The Free Market versus Crony “Capitalism”

Mario Rizzo Bailouts, Financial Markets, Institutions

by Mario Rizzo

This will be a short post. Nearby is a Venn diagram showing the intersection between Goldman Sachs and the federal government: people who before or after were attached to both.

This is one reason that the current political-economic system will continue to fail. Those who exercise positions of political influence are not about the let particular so-called private institutions go under (there have been exceptions, of course). The idea is that they will use the ill-defined systemic-risk notions to preserve the status-quo.  This is why I floated, two years ago, the idea that perhaps the government must break up the large financial institutions so that they can fail without dragging us all (particularly me) down with them. My positive program for laissez-faire, so to speak.

A picture is worth a thousand words!

The Big Story of Crony "Capitalism"

35 thoughts on “The Free Market versus Crony “Capitalism””

  3. This is a great post that makes an important point. In a crony capitalist world, the line between public and private is blurred. It is perhaps worst in financial services, but we also have Government Motors and other such entities.

    It would be instructive to produce the same Venn diagram for Goldman Sachs and its putative regulator, the New York Fed. Hint: start at the top and work down at the NY Fed.

    J Oxman is right to bring up the issue of political contributions. Government guarantees to financial institutions create economic rents, some of which recirculate as campaign contributions.

  4. I’d like to hear the argument that banks can be too big to fail. Say a huge bank goes under. The assets are still there, such as they may be. The buildings, computers, and information are still there. People with the relevant expertise are still there, to be re-hired by the successor firm(s) that are capitalized for pennies on the dollar by new investors. The important thing is to have an orderly process for sorting things out, and this is where government, in the form of bankruptcy courts, may have a role. Yes there may be a period of dislocation and adjustment, but is it worse than continual political intervention?

  5. Don’t forget the “bottom Line” : The trillion dollars paid out by the government went to the President’s most favorite cronies, and will be paid for by the ordinary working middle class. The most crooked and highest risk-taking members of the financial community were rewarded for their bad behavior. And Obama has nine such members of the Goldman Sachs elite running the Treasury Department.!

  6. Dodd-Frank contains a provision to liquidate insolvent financial institutions that are not subject to FDIC–at least, that’s what’s been claimed it will do, sell off the assets and shut down the business. It would have been much better to reform bankruptcy law so as to expedite the process and make it simpler but that goes against lawyers’ interest.

  7. Mario Rizzo is making an important point about ill defined notions of systemic risk. There are no clear definition, no clear example, only doomsday scenarios. The most common argument being used now is that of fire sales; the liquidation of assets and unwinding of positions is thought to be so disruptive that other banks would fail too. Other scenarios going round are that of counterparty contagion (the domino story; bankruptcy losses greater than creditor’s capital), and informational contagion (bankruptcy reveals information about shared risks, and reaction overshoots and causes failure of otherwise solvent institutions). None of them are really convincing.

    It is ironic that the fear of systemic risk would lead to granting more power to the FDIC through the Dodd-Frank act. All signs point to it being the main cause, not only because it decreases the amount of capital banks need or because of the way it almost always oversteps its mandate to insure all uninsured creditors, or because of the particular techniques used to resolve failed banks, but because it delays bankruptcies. It does so by regulatory forbearance, but also because it eliminates the bank runs that would reveal unsound institutions before the peak of the crisis hits when bankruptcies are still manageable.

    What is the role of economic research into all of this? It feels like it’s mostly been providing justifications, sometimes unwillingly, for Too Big to Fail rather than the other way around. Just think of how financial contagion and bank runs became a hot topic at the beginning of the 80s, respectively with Aharony & Swary and Diamond & Dybvig, only to be used as a justification for the bailout of Continental Illinois a few years later. Same thing in the 90s; Schleifer & Vishny provided a framework for doomsday scenarios of Long Term Capital Management fire sales to cling to our minds. Again, think of how liquidity management and their role in crises became a hot topic in the mid-2000s.

  10. M. Bedard makes important points here. And really they are related to information – discovering distress and dealing with it prior to state intervention.

    It seems obvious that the methods of market signaling of potential distress among banks are extremely limited. Reserve ratios are mandated, as are capital ratios. Every bank pays the same price for FDIC insurance, and so forth. At least in Canada the reserve ratios are set by the banks themselves, but again the capital ratios are mandated since Canada follows Basel II. So how can investors and depositors figure out potential distress? Many price signals are not available.

    One way is through the stock price, but this is not available for private banks, of which there are many. Insider trading, a wonderful signal, is illegal. Short selling, another good signal of potential distress, is difficult to do unless the firm’s stock is very liquid, so again that’s only available for the big banks.

    Greater freedom in bank management would allow more angles for signaling and thus more efficient information production. This could greatly help avoid ‘systemic’ problems that arise from waiting too long to unwind a bank.

    That said, however, it is still not at all clear that a bank can be systemically important enough to cause an overall meltdown OR if the danger comes from an interventionist state, including the central bank. I here bring up Iceland v. Ireland as an example of what I mean. Iceland did not intervene, and they are pretty much squared away and back on track. Ireland did intervene and they are labelled as one of the PIIGS.

