The Conceit of Government, from FDR to Obama

(Initial Draft)

Peter Wallison of AEI has a good piece in the Wall Street Journal this weekend (How Regulators Herded Banks Into Trouble, 12.3.11, on how varying capital requirements between security types engineered the financial crisis—both the boom that enriched the bankers, and the bust we’re all now suffering. Politicians perennially forget that rules restructure economic results. Complex rules invite gaming, or even fraud, and can have unexpected effects. As in, “unintended consequences.”

Governments are in partnership with their banks inasmuch as they guarantee them as “lender of last resort.” So the Fed is the banks’ Daddy, meaning, when Junior gets into big trouble, Daddy pays. The rules are the “deal” between them, the terms and conditions of which basically grant banks their profits and in a host of ways can get tinkered up or down. Banks are now mostly very large, and/or very much alike. This lack of diversity or individuality is in large part because bank business models are dictated by government rules. Bank profits depend upon (a) on the state of the economy at any moment in time and (b) the rules.

Banks are also more consolidated than ever because the government let them get that way, waiving antitrust enforcement to permit merger en masse. Heavy government regulation means one behaves in rule-required ways that will be roughly identical to others in your peer group. (It’s what a “rule” means, in fact.) It can be likened to a legal way of creating a business monopoly or cartel. Banks’ job is to keep people’s money safe while reinvesting it at various levels of risk chosen by the depositor. Basic black letter law says that banks owe a fiduciary duty to their clients—of honesty, and to ensure investment decisions they make on their clients’ behalf will be reasonably sound and wise. This common law still applies, but heavy regulation complicates and partially replaces it. Wallison points out that Basel’s rules said banks needed to take only one-half (or one-thirtieth) of the care investing in mortgage-backed securities (MBS) and sovereign debt as they did with ordinary corporate debt (subject to an 8 to 1 capital ratio). This means the rules declared certain securities (and as it turned out later, quite risky ones) to be twice or 30 times more profitable and hence half (or one-thirtieth) as risky to the bank. The rule thus put a thumb on the scale saying, invest in this, not in that—so, not surprisingly, they did. It would seem that no other rules specifically required banks to do any due diligence to inspect the integrity of MBS or sovereign debt. Thus, the rules, in essence, presumed the integrity of these types of securities, even valuing them precisely, in relative terms.

Banks’ job is to diligently inspect the quality of all debt. In theory they know how to do this. Today however this is a premise that could use circumspection. A related question is whether governments do any due diligence (indeed, twice or thirty times as much!) on security types, when they decide to privilege them with differential capital requirements. Rulemakers apparently take decisions by the seat of the pants, perhaps in haste, or based on past habit, ballpark analogies, and lobbyist preferences. Because that is the politician’s way. Hairy complex sets of interlocking rules are a bad match with the typical political process.

Banks still might choose to protect their depositor/investors better, by shunning those same privileged security types despite the super-low capital requirements implying they are low risk. In the boom before the bust, plugging that rule and assumption into their “buy” algorithms brought banks easy profits. What’s more, in the nature of banks’ relationship to governments, the governments guaranteed it. With that set up, banks could hardly do other than what they did. Higher risk investing requires greater diligence and brings higher costs. By rule the costs can be made to disappear because the entire industry is being told they need not worry. Outliers will simply forego profits that will be sorely missed later if a disaster ensues.

All businesses acting uniformly in lockstep can come about either by the imposition of a government rule, or by copycatting, whether out of habit or industry custom, or by way of free-riding one’s competitor’s R&D. If the government makes a rule, as well as financially guarantees you, it would be insane to forego easy profits arising from that rule. You would not only appear to be fatally stupid to a market that takes high short term profits as proof of high competence (even if they the fact that following the herd may not be a mark of brains, only of absent-minded conformity), you in fact would be stupid, given that it is law. No one imagines a rule might be fatally ill-conceived, even if it might be, especially these days. The politicians and regulators may not understand what they are doing when they write the rules; this is the unpleasant reality everyone is far too embarrassed to admit now. The sheer number of the rules would seem to indicate that no one could possibly have traced all the possible consequential effects. Unwittingly, politicians manipulate markets when they rewrite rules. Had there been no rule privileging MBS and sovereign debt, banks would never have felt free to assume that those securities were categorically less risky than all others.

