It has been a busy time for academic economists in the past few weeks. Every lunch break has been dominated by talk about all the goings on in the markets and the government plans that are coming thick and thin. We are trying desperately to remain more knowledgeable about the crisis than the next journalist calling the school for a ‘considered opinion’. It will be months before the vague policy announcements will actually have been written down and implemented, and it will be years before we fully digest the train of causality of the last few weeks, so any lessons are by necessity preliminary. What we can do is to spot the winners and losers from the last few weeks:
- (for households) Those with big mortgages win, those dependent on stocks or interest rates lose. It is thus a bad time for pensioners and others who have paid off their mortgage and see their housing prices go down. It is a good time for young, relatively poor, couples with high mortgages, or even solvent families looking to buy a house: interest rates have gone down and can now be expected to drop another percent or 2 in the next year, and house prices will be low for a while.
- (for economists) Boom time for economists, bad times for financial analysts. The demand for economic advice and our products has never been so high. As a profession, we are on the news all the time, taxi drivers ask for our opinion, long-lost family members suddenly rediscover us as a source of advice, etc. We are all expecting the student numbers to go up again next year as economics is in the news so much. Though it sounds like being an undertaker at a massacre, it must be said that its an exciting time to be an economist. Financial analysts however can expect tough times. There is almost undoubtedly going to occur a shake-out of analysts and financial advisors, if only because the profit margins are squeezed from which these analysts live.
- (for regulators) A bonanza for regulators. Calls to increase the number of regulations on the markets are almost universal. Australia is doing it, the US is doing it, Europe is doing it. Great times to be a lawyer or a regulator of markets. The control of the state over the economy looks certain to increase, certainly in the short run. Indeed, apart from the Brits, none of the other countries seem to have given much thought to how to get rid of the regulation after a while. The structures now being built in the US or Europe (direct interference) to regulate the financial markets may be with us much longer than we would like.
- (for economic theory) The return of Keynesianism. Animal spirits are back. This financial crisis is universally regarded as a bank run and a wave of pessimism. No-one believes this is a Real Business Cycle fluctuation, or that the bout of unemployment we are going to see shortly is due to workers taking a holiday (which, believe it or not, is still a dominant idea in economic theory land). In the background, the anxiety about bankruptcies and unemployment probably heralds an increased role of networks in our theories of the economy: what gets destroyed in a bankruptcy is not education, physical capital, or technology, for they all survive. Hence, classic production factors wont go down and wouldnt be able to explain the coming slowdown. What are destroyed in bankruptcies are the relations between suppliers and consumers, between intermediaries and final good producers, between workers and specialist machinery. I expect more theories to emerge reflecting the importance of the specificity of these links. The notion of trust, which has been all but declared taboo in economic journals recently, also looks certain to make a glorious return to the fold.
Apart from this array of winners and losers, the financial crisis has thrown up a whole set of questions about what to do next. It is hard to say with any certainty what will and should happen, but here goes for a best guess:
- Is this the end of capitalism, i.e. growth fuelled by greedy private entrepreneurs looking to gain personally from their endeavours? Of course not. Whilst the capital markets are in difficulty, the overall economic story of this decade is the 7% sustained growth in India and the 10% sustained growth in China, both fuelled by raw capitalism. Neither of those countries look like killing the goose that lays the golden eggs quite yet. The balance of power between state and private enterprise will shift a bit further to the state within OECD countries for a couple of years, and that is probably all that will happen.
- Are we going to curtail CEO pay? This is probably the deepest and trickiest issue of all. CEO pay has been increasing relative to other workers for decades now, and despite a lot of banter in the media about it, the politicians have let it happen. The basic problem is that pay has probably increased because managers have more control now over their organisation, yet they dont own the organisation and hence have needed to be excessively bribed by the owners to do the right thing. The underlying reason for the pay increase is probably that managers have become more powerful in their businesses: advances in internal information technology has meant most big organisations have been able to get rid of middle-management, with only a small layer of top-managers now pulling the financial strings of large organisations, aided by various automatic accounting levers and loads of low-level bureaucrats enforcing their wishes at lower levels. The loss of middle management means the loss of true internal alternatives to current management: only current management knows what goes on and is hence to a large degree irreplaceable. Yet, managers usually dont officially own the company, so the actual owners have no real alternative but to agree to enormous pay packages for CEOs. The basic problem of control being increasingly in the hands of people who dont own the organisation is what in my opinion has lead to greater CEO pay and its hard to see what can be done about it for most large organisations. The various options on the table all have their own problems:
- If you base pay on long-run performance (for instance by paying them for the stock value 10 years later) in the hope of putting the incentives towards the long-run then you run into the problem that this will be sabotaged by the managersm, who want the rewards whilst they are still young enough to enjoy it, not after retirement.
- If you base the pay on stock performance in the next two or three years in order to use market signals to inform the level of pay, you have the difficulty that this is a short-run incentive which the managers can game (i.e. they know much better than anyone else how to make the short-run profit streams look good even if the long-run health of the organisation is being jeapardised). Indeed, this is what has happened.
- Direct prohibitions on pay can be circumvented in many ways, for instance by having the organisation buy assets of the CEO at greatly inflated prices as part of the performance contract. If you wish to counter all the ways in which direct pay measures can be countered, you will thus need extensive legislation on nearly all the deals made by managements. This would involve interference in nearly all parts of the business.
