These inconsistent rules gave the ratings agencies their outsized power in the economy, because financial firms had an incentive to reach for the AAA rating, gaming the capital requirements to earn higher profits. When it turned out that the government was catastrophically wrong in its command-and-control assessment of what constituted risky debt securities, the economy had no protection against that mistake.

The government should not decide what's risky, security by security, from the top down, which is what it has done since the eighties in the above manner. Instead, with consistent borrowing limits across any asset class, the markets can decide what are acceptable levels of risk, through the rate of return that investors demand for each potential investment. Such rules leave some room for error when one large asset class turns out to be much riskier than anyone had thought. When hundreds of billions of dollars of AAA-rated mortgage-backed securities tottered, the economy had no such room for error, because the government had decreed that these securities were perfectly safe.

These rules should not exist to protect government from any guarantees it offers, including mortgage guarantees. I don't think that we should have government guarantees of mortgages or other housing subsidies. The rules should exist to protect the entire economy from any one party's failure. For that reason, no institution or individual should be able to opt out of the rules as long as he agrees to forego any theoretical future bailout. The "justification for allowing the government to interpose itself to block a transaction between a willing borrower and a willing lender" is that a financial company's right to borrow ends when its borrowing poses such a threat to the economy that bailing out the firm becomes inevitable for the economy's sake.

To answer your question about non-financial companies: A company that exists to operate a business, not to engage in financial speculation, does not pose a systemic risk to the economy. Amazon's 2001-era $1.6 billion in net debt posed a risk to Amazon and its investors, not to the $10.1 trillion U.S. economy. A non-financial firm wouldn't have to operate within the kind of limits I describe, but its investors would.

That is: Amazon could raise as much debt as the market would bear, but the banks and other financial firms that invest in such debt would have to hold a consistent level of capital against the risk that the debt will go bust. Similarly, Amazon could sell as much stock as the market would bear, but people couldn't borrow 100 percent to purchase it; they could only borrow half.

So GE Capital, General Electric's financial arm, would fall under financial-company rules, but General Electric itself would not. If Amazon opened an investment firm, the investment unit would have to operate under the same rules as Goldman Sachs. But crucially, neither financial unit would have an advantage over the other, because the playing field would be level, and each financial firm would operate under the credible threat of failure.

Lastly, another word about financial compensation. The "too big to fail" subsidies that firms such as Citigroup and Goldman enjoy distort the market for compensation even if they don't result in these firms' paying the highest salaries and bonuses.

To wit: in the late eighties and early nineties, investment banks had to take more risk to compete against commercial banks partly because those commercial banks enjoyed an unfair government subsidy after Continental Illinois's bailout. Today, hedge funds pay more to attract Goldman employees partly because Goldman itself pays more than it otherwise could if it did not benefit from government largesse. Further, hedge-fund managers may demand higher compensation for their personal risk of failure.

To dismiss the economic effect of this distortion is to believe that pay packages at firms such as Goldman and Citi have no effect on the compensation demands of recent graduates of elite colleges at the entry level and top executives at the highest level. I do not blame the firms themselves for this situation. Instead, I blame a regulatory system that does not allow for consistent market discipline and competition, the vital building blocks of free markets.

A few questions for you about rules: Do you believe that regulators should set capital requirements for financial institutions, a form of limiting borrowing? If so, why should they be inconsistent, as they are now? Do you believe that the FDIC should exist?


