Tuesday, January 26, 2010

Politics in a nutshell

This morning, an Op. Ed article in the New York Times included the following:

[P]opulism is popular with the ruling class. Ever since I started covering politics, the Democratic ruling class has been driven by one fantasy: that voters will get so furious at people with M.B.A.’s that they will hand power to people with Ph.D.’s. The Republican ruling class has been driven by the fantasy that voters will get so furious at people with Ph.D.’s that they will hand power to people with M.B.A.’s. Members of the ruling class love populism because they think it will help their section of the elite gain power.

I think that about sums it up.

Sunday, January 24, 2010


Big Supreme Court cases are too unwieldy for a simple “rightly” or “wrongly” decided to mean much. Justice Stevens in dissent lists a whole catalogue of reasons why the Court should have resolved this case without reaching the issue of corporate speech per se. I have not read those arguments, not because they may not be persuasive but because I do not care if they are persuasive. Justice Stevens may be entirely correct that the Court should not have taken up this issue at this time, and a future Court may hold that everything this Court said about the issue was “mere” dictum, worthy of little or no jurisprudential respect. But that’s not what I’m here about today.

Likewise, Justice Stevens says that the decision does harm to the Court as an institution by procedural error. That’s a big deal, and, again he may be right. So, again, the case may well have been “wrongly decided” if, absent those errors, the result for the parties would be other from what it is. And, again, I don’t care about that today. This post is about what the Court should have done if the issue were properly before it, not about whether that was or was not actually the case.

The arguments in the opinions seem to me somewhat simplistic. Clearly, the First Amendment was intended to protect the political speech of citizens, and advertisements for or against a candidate are political speech. But, as the dissent points out, we restrict the political speech of soldiers, civil servants, foreign nationals, etc., and we don’t let people electioneer right next to polling places. These are things we do to serve other societal interests and with which we have made peace. Thus, it is wrong, I think for the majority to say that the BCRA is bad because it imposes “any” restriction on political speech, but the dissent is wrong to say that it is OK because it only slightly abridges the freedom of the press. Some slight abridgements are permissible, and some slight abridgements are not. The binary arguments of both sides strike me more as advocacy, not jurisprudence.

My own jurisprudential sense sides with Justice Stevens on the procedural side. The Court should do as little as possible, and that, it seems to me, makes it difficult to defend on jurisprudential grounds the broad holding in this case. But that leaves open the question of what the law ought to be in this regard, i.e., whether the Court's holding and dicta are good or bad for America, whether or not they were right or wrong for the Court to issue. These things are not always aligned, although one hopes that the most often are.

The law is always drawing lines, and the lines almost always do some injustice. Here’s an excerpt from a hypothetical corporate prospectus for XYZ Widgets:

The greatest obstacle to the success of any American widget company is competition from cheap Chinese widgets. This competition has driven virtually every American widget maker out of business. We believe that if American trade law were changed, an American company that is set up to make widgets would have a competitive advantage over others that have closed shop and moved on. To that end, we intend to use the first $100,000,000 of capital we raise to elect legislators and a President who support tariffs on Chinese widgets. Advertising in support of suitable candidates will be a key part of our strategy. Our success as a business depends on those legislative changes, and the use of our capital to achieve it seems to us the best possible use of that capital. Shareholders should, therefore, understand that their capital will be used to influence the outcome of elections.

Conceptually, I cannot imagine a legitimate restriction on the advertising that this corporation seeks to undertake. The political change is essential to the corporation’s success, the shareholders are aware of the proposed activity – and so don’t have to invest if they want someone else to be elected – and the ads are clearly political speech on behalf of the individuals with an economic interest (as are most political interests) in the outcome of the elections in question.

Practically, however, I see the problem. If this corporation can place ads, what about the corporation whose shareholders don’t share the views of management? It’s not always so clear which candidates do or do not support things that are in the shareholders’ interests. And what about pension funds and mutual funds? Many of us are invested in companies whose identities we do not know, much less their political machinations. And then there are labor unions, where the membership or contribution may be a condition of employment? Or non-profits whose contributors don’t all share management’s politics?

