Wednesday, July 30, 2014

Regulatory Predestination and the Right to Exit

Tyler Cowen linked to a couple stories yesterday that touched on a similar theme, I think.

School Choice

First, was this NY Times Upshot story about school principals' estimation of school poverty.  According to the study, principals in the U.S. greatly overestimate levels of poverty among their students.

If I understand the variable on the x-axis properly, this is the percentage of principals who believe that more than 30% of their students come from disadvantaged homes.  If the problem in the US was related to socioeconomic segregation, then this number would be low, since most principals would have only a few disadvantaged students and a few principals would have many disadvantaged students.  If these principals have a reasonable perception, then this would imply that there is massive poverty in the US that is evenly distributed among schools.  As the article points out, widely distributed poverty among a 30%+ portion of the population doesn't seem objectively reasonable.

There are a number of subtle and complicated issues here that I won't begin to understand.  But, this fits with a set of cultural peculiarities that seem to be in place right now in the US.  First is the apparent socioeconomic factor in school performance.  US students who are poor seem to do especially poorly in school.  And, many educators and public education advocates appear to put a lot of weight on this idea - both in terms of advocating that public schools in poor neighborhoods need more public support and in terms of assigning responsibility of poorly performing schools and students to their poverty instead of to the educational institutions and their faculty and staff.

In short, we have school districts that are compulsory institutions, school leaders who attribute student failures to poverty, and school leaders who overstate the level of poverty in their schools.  Is there a bit of constructed fatalism here?  It seems to me that if we arranged a stronger right of exit and choice in primary education, we wouldn't even need to answer that question.  Dismayingly, one reason that public school advocates give for opposing the right to exit is that many poor children will be failed by a system that requires their parents to shop for the best school.  No doubt, there will be many failures of this kind, and it would be a tragedy that requires some sort of safety net for the children who fall through the cracks.  But, especially in light of evidence such as that from the Upshot article, the layers of fatalism in defense of coercion are a potential red flag.  If the attitude of many families to their local schools and the attitude of the schools to those families are both fatalistic - and clearly they are, in both directions - then how does this become anything but a vicious cycle?  Is there really more than one reasonable answer to inner city families in places like DC and LA who take to the streets demanding choice?


The other piece was an excellent piece by Robert J. Samuelson in the Washington Post about Dodd-Frank.  He discusses the fact that Dodd-Frank might undermine the Federal Reserve's role as lender of last resort.  In a system with banking capital and reserve regulations and a public monopoly on currency creation, this might be the Fed's most important tool for crisis prevention.  Yet, this role has been categorized as a "bailout" in the accepted narrative of the recent crisis where private banks and financiers recklessly drove us over a financial cliff, only to be rewarded with "bailouts".

This is a right-of-exit issue again.  Because, what if that narrative is wrong?  What if the crisis was a product of a mishandling of currency production by the Fed, and playing the lender of last resort was one of the important tools the Fed used to save us from their errors?

As with the school issue above, this is an empirical question, but because of the complex nature of the subject, the interpreted facts become a product of the narrative itself, and so the narrative exists above and before the empirics.  The narrative is predicated on an assumption that markets consisting of thousands or millions of professionals devoting their professional lives to safely interpreting a complex ecosystem of human interaction are so uniformly driven mad by greed that they predictably join in consensus behavior that self-destructs.  Only a committee of high priests, chosen by the President and approved by the Senate, can stand above the fray and save us from these savage lemmings.

In a sane world, the transcripts of the FOMC meeting from September 2008 would have discredited this point of view. (Talk about too big to fail.).  The Fed was forced over and over again to substitute emergency liquidity for the sane, conventional liquidity that they refused to supply, and almost everyone seems to agree that the emergency liquidity is the one thing we definitely want to avoid repeating the next time this happens.

Then there are people like Ron Paul, who appear to be radicals, and who call for the abolition of the Fed.  But they are in complete agreement on this matter.  They also think it was the liquidity that was the problem.  Paul is supposedly the free market extremist, but he also thinks his view of the marketplace should be trusted over the millions of professionals who actually spend their working time trying to allocate capital.  He thinks they are savage lemmings, too, stupidly rushing off the cliff together and taking the economy with them, apparently because they can't forecast monetary policy as well as Mr. Paul can!  How is he any different than Barney Frank?