Of course it is also possible that the banks manipulated these rules themselves, as a safe harbor for profits. Perhaps it was a dastardly plot to shift responsibility to the rulemakers in advance. The rise of law and economics has indeed proliferated such knowledge to at least some crafty bank employees and their agents. Today we see in all the techniques of bank behavior how much they love their regulators—whom they can simultaneously use, then blame.

The recession and sidelined cash is just the market saying, we don’t trust the politicians to make the right rules. They are all thumbs. (Thumbs on the scale!) We’ll figure out what to do after we get through the period of investigation, recrimination and vengeance and see what the new rules to “fix” things are.  After the new distortions are assessed, the overall investment picture can become clearer and a sense of general safety can return.

Politicians seem such busy-beavers today, “doing things” “for” us. Why such whirling dervishes, generating laws in bulk? In its broadest outlines, law is mostly static. Politicians seek to appear to the public to be men of action “doing something.” This leads them to make too many economic and personal choices that they are not supposed to be making “for” us at all, picking winners and losers. It is now to the point where, famously, they no longer even read the laws they promulgate upon the body politic. Their process is finger in the wind (test the zeitgeist for what buzz evokes positives), then claim to be acting in name of the democratic will of the people—who, like banks to regulators, can later be blamed, should anything go wrong. As a republic, not a direct democracy, our representatives are supposed to be doing the right thing, in their best judgment. We rely on their decency, wisdom, and intelligence and vision for the long term. They have no way of knowing anything about their constituency anyway, because to pollsters, people only express self-interest, not the public interest. The public interest can only be assessed at a remove, which is the representative’s job. Pollsters get whatever they fish for. Responders also like to echo conventional wisdom. Implementing conventional wisdom is not politicians’ job.

Default politician behavior reduces to what they want to do. Unfortunately mere party-line fealty and personal nest-feathering gets superficial justification from misreadings of libertarianism. (Note to libertarians: The Fable of the Bees was not a libertarian manifesto. It was an exercise in wit. Wealth is not proof of God’s favor; this confusion, often observed in history, is a known pitfall of Calvinism.)

The lawyer class is often unconscious of the distinction between risk and uncertainty. They too tend to be rabid form followers. Lawyers after all can always blame their client for any substantive decision, after it goes wrong. Substitutes for thinking—by herding and copying—is habit forming. It is also sometimes perfectly reasonable to assume a thing is valid, safe, advisable, or legal if everyone else is doing it. Where there’s smoke, there may be fire.

Investment “risk” is inherently uncertain. By contrast, actuarial risks are insurable, giving rise to the insurance industry. But insurance risk is not the same as investment risk. Insurance law presumes the existence of competitive firms in the form of insurance firms—or at least, it used to, before the structural implications of the law and the conventional boundaries among previous types of firm got broken down. Insurance companies, as firms, are checked by market competition and creative destruction, ie, market forces. The quality of an insurance company can be determined by (a) state licensing and regulation (this however is a joke; market discipline is really the only protection here); (b) well done assessments of solid, longitudinal empirical data-sets about a risk within a population; (c) a limitation to specific, assessable types of risk. Investment risk is not the type of risk, like a casualty loss, that can be averaged, determined, and made static, and turned into a firm to compete on the market for avoiding that risk. Rather, investment risk is about predicting the future, which is (more or less) inherently “uncertain.” About the future, we are all free to speculate by buying stocks and bonds, which is a kind of betting game, with its integrity and presumed accuracy regulated by the government.

Politicians wrapped in soundbites simply may not be qualified to make all the rules they seek to impose on us in their show of “caring” for us. This, I think, is what Richard Posner is getting at when he speaks of The Crisis of Capitalist Democracy. We need systems engineers today who really do understand the system. Politicians are mostly not this, but marketing specialists. They dissolve always into futile calls for infinitely ethical global governmental forces (themselves) to abolish investment uncertainty in a complicated utopian merger with perfect empirical risk analysis, forgetting that the past is no divining rod of the future (nor of truth).

