Casey Mulligan’s important post on the relative separability of the performance of the financial and non-financial sectors of the economy (among many other refreshing and illuminating posts) highlights what I think are some of the great neglected facts of the ongoing discussion about the implications of the financial crisis.
First, financial markets are a necessary instrument to wealth creation, but are not a fundamental cause of increasing prosperity. It is a tremendous problem of economics journalism that journalists and opinionators don’t really understand the mainsprings of economic growth. Financial innovation affects growth at the margin by more efficiently allocating capital to its most efficient uses, but this is obviously secondary to developments in the real economy that increase capital’s productivity. Derivatives can make us a bit richer, but productivity-enhancing technologies make us rich.
The conditions for entrepreneurial discovery, and therefore scientific and technological and organizational innovation, and therefore productivity growth, and therefore increasing prosperity and welfare remain very, very strong. Yes, if the flow of capital to would-be innovators dries up, then innovation and growth dries up. But there is in our system enormous ongoing potential for innovation, and therefore for increasing returns to capital. And there is an enormous amount of capital, the owners of which continue to want a nice return. The magnetic force between capital and innovation is so strong, and our overall institutional environment so sound, that we can be pretty sure innovation and growth will continue with barely a hitch. The financial crisis is not going to keep us from getting a hell of lot richer.
I think it’s pretty clear that our recent troubles are primarily due to a variety of misconceived U.S. government policies intended to promote home-ownership, and secondarily due to combined financial market irrationality and regulatory failure. Suppose you agree that the government screwed up in failing to regulate leverage. What does this imply about the feasibility of relatively free-market capitalism? What does it say about the desirability of government regulatory intervention into the non-financial economy–the part that actually delivers prosperity. Very little.
What does it say about the alleged dangers of free market ideology? Again, very little, if anything. I think Ross Douthat put it extremely well in his reply to Jacob Weisberg’s silliness:
[A]rguing that a single bad economic contraction following a long period of growth permanently discredits an ideology that can be implicated in both the growth and the contraction is like arguing that, say, Weimar Germany permanently discredits partisans of democracy.
Past and furture Treasury Secretary Larry Summers does understand a something about the deeper sources of economic prosperity, and thus in his FT op-ed titled “The Pendulum Swings Toward Regulation,” he says almost nothing about regulation (just leverage, really), and concentrates on the ways government subsidies might at once soften recession and enhance the productivity of the real economy.
So there is a need to ensure that the pressure to increase spending is directed at areas where it will have the most transformational impact. We need to identify those investments that stimulate demand in the short run and have a positive impact on productivity. These include renewable energy technologies and the infrastructure to support them, the broader application of biotechnologies and expanding broadband connectivity, an area where the US has fallen behind.
I happen to think Summers is making a mistake in believing that government has adequate information or motivation to do a very good job at identifying growth-enhancing investments (in energy, biotech, broadband, or otherwise), but the implied broader point is that financial markets are a sideshow. The real economy is where it’s at, and the best the government can do is to promote the enabling conditions of innovation and growth. The contemporary debate was and continues to be whether government spending can complement or enhance relatively free markets, not whether we will be better off if those markets are more heavily regulated and relatively less free.
Indeed, I think the evidence points to overregulation of the economic uses of many forms of “intellectual property.” More generally, the evidence that dominant firms support regulation that increases the cost of entry into their markets remains overwhelming. Thanks these sorts of regulations, we’ve foregone a lot of innovation and growth. At a smaller scale, regulation of small business — most notably the businesses poorer people are likely to start — continues to suppress a lot of welfare-enhancing entrepreneurship. Libertarians continue to lead the way in emphasizing all this, and continue to be right about all of it. We have witnessed nothing in the financial markets to reinforce the wisdom of this kind of welfare-reducing regulation.
Libertarians and other free market cheerleaders have made huge permanent strides in convincing the world of the importance of entrepreneurial discovery, competition-driven innovation, and the role of rent-seeking regulation in hobbling these. The prevalence of these ideas has made the world much wealthier, and stands to make it wealthier still. Larry Summers might not jump at the chance to admit this, but neither do I think he would disagree. He’ll just emphasize that active government spending can nevertheless be growth-promoting. That’s not much of a “pendulum swing” back toward a more regulated economy. If we’re really in the middle of a PR nightmare for capitalism — if this is our big generational crisis of confidence — and the importance of things like infrastructure upgrades and subsidies for renewable energy is the upshot for the left-leaning economic policy establishment, then what we’re going through amounts to the fire-tempering, the locking down, the consolidation of decades of libertarian-leaning economic policy gains.