- If you put government representatives on the Executive Boards of companies in order to keep an eye on the managers and circumvent the issue of buddies appointing each other to these Boards, then this is first of all a direct political interference in business but also means that the government becomes an even bigger target for political coopting, eventually undermining the credibility of government.
- Perhaps the best way out is to simply allow for high CEO pay but to have punitively high taxes for high incomes. Managers who then move abroad because of higher incomes are the kinds of managers you didnt want in the first place (because they are solely money oriented and hence were the ones most likely messing up the business for personal gain). Also, the market does have some mechanisms for self-correction, such as increased ownership concentration giving a single shareholder an incentive to monitor the CEO more carefully, though these appear not to have had much effect on CEO pays so far.
- Rule Brittania. I fully agree with Ingolf’s piece . The plan of the Brits to recapitalise their backs by means of voluntary additional preferential share floats is by far the most practical and best plan I have seen.
- Its voluntary nature means banks can opt out. Because the government only buys those shares the market doesnt buy at the going rate, the correct price is given by the market and existing investors are enticed to start investing again.
- It is also the option that has a clear exit-strategy: as soon as stability returns, the government can sell the shares on the open market and hence cease its interference.
- It is furthermore one of the few plans that dont mean the taxpayer is bailing out rich investors or managers. Indeed, I expect the Brits to make money on their plan since the value of the banks will rise fast once it is clear they wont fail, implying that the government can expect to make a tidy profit for the taxpayer on this plan. In all ways, the Brits got it right. The distance between high-class economists and policy makers in England has proven itself to be very small, something both the Americans and the Australians can learn from.
- Compare this to the abysmal plans of the Americans (and I fully agree here with Nick’s observations though I am less positive about detecting some hidden brilliance in Bernanke’s support for it). The original plan to have a reverse auction for bad assets of many diverse banks is incredibly hard to implement. You can only implement a reverse auction if the assets bidding against each other are roughly equal in terms of risk, which means you have to carefully credit rate all the assets sent to the auction. That cant be done in a hurry. You need a long time to credit-rate all the bad assets into homogeneous groups so that you can actually organise the auctions. There are immense lemons-market information asymmetries in the whole scheme, relating to the assets the banks will put forward and those they will actually bid for. Even once they are sold, the split in servicing and ownership (as I understand it, the original banks keep servicing the assets but cease to own them) creates free-rider problems. The heavy political interference also gives rise to immense opportunities for lobbying and political rent-seeking because the allocation of assets to risk-groups is highly sensitive to corruption. The original plan is thus an implementers nightmare and the plan is best forgotten altogether. It probably will be implemented in some form simply because too many people would lose face if it is not (including Bernanke and the US Senate). The combined plans of the Europeans via the G7 and G20 appear mainly made up of smoke and mirrors, so there is less to worry about there.
- The deposit guarantees handed out by various countries, including Australia, are far more difficult and onerous than they seem and should not be seen as good policies at all. If you truly guarantee all deposits, then the whole risk pricing system gets incredibly distorted and you end up with the danger that everyone sends you the bad assets because you guarantee them, whilst the good assets go elsewhere at higher rates. To be able to differentiate between private\bank deposits, national\international depositors, savings\non-savings is possible ex ante but is heavily subject to gaming after you introduce your guarantees. Hence the nitty gritty of these guarantees is full of thorny issues and I would hate to be the Australian lawyer having to draft this legislation. There are so many ways it can go wrong, that I almost hope these guarantees will quietly leave the table before they are implemented. Lets hope this was one of these spur-of-the-moment plans that dont actually happen or else have some self-destruct clause in them.
- Are we going to see some international system of financial regulation, like Bretton Woods? Despite the calls in this direction, I cant see it happen. The coordination would require developing countries to be on board too. At the end of the day, each individual country will opt out of anything they see as against their interests, with various countries benefitting from laxer financial regulation to the others. Hence a truly joint plan looks dead in the water before it is even floated. Good ideas, like the old Tobin tax idea to put a small tax on every financial transaction so as to discourage frivolous money flows and hence avoid the endless repackaging and re-selling we saw this time around, are still good ideas but the coordination needed is too much to ask for.
There are some truly staggering events that have taken place the last few weeks for which it is hard to give a satisfactory explanation. Perhaps most baffling of all is the behaviour of the US congress with respect to a half-baked rescue plan that entailed a direct transfer of the taxpayer (i.e. the middle classes) to the fairly well-off (your average investor). Just think about the basic message they swallowed: there is this thing called market confidence which my crystal ball tells me will return (i.e. no evidence at all) if I give money to the rich and tax the poor. Then market confidence can go back to saving the poor, even though it hasnt helped them the last 30 years (relative poverty has gone up in that period). The degree to which Democrats were lulled in relative high numbers to support staggering transfers to the rich says something about the gullibility of the elected. The alternative explanation, i.e. that they knew full well whose pockets they were lining in return for promises without guarantees, is too awful to contemplate. As the Brits show, you can devise a plan to restore confidence that costs the rich and probably means a benefit for the poor, rather than the other way around.