This is just textbook dogmatism (with a bigoted mindset) at work.  There is a widespread set of beliefs about the finance sector that is predicated on ungenerous, illogical, morally loaded presuppositions about how the financial world works.  The financial industry is a target you can safely treat with reflexive cynicism and receive social approval for it, among practically any political or social faction.  Is it that crazy to imagine that this leads to constructed narratives that - shock! - use finance as the antagonist?  I don't say this to paint financiers as victims.  That's not my point.  My point is that cheap cynicism and bigotry makes people stupid.  And stupid people have stupid opinions and support stupid policies.  The danger for me here is to use this as an excuse to dismiss all opinions that differ from my own.  But, so much of what I hear with the banks as the heavy and the Fed as the hero just appears to use convenient preconceptions, with no connection to facts.  In hindsight, nobody would have wanted to own banks over the past decade compared to other equities.  I know, Goldman Sachs owns the Treasury Department, and CEO's walked away with millions of dollars while firms failed, etc. etc.  These things, and many more, are true.  But, show me a bigot that doesn't have a briefcase full of incontrovertible facts in their defense.  I know this is a very convenient point for me that makes my argument non-falsifiable.  But, it happens to be true.  There are a lot of problems out there.  But, please.  Assuming that an entire industry, including financial representatives as well as high wealth individuals with their own capital on the line, will behave destructively pro-cyclically, but that a committee of political appointees won't, is madness.  It's believable if you're reflexively cynical about it, though.

The Fed transcripts from 2008 are damning in this matter, but you can't reason someone out of something they weren't reasoned into.  This intellectual framing is made possible, as with the school issue above, because there is no right to exit.  We are captives of our monetary and banking regulation framework.  I can buy or sell assets if I disagree with the marginal investor.  If I'm right, the marginal investor pays, and if I'm wrong, I pay.  Tread very carefully if you disagree with the marginal investor, by the way.  But, if I disagree with Chris Dodd, Barney Frank, or Ron Paul, I'm screwed either way.  If Ron Paul wants to give me the right of exit from a monopoly liquidity provider, more power to him.  But, if he wants to saddle me with some monetary policy based on what he thinks the S&P 500 should be going for, then he should go buy some puts and leave the rest of us alone.  At least he gets it half right, which is better than Dodd, Frank, and the rest of the folks writing the legislation that Mr. Samuelson is reviewing.


  1. TravisV from TheMoneyIllusion comments section here.

    Kevin, I agree with lots and lots of this excellent post. However, I'll only be sure you'll have fully grappled with the issue of financial regulation when I see you write something like this (by Sumner):

    "My first best solution (admittedly not realistic today) is to get rid of all government intervention in credit markets. No Fannie and Freddie, no FHA, no deducting interest on mortgage loans, no FDIC, etc. Laissez-faire.

    My second best solution is to try to regulate to make our system look more like Canada’s. Unlike 99.99% of bloggers I think small banks are the problem and big banks (like Canada) are the solution. I also favor bans on making sub-prime loans with taxpayer-insured funds. Require a minimum of 20% down, unless the lender is not insured by FDIC. Also change laws on non-recourse loans, etc. Change tax laws so that debt is not subsidized (as compared to equity.)"

    Have you written anything on government deposit guarantees and how much moral hazard they've created?

  2. I thought I had written about it more specifically, but the closest I can find with a quick search is this post that contains some earlier ideas that became a part of the recent 11 part series of posts:

    I agree with Sumner wholeheartedly. So many long lists of regulatory challenges could be simplified with just one policy - no FDIC. Once you do that, you really don't need any other banking regulations.

    I'm not an expert. But, I wonder if the best system would be to have the Fed managing a pegged NGDP growth futures market. Banks would be free to borrow reserve notes from the Fed and distribute them at will, but in order to do it, they have to agree that they will accept currency from all other banks at face value. Bank clearinghouse/trade association/private deposit insurers that would be owned by the banks themselves, like a co-op, would contract with each bank as the FDIC does now.

    US banking is full of these liquidity crises, and everyone seems to think that liquidity crises are just something that's going to happen when you have these leveraged financial intermediaries. But that's wrong. There is one, and only one, cause of bank runs, and that is the legal restriction against banks issuing currency or scrip. If there wasn't a legal restriction, when you ran to the bank and said, "Give me my $100,000, now!", they'd scribble on a piece of paper, "This is $100,000. So says First Bank of Erdmanntown"

    In the past, before FDIC, banks issued certain notices or signaled in certain ways that they were financially strong. I think private deposit insurance could use branding like that, which banks would publish to their customer base in order to help potential customers feel secure. But, I'm not sure any of that would even be necessary. If the other banks were partners in a mutual fund of deposit insurance, and they all knew that they were required to accept that $100,000 bill from First Bank of Erdmanntown, there isn't any question that the insurance terms would be robust. I suspect the deposit insurance would settle at an equilibrium that eventually made it so rarely used that it was practically out of sight, as forms of bank capital would develop through a sort of arbitrage of the cost of manageable banking capital.