“[Summers] says almost nothing about regulation (just leverage, really).”
Will, you speak here as if the regulation of leverage were a minor point. But it's pretty much the crux of the regulation biscuit anywhere I've seen the issues discussed. What other forms of regulation have you seen advocated on the basis of the current downturn, and by whom?
I'd argue that the practice of offering resetting mortgages needs to be adressed as well. Surely they contributed to the growth of the bubble (by delaying bankruptcy of people who couldnt afford the houses they bought, therefore increasing demand and prices). As well as giving the CDO's with the bad mortgages time to spread through the system.
“The conditions for entrepreneurial discovery, and therefore scientific and technological and organizational innovation, and therefore productivity growth, and therefore increasing prosperity and welfare remain very, very strong.”
This seems quite likely. It is also the reason why economic contractions don't turn into vicious cycles of lower consumer spending leading to businessess laying off workers, leading to lower consumer spending ad infinitum.
While many existing businesses may lose business in a downturn, what prevents this from becoming a vicious cycle is that capital gets attracted to NEW business opportunities discovered by entrepreneurs, which hire people arresting and reversing the process by which the vicious cycle might operate.
Unfortunately there appears to be little acknowledgment of the role of entrepreneurship's role in recessions in the popular press.
I'm not as optimistic about the future of market-friendly policies. Sure, if Larry Summers were the far left of the options in play in the big political world, then there wouldn't be much to worry about. But he's not. Naomi Klein, or maybe Hugo Chavez, is.
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Comprehensively regulating leverage is pretty difficult in practice. Almost all conventional financial institutions already subject to some significant form of leverage regulation. The problem is that when there is a desire for leverage there are a multitude of options for operating outside of regulatory regimes, e.g. nonregulated institutions, new types of securities or contracts. Unless you want to impose a fairly imposing, expensive and draconian regulatory regime on a large portion of the economy it is quite likely there will be ways out of any more comprehesive rules-based regulatory regime. You could try to avoid the problem by giving regulators more discretion, but then you sacrifice the predicatability of the rule of law and subject large portions of the economy to the will of the individuals doing the regulation. All that comes with a price that is likely to be higher than any advantage attendant to less leverage.
Do businesses have a fiduciary obligation to their shareholders to seek rents where available? If they don't do so, are they engaging in charity? If so, is the business of business business, or something else?
“More generally, the evidence that dominant firms support regulation that increases the cost of entry into their markets remains overwhelming. Thanks these sorts of regulations, we’ve foregone a lot of innovation and growth.”
I've always suspected that there is a somewhat faustian symbiosis between the Hollywood studios, production companies, etc. and the WGA that your above sentiment articulates. While the WGA is certainly often at odds with the various business entities employing its members, the mere existence of such a union, and the way it is structured and chartered ensures a certain dearth of competition from emerging talent. This benefits businesses that themselves have to compete in a media market that is made up of players who are increasingly horizontally integrated, and therefore encouraged to homogenize their content.
I have always been curious about your feelings regarding the WGA and its recent strike.
A very good post. As a former tech entrepreneur and F500 exec, I think your observations about the role of innovation in the non-financial, real economic sector are dead on.
I'd push back a bit on your skepticism regarding public investment in the real economy. For instance, having followed global broadband deployment closely through the years, I would say government investment and backing of that infrastructure makes quite a difference. I could easily see the same happening for the electrical grid, and physical infrastructure in general. I think the Obama proposal for an infrastructure bank, in which infrastructure investments are at least somewhat divorced from the seniority of the elected representatives in various areas, makes more sense than what we've got.
I've been wondering about the possibilities of quasi-independent entities similar to the Fed and the infrastructure bank proposal as vehicles to invest in things like alternative energy. You can make fun all you want of those oil molecules waving their flags of origin, but that obscures the large externalities of the current energy market (9/11, $10B/mo Iraq, etc) for which the government (and taxpayer) ultimately bear the costs.