Deciding on capital requirement rules is a matter of what risks are banks’ responsibility and what government’s. The government is the lender of last resort and must referee, only, and avoid “playing” in the game. When it inflates the currency by expanding money supply, it is playing. In response to 2008 crisis, we did this, unjustly channelling funds to administration cronies (the banks). Regulators should not be in charge of setting the relative risks of MBS, sovereign, and corporate debt. All they are doing is trapping banks into a particular investment allocation, and turning the government into a “player” in the investing game.

Super-leverage allocated to specific privileged asset classes suggests that banks tampered with the rules, exploiting their role as “public-private partner.” If government is to be a player, then banks have politicians cornered, for it is banks who understand their business, not politicians or even the regulators (or, not all of them all the time). The banks have all the expertise. If you are a regulator, you must of course listen to the banks (be lobbied by them). While they know more, they will also from time to time tell the truth. But our regulators would seem to have abdicated their role of defender of the public interest who takes all this professionally with more than a grain of salt for cronyist mentality.

Super-leverage granted by law to one type of investment is just a government subsidy for that type of investment. Bank capital requirements relate to bank entity type. It should be flat as to that entity type. Bank type is also the fulcrum of choice (and competition) for bank customers and the unit of risk so far as they are concerned. The government should not be funneling bank customers into MBS or sovereign debt. Entity type shaped FDR’s original “deal” (i.e., the laws and regulations) as between thrifts, commercial banks, investment banks, brokers of stocks and bonds, insurance companies, brokers of commodities, casinos, etc. Rules by entity type recreated the economic field of play. Later, the politicians permitted these entity types to remerge back into one, while keeping other rules intact made now obsolete by those changes. Political “compromises” here, saying, okay, we’ll keep this rule in place here, but waive it there, are very perilous. The abolition of Glass Steagall at the turn of the millenium, for good or for ill, increased entity self insurance by entity diversification. But unseen it also increased the risk of lowered due diligence and failure to evaluate the quality of whatever was conventionally defined by existing rule as “non-risky.”

So what we got was regulatory supervision—not decreasing financial risk, but increasing it—by dictating investment choices and eliminating bank incentives to be duly diligent in evaluating securities like MBS and sovereign debt. If banks were still small and diffuse and free to fail, a few belly-ups might have taught lessons of risk and how to avoid it to everyone else. To reinstate competitive entities would require deconstructing banks from their current monopolistic size. But creative destruction in banks is frightening to us all, given the expectations we have built up about them based on the seemingly (though in fact not) stable models of the past. The S&L industry imploded in the 80s at taxpayer expense because those institutions were trapped into a narrow business model by old bank regulations. We all like and want FDR’s socialist promise of a taxpayer guarantee, at least for some things. That’s why politicians go about irresponsibly replicating it. But FDR not only offered it, he limited it, to those original things. Those conditions now no longer exist. But our politicians can’t bring themselves to end the endless guarantees—they just keep on spreading them into places it doesn’t belong.

Government needs to limit its guarantees. It has to take care to limit the nation’s upside liability as a whole. Right now, government is not bothering to understand these things well enough to get the rules right. Ideologues of left and right confuse the picture with partisan litmus tests (their own version of wooden rules with unexamined unintended consequences) and demands for heads to roll. (Satisfying, but mostly symbolic). No one can see the forest for the trees. The system has been turned into a chaos of inconsistent rules breeding only confusion and conflict.

Understanding a thing from the top down (as intellectuals do) is not the same as regulating from top down. Our legislators do not understand the integration of law with economics. We need a moratorium on more laws and regulations until they truly figure it out.

One rate per debt type was just the wrong way of devising the capital requirement rules. Newly merged banks are attempting to self-insure among entity types. But these firms may now be simply too big to understand, much less to manage. The rulemakers ignored the reasons for separating by entity type, not debt type—they simply had ceased to comprehend the logic of the system as a whole. The politicians are no longer expected to be able to do more than lip reading or mimicry. Lawyers play all sides of the aisle, and nimbly evade all lines of fire.

Superficially, it makes sense to assume that, if an 8% capital requirement is correct for corporate debt, then government guaranteed mortgage backed securities might, seat of the pants, be “half” as risky as corporate debt. But you can’t hold that figure true forever just because the number is now enshrined in a legal formbook. That would legal incompetence (or rather, business incompetence, meaning, a business lawyer might miss it while blaming the client). These numbers were set up when the economy was smaller, different types of investment entity were clearly separated from each other, and the way those industries functioned were well understood. That doesn’t mean they’re wrong to have merged. Perhaps entity consolidation and diversification does optimally alleviate pertinent risks. But there were also diseconomies of scale in the new entities being allowed to form. Were they accounted for in all the vast complex of rules?