    As far as I know, in the banking literature, researchers still struggle with ascertaining how systematically important a particular bank is. For example, banks’ returns could be correlated with each other because there is a big bank (e.g. Goldman) that affects everyone, or because every bank holds assets that are correlated (e.g. real estate). Working out the quantitative differences is difficult.

    I’ve dragged this out enough. I’ll close by saying this: a free banking system with competitive clearinghouses would solve most of the problems related to distressed banks & bailouts. Like the Suffolk System, but with multiple clearinghouses instead of just the one (or two, for a time).

  11. I am surprised by the naivete. This “public-private” distinction is important only if we presume that they travel in opposite directions. However, if both are subject to the same restraints, such as uncertainty and ignorance, then who cares if they are “blurred?”

    But, you will say, we have perverse incentives and moral hazard, right? Wrong. The world is not so simple, and people are not that competent.

  12. It’s time we acknowledge that the qualifier “crony” is redundant. “Capitalism” didn’t start out as “our” word. It was first used by early laissez-faire radicals to disparage the reigning system of employer privilege. Mises and Rand tried to appropriate it, but that usage never really took hold in the wider world.

  13. MGM, I hope you don’t imagine that actors in the political realm are subject to the same restraints (constraints, incentives) as those in the market.

  15. Mr. Walstad,

    Incentives and constraints, as you put it, have led to all sorts of confusion. For example, when things go badly, most people are inclined to say, “The right incentives weren’t in place!” I think this is terribly confused. Have you not considered the possibility that things can go badly just because we are cognitively limited creatures? No matter how pure the incentives, and no matter how clear the constraints, there is still that thing called “uncertainty.” (And I don’t mean things like “regime uncertainty.” I am talking about real uncertainty.)

  18. @MGM… of course they run in opposite directions. If they ran in the same direction, public effort would be almost unnecessary, as private efforts would already be actively working toward the goal, without the violent motivation provided by govt force.

    If the world is less simple, and people also less competent, then the moral hazard is magnified, not eliminated.

  19. MGM, of course we are limited, and of course some bad things will happen. Nevertheless, there is a wide range of conceivable possibilities. We might do a little better or a lot better; we might do a little worse or a lot worse. Do you claim that institutions make no difference whatsoever? I would have thought that better institutions will generally give better outcomes, even if nirvana itself is unobtainable on Earth.

  21. Chidem Kurdas;

    Is expediency such an important feature of bank bankruptcy regimes? Are liquidity losses so important that expediency must be made more important than maximizing the value of the distressed bank and working out claims priority? I’m skeptic. In the end, aren’t the high costs of the Lehman bankruptcy simply due to the complexity of Lehman’s structure, the same complexity that reportedly led BoA to acquire Merrill Lynch instead?

  22. A very insightful Venn. The govt and so called too-big-to-fail institutions are known to have very robust risk management systems. But the problem is that these risk management tools are of no use when faced with people with shady and double standards. Breaking of these big financial institutions may definitely help in the long run!

  23. Bankruptcy is problematic for banks because of their involvement in the payments system. Checks must clear at the end of every business day. It would wrek havoc with the payments system if such cliams were tied up in a bankruptcy court.

    Bankruptcy needs to be reformed generally. And DFA should have tackled it for banks. The longer assets are tied up in court, the more they depreciate. Quicker is better.

    Australia allows only 6 months for an attempted resturcturing in bankruptcy. After that, the assets must be liquidated. Not peprfect, but better than what we do.

  24. I’m not saying there’s not room for improvement, but I’m not seeing the need for speed many economists are insisting on. I’m just trying to understand. Even in the case of Lehman insured depositors were made full by the FDIC without any interruption in service, with seemingly no impact on the payment system. In the absence of deposit insurance it could just be said that small deposits are exempt from the automatic stay, or a similar scheme. If uninsured creditors need the liquidity anyway there are always vulture funds. The recovery rates generally aren’t bad either, Lehman really is an exception to this regard. It just seems to me like expediency doesn’t necessarily mean maximization of the value of the distressed firm, and maximization of the value is already the prime concern of bankruptcy court – so much that it often supersedes the priority of claims. It seems to be so obvious to so many economists that I’d like to see it too, but I’m not.

  25. I’m reading Charles J. Shields’s new bio. of Kurt Vonnegut, And So It Goes, Kurt Vonnegut: A Life, and he writes (p. 126):
    “Big business and big government, he [Vonnegut] complained…were partners in foisting socialism on the country. How they sapped, in combination, Americans’ spirit of individuality with guarantees that adults would be inured from failure was humiliating.”

  27. Check clearing is a substantive answer to the question of why banks can’t simply be allowed to fail. But is it convincing? Can’t it be addressed by the requirement for a segregated reserve fund, not frozen on bankruptcy, to pay the remaining outstanding checks? The larger the bank, the larger the required set-aside.

  29. Jerry, isn’t that sort of like saying “ask Madoff’s clients how investment funds work”?

  33. “Capitalism” didn’t start out as “our” word. It was first used by early laissez-faire radicals to disparage the reigning system of employer privilege. Mises and Rand tried to appropriate it, but that usage never really took hold in the wider world.

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