ScottB should look at the failures around the world, not the government successes. There are more lessons in mistakes. If there is an infrastructure bank the politicians will get control of it, at least after a little while.
If day to day operating funds dry up then main street is going to suffer some pretty serious friction burns.
“I think it’s pretty clear that our recent troubles are primarily due to a variety of misconceived U.S. government policies intended to promote home-ownership, and secondarily due to combined financial market irrationality and regulatory failure.”
Sure, because the housing bubble was caused solely by government policies promoting homeownership. No problems in the private mortgage market, especially not with non-conforming mortgages and independent mortgage servicers. Nope, no market failures there. Move along folks, nothing to see here.
“Libertarians and other free market cheerleaders have made huge permanent strides in convincing the world of the importance of entrepreneurial discovery, competition-driven innovation, and the role of rent-seeking regulation in hobbling these.”
The assumption that libertarians and “free market cheerleaders” — which presumably doesn't include Democrats — are the only ones who promote competition and entrepreneurship, and the only ones who understand that rent-seeking is inefficient, is laughable. Competition, entrepreneurship, and lack of rent-seeking regulations isn’t libertarianism, it’s basic neoclassical economics. Your entire post substitutes this kind of framing for substantive argument (who WOULD want to “suppress welfare-enhancing entrepreneurship,” or see wisdom in “welfare-reducing regulations”?).
“[T]he implied broader point is that financial markets are a sideshow.”
And that's where you lose all credibility.
Wake me when you have a real argument.
let them eat growth…the dirty rabblethey are.
Value is relational, not absolute.
Mulligan's post is statistical cherry picking.
If he really believes what he wrote, he should go to Intrade and short recession contracts.
Right Stuart, I don't mean that there aren't other related forms of regulation. It's just that regulation tailored to leverage is either a Very Big Deal or it isn't. It seems to me that on the one hand, Will wants to say that any amount of extra marginal regulation ineluctably makes markets substantially less free, while on the other — when the apparent need for extra marginal regulation threatens the neat libertarian ideal — Will wants to say it's really no big deal, since we're *only* talking about leverage. (And apropos of DW Anderson's remark below, any talk about regulating leverage should be a pretty big deal, precisely because it would be so hard to do successfully.)
With all due respect WW, I'm just not feeling that Prof. Mulligan has a clear understanding of how global capital flows get into our economy as a business practice.
Here's a nice prediction for you: within 24 months the banks that ate the remnants of the investment banks will spit them out again, with new names and in perhaps a slightly different form, probably by selling them or otherwise joining them to private equity. But the business will be the same.
There have to be institutions that handle risks the old investment banks did, and they won't work inside the confines of a commercial bank.
As to the regulation issue: We've discussed here earlier that this puppy failed in 4 places. So only 4 reforms/regulations are needed to adjust for similar events in the future, I'd argue:
* ratings agencies must be neutral and independent by law and overseen by the SEC
* a larger percentage of collateral must be held as a reserve pool
* institutions with mortgages must hold on to a certain portion of them
* derivatives and swaps should voluntarily list before the gov't makes 'em
* the annual bonus system must go to a partial-pay, partial-vest over x year model before the gov't outright limits compensation
Excellent summary of needed regulatory reform, webgrrl. There's also a meta-reform needed in the form of simpler, more uniform regulation. (If it acts like a bank, it is a bank, etc).
ScottB, actually, I don't agree with your meta-reform, I think. Banks that accept deposits need to be more tightly regulated to protect those deposits and backstop consumer confidence in the basic economy. Future innovation in finance, greentechnology, biotechnology, and nano-manufacturing (or whatever we're gonna build in 2020) will require more advanced entities that can handle different kinds of long-term risk. They need the freedom to invent themselves for this coming world.
This is one of those situations in which you just have to shrug and admit not all good things can be made to go together. I just moved to LA to work as an editor, and I'm trying to get into that guild myself. It ain't easy, but the guilds/unions insure that, once you're a member, you're guaranteed good pay, benefits, etc. Without the collective leverage of the guilds and unions, the studios and production companies would be able to play individual contractors and employees off one another, thus paying everyone as little as possible and providing as few benefits as possible. So you have to balance your values. I wish the guilds/unions were a bit easier to join, but then I'm on the outside looking in.