The law is being asked to make business judgments law simply should not be making at all. Law is static. Markets are not. The market will adjust to any fixed rule, changing the “new normal.” Positive feedback loops (“positive” does not imply good) can ensue, at many unexpected levels. The media’s celebrity focus on political figure summiteering, however, follows an old trope, of suggesting to the public that our pseudo-gods and deities, through law, can command markets. These heroes then arrogantly begin to believe their press releases and to act accordingly.

Lawyers often go to law school precisely because they don’t like math or statistics. The type can quite easily ignore economic reality as they proceed to plug old forms and numbers into new contexts.

The lesson to be drawn from Wallison’s article is that the regulation has to be appropriate to the type of entity regulated and all surrounding circumstances. If the type of entity regulated is changing, the regulation must change accordingly. Some laws and regulations already incorporate change automatically by being general, and thus able to encompass change. The wise lawmaker has to be able to tell the difference between what a general rule encompasses, and what specifics can be dictated without being overly controlling. Too often, rules are simply ill considered and ill expressed: the legal academy calls it, unsurprisingly, “bad law.” Rules can proliferate that may seem neutral or general but serve only a special interest, tilting the field to an industry, or even a particular company. This accounts for the rise in constitutional and other challenges to the validity of laws, and other contentious litigation.

If you are a lawyer whose job is to draft and negotiate contracts you probably deal every day with irrationality and greed in a counterparty, some tolerable and excusable and resolvable, some less so. Many authors have touched on the decline of ethics in the culture, the rise of strange entitlement or rights claims, of illegitimate techniques of cherry picking, sophistry, or an ends justify all means however corrupt sensibility. Inexperienced and youthful soldiers are then used to execute orders in fealty to corporate “business models” so as to dissociate their bosses.

Where the left is correct, emotionally speaking, is in this: there has been an encroachment by a corporate mentality by which humans accept a status as drones in a hive, whose 10 commandments are presumed to be not God’s but only those of their (IPO sanctified) business model. This is not only an insight of the left’s but also of conservatives, eloquently expressed by such as Russell Kirk and Richard Weaver (Ideas Have Consequences).

The left is also right to sniff out the ratiocinations of the University of Chicago business school and its law and economics scholars as legitimizing a lot of nonsense, though it is grossly unfair to blame the original expositors of legal and economic truths for emboldening all their epigones’ ridiculous misinterpretations. Necessary changes and reforms to antique rules in the governing structure, have simply not been made properly in some cases. People will seek to exploit the discontinuities in an ill-understood, overlarge, and rickety system that isn’t rapidly adjustable, to rip other people’s faces off. That’s human nature. A system greased to permit so much to be done on distant auto-pilot, by rule or computerized aggregation model, leaches much of the humanity and personal or ethical restraint out of it, which is what corrects for errors in any rule.

Congress has set about to grease certain wheels at the urging of those who stand to profit from it, without doing the job of seeing that the checks and balances which once, more or less, worked to purge risk out of the system and elicit important information, via the very creakiness and slowness of the old ways, were being overrun.

These lawyers in Congress and all their “best and brightest,” could not get the rules right (which includes knowing what should not be subjected to rules). Instead they considered it to be their job to spin out as many of them as possible, mistaking campaign slogans for policy prescriptions, and the rewards behind the revolving door.

Do our legislators even know what “law” is any more? Basel was a collection of internationals, ie, a group less authorized than nationals. Their acts seemed plausible, and were not much scrutinized for systemic effects as opposed to self-interested ones. An endless stream of meetings and the image of “power” on a world stage does not guarantee legitimacy, authority or coherence. We’ve had an abdication of true law, and many self indulgent shows of “control” by so-called “leaders.” The law is made to seem a mere question of what the polls say from day to day, manipulable in the future perhaps by everyone clicking on their remotes.

If that ever becomes so, then there will be no law. It will be nothing but semantics, to argue about unto exhaustion.