December 14, 2009

IRA STOLL, Editor and founder, FutureOfCapitalism.com:

Thanks for the opportunity. I've got a long list of questions about the arguments you make for more of what you say is "reasonable" or rational regulation (does a proponent of more regulation ever describe the regulation they want as unreasonable or irrational?). But I think I will just begin by asking about this line from the preface: "In their unique ability to offer executives and employees multimillion-dollar bonuses, financial companies made it difficult for companies in other industries, like engineering and technology, to compete for talent." Given the mind-blowing, world-beating successes of the American tech sector of the past 20 or 30 years—Google, Microsoft, Ebay, Intel, Dell, Apple—isn't it hard to justify your implied claim that government intervention is necessary to prevent finance from starving tech of talent? After all, the compensation in finance is actually lower, by some definitions, than in tech, which may be why the top three names on the Forbes 400 rich list include twice as many high-tech guys (Bill Gates and Larry Ellison) than finance guys (Warren Buffett). Nor is it a zero-sum game—the IPO windfalls that the finance guys make possible create incentives for people to go into high tech. If you are looking for a culprit in the supposed high-tech talent crunch, government-monopoly primary and secondary schools and government-created immigration quotas probably should bear more of the blame than free-market compensation competition from finance, don't you think?



Dear Ira,

First of all, thank you for engaging in this discussion.

Regarding tech: Yes, the American economy has an amazing capacity to innovate and create wealth, despite, as you note, the U.S. government's immigration and education policies, and also despite the distortions that come from the government's "too big to fail" subsidy of finance. These "too big to fail" distortions do exist, though. Like all government subsidies, they thwart true free-market allocation of resources and harm the economy's ability to reach its full potential.

For 25 years, since Washington first protected the uninsured lenders to big banks from their losses, banks have been able to borrow more cheaply than they otherwise could have without such an implicit government guarantee. The financial industry has been able to use government-subsidized leverage to earn higher revenues, and use those revenues, in turn, to push up salaries and bonuses to executives as well as to skilled staff.

As early as 1987, smaller banks understood the implications of this state-subsidized capitalism. "These banks have the ultimate anticompetitive government subsidy," warned Kenneth Guenther, the executive vice president of the Independent Bankers Association of America back then. "They are too big to fail, and regardless of how mismanaged they may become, the buck will stop with the taxpayer."

Other industries have had to compete with government-subsidized finance in the same marketplace to attract executive and other top talent. Because of the distorting effects of a government subsidy, it is not at all clear that gains in executive pay across the private sector over the past two decades resulted from true free-market forces and not instead from government distortion of those forces. After all, finance often dominated profits and economic growth during this time period.

I am all for "free-market compensation competition" in finance and other industries. However, do you think that such a system is what we have had in recent years—and what we have now? Even today, firms such as Goldman Sachs can pay record bonuses in no small part because they benefit from lenders' perception that, in a future crisis, the government will not let them take losses. Unfortunately, the president's railing against "fat cat" bankers misses this point.

I'm glad that you brought up initial public offerings (IPOs) in tech. Stocks are an example of how the government can consistently, predictably regulate a financial market without micromanaging it. Washington doesn't pick and choose which stocks are safe and which stocks are not. Instead, it limits borrowing against stock purchases through consistent margin requirements. When the tech bubble burst starting in 2000, investors lost money—as they should have—but they did not leave so much unpaid debt behind every blown assumption that they bankrupted the financial system, requiring inevitable bailouts to keep the economy running.

The housing market, by contrast, as well as the credit-default swaps and securitization markets were speculative, with no consistent borrowing limits. If Washington had required a 20 percent down payment for the purchase of a home—a consistent limit on borrowing against a speculative asset—the bursting of the housing bubble likely would have looked more like the bursting of the tech bubble.

Unfortunately, in supposedly fixing Wall Street, Washington is going in the wrong direction: toward bureaucratic micromanagement in a futile effort to predict and prevent failure. Instead, they should unleash free-market innovation within consistent borrowing limits and disclosure requirements, better protecting the economy from inevitable failures in finance.

A word about rationality and reasonableness: the de-facto arbitrary regulatory system in which businesses currently operate is irrational. Under what rational, replicable line of reasoning did the federal government engineer a bailout for Bear, Stearns shareholders at $10 a share, wipe out Lehman Brothers shareholders entirely, and give Citigroup and AIG shareholders a chance to recover from otherwise bankrupting losses?