On a related theme, Will mentions the potential for regulation to stifle innovation and entrepreneurship, which is true. But plenty of products can have negative consequences for environment or health which are so long term or cumulative that pure markets simply can't price appropriately for those costs. Entrepreneurs aren't motivated to increase welfare, they're motivated to increase profit. So if their product happens to harm welfare, but does so far enough down the line, or in a sufficiently cumulative sense, that demand can't account for it, they have no incentive to fix their product absent regulation. In a free market scenario, companies could dump those products on the public, make off with their profit, and it would be years before anyone realized the product was doing major damage. So you have the same thing there: a trade-off between welfare and innovation/competition.
Re Democrats who love free markets: this sub-species may actually exist, but it's a well kept secret. I've sat through enough Democratic speeches to last a lifetime and not once have I heard anyone sing the praises of the entrepreneur, a.k.a the person who actually creates the jobs in a market system. Instead, it's all about how government–not enterprising individuals– will be our salvation. So it's not surprising we're worried. (And yes the GOP has been pretty pathetic in this area too, which means the PR burden of capitalism falls on libertarians, who rarely have the forums or money available to offer a loud rebuttal.)
Mari, please allow me to introduce myself, I'm a woman of wealth & taste. . .I have been affiliated with Democrats nearly all my life. And I am well-known as a market advocate, a Street Walker, a person who started her company's own internal market. You might be surprised to learn that many Wall Streeters are Democrats. I would not until now have called myself or them a “secret.”
Interesting post and I agree with a lot of what you say. Still, I find two issues with your piece:
1) How you can be certain about the claim that “[f]inancial innovation affects growth at the margin by more efficiently allocating capital … but this is obviously secondary to developments in the real economy…” In particular, it seems that the correct allocation of resources is THE central difference between capitalism and other forms of economic organization. If developments in our capital markets can make our allocation even more efficient, this could arguably give us a significant advantage over other countries. Indeed, this could be a central reason for why “the rule of law” is required to achieve otherwise libertarian economic growth – without the basic correct allocation of capital which the rule of law provides, economic growth cannot begin to develop.
2) You make two claims which may contradict each other:
A. “Financial innovation affects growth at the margin by more efficiently allocating capital to its most efficient uses, but this is obviously secondary to developments in the real economy that increase capital’s productivity.”
B. “I happen to think Summers is making a mistake in believing that government has adequate information or motivation to do a very good job at identifying growth-enhancing investments.”
If the second is true, how can you claim the first with confidence, e.g., if the government cannot know what is correct, how can you? Not such an error, but I find it interesting that you can make such claims about the right course and yet claim that the government is ignorant about the way to go forward.
Just small comments – take them for what you will. Many thanks for your work.
There is no 'free market'. There never was. There never will be. Laws defining property rights and procedures for adjudicating contract disputes are regulation. You can't have a market without 'em.
The question up for discussion then is not whether we should regulate. We're arguing about the structure and nature of whatever regulations we adopt.
The political and public policy point falling out of recent history is that reasonable voices were raised (Buffet, Soros, etc) that said “Hey! There is a feed-lot sized shit-pile of complex, opaque financial contracts out there that no one seems to know how to value, and can barely even price! We need to get some regulation around these babies so we can all agree on who owns what and how disputes are resolved!” In response, Greenspan/Gramm et al claimed “Hell no! The market knows best! Securitize, baby! Securitize!”
Also? Note to our esteemed Blog Host? Anytime someone says “By now it is pretty clear that X”, it's almost axiomatic that 'X' is almost certainly not clear, and probably not even true. As a rhetorical trick that translates as “I so badly want X to be true!”
@plugger
“There is no 'free market'. There never was. There never will be. Laws defining property rights and procedures for adjudicating contract disputes are regulation.”
Wait – are you saying that before the first woman traded the first yummy fish head on the beach for 5 cowrie shell beads and a handful of face paint, there had to be an SEC? Surely you jest.
@webgrrrl –
Consider the consequences had the yummy fish head proven toxic, and killed it's buyer. Or it turned out that the 5 cowrie shells were taken from an area of the reef that was a traditional hunting ground of another clan. In the social context of this time, the woman or her trading partner would have been ostracized, branded witches, and probably (under the social contract of the time) traded by her husband/owner at cut-price to the neighboring tribe.
