When AIG top management approached their staff about foregoing bonuses, the response – as described at The Hill – was "take a hike." Management, in turn, felt they had not choice but to pay the bonuses. Partly they were afraid of the costs of potential lawsuits for breaching contracts that had been written prior to the receipt of any bailout money, and partly – most importantly – they were afraid that without the bonuses they would be unable to retain the services of the "quants," the technical experts who had created the mess by devising Credit Default Swaps that got AIG into trouble in the first place. The feeling was that the quants who had created the mess are the only ones with the skills to undo it.
Okay, here I go saying the unthinkable: management has a point. If a nuclear reactor fails, it is probably not a good idea to fire all the nuclear engineers and bring in civil engineers to fix the problem. Which leads to a more general point that needs to be kept in mind. Everyone I talk to in the banking industry makes the same argument: government does not have the talent that one finds in the overcompensated private sector. Nothing complicated about this – the smartest and most skilled operators follow the money, and the private sector pays better. Much better. Partly through bonuses. Do we really want to try to change that situation? It is not feasible for government to pay the kinds of salaries that would be necessary to compete with the profit-making opportunities available at the commercial banks and hedge funds. (You feel outraged about taxpayer money going to these executives now? How would you feel if taxpayer money went to these guys at that rate all the time?) What about the opposite approach: using the power of government to prevent such high salaries being paid, especially by firms receiving bailout money? The problem, obviously, is talent drain, at a time when the firms receiving bailout money are exactly the firms where we most desperately need our best nuclear engineers on the job. So what, we’re stuck with this system of super-compensation for insane risk-taking backed by a promise of public funds in the case of failure? The infamous "privatize profit, socialize risk" approach? No, but in the short term we are stuck with the consequences of having adopted that system over the past decade. In other words, there are obviously some things we need to do to correct the system of incentives going forward, but until the reactor stops leaking radioactive steam into the atmosphere we have to keep the nuclear engineers on the job.
What are the steps for the future? We have to think structurally, not functionally. People react to incentives, smart ambitious people often seek to make as much money as they can, in a global financial system making money involves risk-taking, within limits risk-taking is a good thing that we want to encourage. Theoretically, the mechanism for rewarding and punishing risk-taking was supposed to be "the market," but there are publicly necessary functions that should be shielded form the operation of that system. As a recent NYTimes editorial put it, you don’t want a utility and a casino in the same building, but that does not necessarily mean that you want to abolish casinos. So . . . 1. We do not want to nationalize the banking system. We really don’t. No, not because of the idiotic analogy to Soviet communism – the USSR didn’t have a nationalized banking system, it had a nationalized economy, which is not the same thing. But other countries have experimented with nationalized banking systems in capitalist economies (France, South Korea), with less-than-ideal results. There are other problems with a nationalized system, as well. Globally, it creates opportunities for arbitrage by international investors that can work to the significant disadvantage of the national bank. It is also the case – as unpopular as it may be to say at this moment – that government are not efficient allocators of resources. You do not want the political branches controlling the availability of investment capital, for starters. Privately controlled investment that makes money on its successes and loses money on its failures is still the best way we know to keep capital flowing. Which means that the risk of failure has to remain in place. What we do want to do is identify those banking functions that are socially necessary – the utilities – and separate them from the risk-taking, purely profit-driven enterprises. Call it the Enron principle: we want to diminish the extent to which a system can be gamed in proportion to the extent that the consequences of gaming the system could be disastrous for our society. For the very same reasons that complete nationalization would be a very bad idea, partial nationalization might make some sense, so long as it is restricted to areas where we don’t care so much about the inefficient allocation of resources – there are other goals besides efficiency – and do not need or want the services of the quants. 2. We do not really want the government – even at this moment – to be in the business of rewriting contracts. The behavior of the financial markets is all about confidence; the problem with the credit freeze, remember, is not that banks have no money to lend, it is that they have no confidence in seeing a return on those loans. The specter of the government using its power to undo transactions that people entered into in the hope of making money can only diminish global confidence in the system as a whole. 3. Where the consequences of failure are intolerable, the opportunities for profit need to be limited; that’s the converse of the basic premise that smart risk-taking should be rewarded. Back in the Depression, the Glass-Steagall law tried to separate the utilities from the casinos by prohibiting bank holding companies from owning other financial institutions. That law was repealed in 1999 by a bill sponsored by Phill Gramm, the same economic genius who gave us the Commodities Futures Modernization Act of 2000 that deregulated the derivatives market. That Act included the notorious "Enron loophole" deregulating energy-related trades, specifically crafted by Enron lobbyists working for Gramm. The story is too good not to repeat: the bill was passed two days after the Supreme Court’s decision in Bush v. Gore, was never debated in either the House or the Senate, and was signed into law as part of an omnibus spending package. In other words, an awful lot of good can be done just by undoing the spectacularly stupid and corrupt things we – our government representatives — did recently. Laissez-faire capitalism did not work well in an industrial economy; it works even less well in a post-industrial finance-driven system of capitalism. But restoring sanity to the regulatory system may not be enough. People are right to be thinking