    And, the clearinghouses would be terrified of banks that were too large. TBTF wouldn't ever rise to the notice of people like you and I, although I agree with Sumner that the average bank in a free banking regime would probably be larger than what it is now.

    I'm not sure you'd get them to agree, but I'd say a decent banking/monetary system would be part George Selgin, part Larry White, and part Scott Sumner.

    I don't write about it much because the solution is so simple - get rid of FDIC - and it's a non-starter. And, if you don't start with that, you're probably just going to end up with a political mishmash of stuff that isn't going to stop the next crisis anyway.

    1. TravisV here from TheMoneyIllusion comments section.

      Thank you very much for your reply! I think we're on the same page / wavelength. You wrote this and I agree:

      "I don't write about it much because the solution is so simple - get rid of FDIC - and it's a non-starter. And, if you don't start with that, you're probably just going to end up with a political mishmash of stuff that isn't going to stop the next crisis anyway."

    2. '... I'd say a decent banking/monetary system would be part George Selgin, part Larry White, and part Scott Sumner.'

      Add Charles Calomiris to that group.

    3. Thanks for the reference, Patrick.

      You know, looking at his papers, I think he might have given up on his foreclosure paper a little too soon.

      In that paper from September 2008, he says that foreclosures shouldn't lead to extreme price declines, but: "It is conceivable that unusually tight consumer credit conditions, or other factors, could weigh on the housing market and produce more price decline than we estimate."

      But, by December 2008, he was telling Congress that the subprime boom was worsening the bust. Here, he gives the subprime boom a causative role in the housing boom, and subsequent bust.

      I think he needs to go back to that foreclosure paper. The causation could very well run from the boom to subprime, not the other way around. In other words, low long term interest rates led to very high nominal home prices. They also created an environment where subprime borrowers could conceivably finance a home with a mortgage. Subprime and the semi-related bank boom in AAA-rated mortgage securities may have had a minor effect on home prices. I think prices would have gotten 95% of the way to their peaks in any case - because the prices were justifiable in the rate environment. And, Calomiris was right originally that, short of a demand shock unrelated to the housing market, any related foreclosures would not necessarily lead to extreme price declines.

      The GSE subprime mess is a good example, along the lines of this post, of how regulatory and public interventions tend to be pro-cyclical. But, I don't think it necessarily should take much of the blame for the bust. I think money illusion issues cause people to pre-judge home prices in the 2000's as a "bubble". If you have a bubble, something needs to be blamed for the bubble. Being complex, we rest on our priors. Free market supporters blame the GSE's and regulation supporters blame greedy bankers. I say, rid ourselves of money illusion. There is nobody to blame for a "bubble". (Did you see the graph at the end of my recent post on inflation and interest rates in 2014-2015? There sure as hell was a bust, and I think we can blame someone for that.)

      That GSE stuff is also a great window into the anti-finance, or anti-market bias. If private agents did what the GSE's did, it would be "predatory". GSE's aren't called predatory in the public discussion, because they were semi-public - even though their own risk officers were saying to the executives at the time, "This is predatory! Please, stop." Even if the GSE's demand that private agents go gather questionable subprime mortgages, the public conversation still tends to finger those private agents as the predators. There is simply a predisposition for ID'ing private financial agents as predators and not ID'ing public agents as such. It's a predestined narrative. There is no possible outcome that could reverse it.

      Same thing with student loans. What the federal government does now would have people marching in the streets if it was done by private agents. The way to have a functional student loan subsidy would be to make banks take all the risk, but to subsidize the interest rate. But, this would involve a first order effect of having the government pay money to bankers. It would mean that collection officers would be hounding college dropouts. It would mean that bankers might tell some kids that they weren't going to take the downside on an investment in a C student going for an art history degree from the local community college. Not only are all of those scenes ugly, but they are uglier for having a profiteer involved.

      So, instead, we have guys with $35,000 in debt from that Masters Degree in puppetry volunteering as puppet-indignation organizers at Occupy Wall Street. We have a system more predatory than any private financier would ever bother with, because if constraints are filtered through financiers, we blame the financiers.

      Sorry for the lack of links. Blogger isn't cooperating.