Want to exchange something? There is — there must be — consequences should one party to the exchange renege or act dishonestly. Without consequences there can be no trust, and trust (as we're discovering) is no less important to the tribal mind than the modern banker.
plugger, no no no no. As I've said here before, it's very important to ensure that in your thinking you place civil society and its activities – of which the market is one – before the external state and its laws.
Rights arise from the relations and customs of family and civil society, or they inhere in persons. Either way, they are not outlined by or derived from the external state. Taboo is not regulation; custom is not law. Can you not see the difference between tribal traditions of fairness and regulation of the state?
I think with all due respect you don't really understand the force of what you are saying, or its implications.
webgrrrl –
Why on earth would you want to believe that–say–church law, or tribal tradition, or a family's personal vendettas, have any more a priori legitimacy than the laws a State sets down? In principle I do not see any difference between 'tribal traditions of fairness and regulation of the state'. Tribal elders possess the same monopoly on 'legitimate' force. They are vulnerable to the same human temptations and failings that lead to capricious authority.
In fact, in a Democratic state there is at least a process for changing the laws and regulations by which we all agree to operate. Further, law is written; formalized in a way that tradition is not. I would argue that there is more liberty under Law than Social Tradition. (At this point I mumble about the obligation to disobey 'bad laws' and so forth, but would derail that discussion with an discussion about the design of the processes under which a state might best operate.)
I very well understand the force of what I am saying, and I embrace its radical implications. If we acknowledge that our network of social interactions–of which the market and its advantages are just one–depends upon social laws, regulations, and upon their impartial enforcement, then all that remains is the question of how these are agreed upon and how they operate.
To embrace the times for a moment, we are learning from recent events is how the absence of any written laws concerning complex financial transactions has destroyed the requisite trust, and undermined the efficient functioning of the market. To build trust again, our 'tribe' needs new 'traditions' to guide us when answering questions about property and market transactions.
alas plugger, I myself am tempted to say something radical – let's agree to disagree, with all that implies.
As for trust, I'm not sure you're aware of the social science studies that show how best to rebuild it. Wharton has some nice ones.
plugger,
Since I lack webgrrl's restraint, I'll throw in my $.02.
There are many social institutions and there is a great deal of legislation (I think that's what you mean by laws) around these institution. Some of this legislation adds value, much of it adds nothing (or has costs and benefits that net out to something trivial), and (I think) the majority does harm.
I think it's a huge mistake to misinterpret this situation to be that it's the legislation that makes the institutions possible.
It's just not true.
As a practical matter, you're right that we're going to get more legislation around financial markets and it's important to consider what form it should take to make things better. But, I expect a kitchen-sink of regulations to come out of this process that will not improve trust or “The efficient functioning of the market.”
To expect something better requires faith that I lack.
Characterizing the power of social institutions as 'legislated' seems to be to abuse the term. I didn't vote for my family, my country, my place or time of birth. I did not volunteer my membership. These are accidents. And whatever 'rules' these institutions impose are never formalized. They are simply rung down by those in positions of power within those institutions.
My point is that these institutions I have been saddled with exert just as much — sometimes even more — power over my person than any State. Their power, their authority, is no less real than State power; certainly not in the primitive societies webgrrrl introduced to the debate with her example. Arguably though, in the current situation the actions of the 'social institutions' of Wall Street (they were not part of the state by any stretch of the imagination) have impinged on the liberty of many. Any serious advocate for liberty must acknowledge that.
For some reason, libertarians claim to look to the State merely as a minimalist means of arbitrating disputes between individuals. My instinct is that there are also disputes about the power of non-state collectives that must also be addressed, and part of the task of a minimalist state is to protect my individual liberties against the failure or malfeasance of these collective institutions.
Gotta be careful you don't oversell it though. I would make the claim that the single most important thing regulators can do is to make parties to transactions be as transparent as possible about the nature of what is being bought and sold. And not merely to one another. The overall agora benefits from the information in the price signals sent from the stalls all around them.
Public markets. Public visibility.
well said men, please keep in touch
I have been saddled with exert just as much
sometimes even more power over my person than any State.
Their power, their authority, is no less real than State power
I have been saddled with exert just as much
sometimes even more power over my person than any State.
Their power, their authority, is no less real than State power