December 03, 2009
It's The Market Too, Buddy
Posted by David Zaring

There's lots of commentary out there on the financial crisis, and some of it, e.g., the WSJ editorial page, Charles Calomiris, Russ Roberts, John Taylor, Greg Mankiw, to name a few, is focused on identifying the ways that government policy precipitated each and every one of the problems.  In some of this there is a moment where trust in markets and competition (which I share) blends into unfalsifiable blind faith, and so I wanted to launch a screed about it.  It's the kind of thing I try to shy away from, because it turns on economic analysis, and I'm certainly not an economist, and nowhere as bright an economist as some of the blame government crowd.  But when they do blame government, they aren't for the most part, writing papers, they're just opining.  I can do that, on occasion.  And there are far too many of these Johnny One Notes out there. 

To see why I think the "blame the government alone" crowd is unpersuasive, you might ask yourself whether there were private market participants who suffered because they backed or shorted, with their own money, the government policies that these observers try to characterize as the entire - not part of, but the entire - reason for the financial crisis.  And indeed, you can always find such participants (not sometimes, but always - every single time), people who had skin in the game, on each side of every government policy, which isn't surprising; indeed, it just strikes me as Coasean. 

Often, this exercise is easiest to do by looking to the shareholders and employees of the institutions that suffered most during the crisis.  These people lost lots of money.  They made mistakes.  And so pretending that if only we had more market discipline then we wouldn't have had a crisis is, at best, naive.  There was a market out from every single government policy that has been blamed for causing the crisis that has not been taken. Consider:

  • Frannie - the government-sponsored enterprises sponsored overinvestment in housing.  When they failed, their creditors got bailed out at 100 cents on the dollar.  Their managers, however, got fired, and their shareholders lost everything (that is, the stock's value declined 95% over the past five years).  Frannie's shares traded on an open market, and the people who bought and held those shares had every reason to ensure that the company did not overlever in a way that led to its failure by the government.  But they failed to do so.  Where are the cries of market failure?
  • Bear Stearns - the government's engineering of a sale was of little comfort to former CEO Jimmy Cayne, whose billion dollar fortune declined 90% in value.  Why were his market incentives insufficient to steer the company along a course of safer lending?
  • Bailouts of too big to fail banks - again, one might ask how Citigroup's shareholders feel about its TBTF status.  Good?  Their investments have also declined in value by 91% over the past five years.  To long-term investors, what happened to Citigroup is essentially exactly the same thing as failing.  But they nonetheless did not steer the bank on a course towards solvency - even though they owned it.
  • Deposit insurance - depositors don't care if their banks take risks.  But can you think of anyone else associated with a bank who might?  And some kind of market indicator that might, in theory, respond to excessive bank risk taking?
  • Badly designed and applied capital adequacy standards from Basel - As ineffective as these were, it's worth noting that left to their own devices, banks give the impression that they would lever up much, much more than Basel permitted.  As far as I can tell, there isn't a single shareholder or CEO of a bank who insisted on the bank holding sufficient capital, except maybe Jamie Dimon.  And, if I'm not sounding like a broken record yet, these people (employees and shareholders) get fired and lose money when stock prices go to zero, which they did regardless of whether the banks were Basel I or II compliant or not.  If the regulatory rule isn't effective, shouldn't market discipline have solved that problem?  I thought that was the entire point of the Coase Theorem.
  • Mark to model accounting - Some people act like abandoning mark to market accounting is a crime against capitalism, and it sure is dodgy, but there is something to the idea, shared by anyone who owns a house, that net worth needn't be recalibrated daily for assets that won't be sold.  Many banks, even some small enough to fail, have both benefited from the change to mark to model, and at the same time managed to raise more capital from private investors, who are completely welcome to stay away or sell the stock if they think that any departure from mark to market means that institutional valuations have become fictional.
  • The brief short ban - I'm no fan of these sorts of bans, but the idea that market discipline requires the ability to short stocks at all times seems pretty unlikely to me.  Stock can always be sold, even if it cannot be shorted. And consider privately held startups.  You can't short or sell them.  But it is still possible that they are exposed to market discipline by the potential consumers of their products, and financiers of their growth.  It might be possible to analogize these sorts of institutions to financial intermediaries.
  • The hedge fund industry counter-example - Hedge funds have done better than banks throughout the crisis, and they are less regulated.  But have they done better than thrifts?  Community banks?  Defense contractors?  They're all pretty heavily regulated industries, and they also did better than the big banks.  In addition, remember that, in the "nobody knows anything" spirit of this post, the hedge funds deemed before the crisis to be among the best, like Citadel and Greenlight, not to mention Pershing Square, did the worst.

You get the idea.  There is not a single government policy out there that didn't have market participants on either side of it.  Government policy may have contributed to the crisis, or it may not have, but there is no question - none, in my view - that there was market discipline that in every case could have corrected for the government policy, but failed to do so. 

Relatedly, I take it that this is why people like Lucian Bebchuk have tried to explain the crisis by noting that government policy, or even mere leverage, can mean that equity holders and employees don't suffer all of the consequences of all of the risk they are taking.  There is something to this - employees compensated annually, and close to retirement, may not care if their employer has a good 15 year plan in place, but creditors might.  But without wanting to be glib, I don't think that many people think that the possibility of losing everything is a requirement of efficient markets.  Consider prediction markets.  Economists love those, but I imagine that not every participant in them stakes their entire net worth on their bets.  Or consider Steve Jobs.  He has a lot of his net worth tied up in Apple.  But does he have all of it there?  I wouldn't want to argue that he's incapable of caring about the fate of the company given that, regardless of what happens, he will still have a $50 million nest egg.  But I think that is exactly what Bebchuk, et al., are arguing.  This screed is not about that case ... but with Bebchuk style arguments being made by the government-critiquers, it is worth thinking about its limitations.

All right - enough armchair economizing from me.  But enough of private sector expiation from anyone else.  These people and institutions are not victims, they are, at least in some ways, perpetrators as well.  And that is why I do not view the crisis as a call for deregulation.

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