about the need for structural changes. Toward that end, we may want to nationalize certain aspects of the banking system, or at least to regulate their operation to the point where they are effectively separated from the private financial markets. Such sectors would not attract the best of the "quants," but that’s okay – the point is to create sectors that do not have the potential for nuclear meltdown even though hey will not produce nuclear power. It’s the utility model again. So what functions that the banking system serves are analogies to clean water and electricity? Start with private mortgages. It was a really dumb idea to turn Fannie Mae ove to private shareholders back in the 1968. That program was created in 1938 in response to a lack of liquidity in mortgage markets. The reason for change in 1968 was to get the costs of the programs off the government’s balance sheets in order to help pay for a war — something simultaneously classical and contemporary about that move, isn’t there? Then in 1970 we created Freddie Mac to expand the secondary mortgage market. Both steps were essentially ways to raise revenue — to pay for our wars — by allowing utility-style function (enabling people to buy homes) to mix with casino-style functions (speculating on the future of those mortgages). Let’s start by undoing those moves. It is worth remembering that the asset-backed securities on which AIG was writing insurance policies were not unregulated; at that stage of the transactions all the underlying valuation information was availablt. It’s just that the form of the security (bundles of huge numbers of mortgages) and the system of trading created overwhelming incentives to ignore the underlying valuation information and rely on historical trends. So the ratings agencies and the bond underwriters and everyone else screwed up. That’s what "risk" is all about, and it’s why you don’t want it in your living room. On the other hand, you don’t necessarily want the government to be in the business of supplying credit for real estate speculators like the folks buying up hundreds of properties in Detroit for a song. How about a public mortgage guarantee program that is limited to a single property that is used as a primary residence, and restricting the secondary mortgage-based investment market to other loans? How about offering rates that, while good, can still be undercut by private lenders willing to take on riskier loans, with assurances that in the event those riskier loans go bad those entities will not be "too big to fail"? It is an equally bad idea to have private providers of student loans. That one should simply be nationalized outright. Which would not prevent any lender from offering a loan that could be used to pay for college, it’s just that those loans would not come with any governmental support or guarantees. Conversely, a nationalized student loan program should define its mission as giving as many students as possible the opportunity to go to college; in terms of long-term returns, there is simply no better investment that the government can make. What about commercial paper – the short-term credit that keeps our small businesses in operation? There is a good argument that the current crisis demonstrates the desirability of a permanent version of the instruments Geithner promoted at the New York Fed and now at Treasury, a backup system of government-provided short-term credit available in case the private system fails. Such a system has to be designed carefully to avoid creating structural incentives that make the government financing always the more attractive option; the idea is that publicly financed credit should be a last resort, not an entire competing system. The credit card industry is a disgrace. One reason to avoid incentives for seeking rewards by taking on excessive risk is to avoid encouraging predatory behavior. A national usury law limiting interest rates on private credit agreements to 10% would mean that some people cannot get credit cards, but it would do a tremendous amount of good in reducing the chance of triggering yet another crisis that many forecasters see looming on the horizon. If you can’t make a profit lending money at 10% interest, you’re in the wrong line of work. 4. We have to use the power of government to reduce – not abolish, merely tame the excesses – of the risk-reward relationship in the private financial markets. We need to restore or invent limits on the level of leveraging. By ""we" I am talking about a global effort, not a local one. The only alternative would be some kind of weird financial protectionism that tried to limit the interactions of the American and global financial markets. Which would not work: any such system simply begs to be gamed. Some kind of an antitrust principle to limit the size of any single fund or coordination among funds might be a good idea, and the same goes for commercial banks and other financial institutions. Basic premise: in the private sector, no business should ever be allowed to become too big to fail, as a basic matter of preserving the risk-reward relationship. 5. We do not want to abolish all "derivatives," a term that covers a multitude of different kinds of instruments ranging from currency futures to, well, credit default swaps. Derivatives were created to reduce risk – basically, they are various forms of side bets — and they often work in just that way. When they fail, they can fail badly, but the solution is to ensure that the consequences of those failures do not endanger the "utility" side of the operations, not to prevent side-bets in our casinos. I recently wrote a post arguing that the sheer size of the derivative market and the relative opacity of at least some categories of those instruments makes them a danger – I called them the dragon in the living room. But the solution is not to kill the dragon, it is to get it out of the living room. Dragons, after all, keep the pterodactyl population in check. I should note that my previous post resulted in a fairly outraged e-mail from someone at the International Swaps and Derivatives Association, who argued that I was looking at the wrong numbers. I remain unconvinced – the role of CDS’s and asset-backed securities in creating the current crisis cannot be denied – but he made some good points about other categories of derivatives. The real point is that if you want to talk about restructuring a nuclear reactor, you had better have some nuclear engineers in the room. All of this may seem awfully obvious and old hat by now. In fact, I am pretty sure that what I am articulating here is close to the thinking of Geithner and others in the Obama administration. But lately the torches-and-pitchforks voices have begun to drown out serious discussion. Time to take a deep breath or two: populist rage is a rotten basis for policy-making.