Assuming some of these entities can rightly be prohibited from some political action, where do we draw the line? Can we draw it so sloppily that it catches my electioneering start-up? Or must there be an exemption for truly voluntary enterprises that have stated their political plans for all to see? What about a donor-financed non-profit that has made the same disclosures?

PACs are intended to allow shareholders to band together to support candidates, but individual contributions to PACs and contributions by PACs are limited. For me, those limits vitiate any argument about how PACs allow shareholders to do what BCRA prohibits corporations from doing. If, however, the limitations on PACS were removed, and corporations that have disclosed their intentions to shareholders are permitted to use contribute corporate funds to PACS, I don’t think I would have much objection to a requirement that PACs be the conduit for political action money. But then, why bother?

As in so many things, transparency seems to me to the key here. If a corporation clearly has political interests, and it makes clear to investors what those political interests are, and no one is forced to invest in that corporation, then I don’t see why the corporation ought not to be able to use corporate funds to advance those announced interests. Right now, we have no such law, and the Supreme Court cannot write one. If this decision is seen as the Court’s way of getting that law written, and we end up with such a law, the correct philosophical view, I think, is not to assume that the Court wants or has enabled the wholesale use of corporate funds for political purposes, but only that it has said to Congress “give it another try.” Frankly, I have not, and may not read every word of every opinion in this case. It’s only as interesting to me as it is. So I cannot say whether the Court invites or does not invite Congress to take a Mulligan. But it doesn’t matter. Congress certainly will try again, and maybe this time, they’ll get it right.

The sky is not falling.

Monday, January 18, 2010

Who Shot John?

I have several objections to the efforts to assign personal responsibility for the financial mess. They all pretty much boil down to asking the wrong question, because the question itself proceeds from a bad premise.

That premise is that things will be all better if the person or persons responsible are “held accountable.” I do not believe that premise holds. We suffered a systemic collapse, and we need systemic solutions. Finding wrong-doers is necessary, but it is not sufficient, and it is not more important than finding systemic causes and fixes.

We build dams to hold back rivers. But what happens when there is a storm upstream, or unprecedented ice melting, or whatever, and the river comes at the dam with unprecedented fury? If the dam breaks, we can, and should ask why it broke. But that answer won’t help us if we have not dealt with the possibility that, if the dam had not broken, it would have been overtopped, causing some flooding anyway, or that the banks would have flooded, hurting the people who live along the river instead of those in the town below the dam. We must deal with the fact that the water had to go somewhere.

Now, we certainly don’t want our towns defended by dams that will not hold, so something must be done about the dam. If we can figure out whose contribution to the dam failed, we need to find a new contributor for that part of the damming process. But we ought not to fool ourselves: the real problem was the river. We need to be asking what we can do to prevent the river from coming down on us like that, and nothing else we ask should be viewed as more important than, or as a substitute for, that inquiry.

And even if we do identify a “culprit” – someone who should have done a better job – we need to find a way to prevent the person who gets that job next from being able to make the same mistakes. Probity and competence are nice, but systemic changes – regulations – are critical to counteract human foibles. To the extent that removing people becomes an obsession, fixing the system that made their bad behavior possible loses its urgency. So, again, actually naming names and lopping heads can be counterproductive, however satisfying it may be.

Consider one domino in the financial mess: the ratings agencies. They were, in my opinion, the guys whose part of the dam cracked. Goldman Sachs is accused of selling short against securities that they created, after “persuading” the ratings agencies to issue those securities high ratings. What if the agencies had said “no.”? What if no subprime-backed paper got AAA ratings? What if the ratings agencies announced that paper backed only by alleged property values (and by none of the usual mortgage underwriting tests) would only be rated AAA if it could withstand a 50% decline in the value of the underlying real estate? What would have been issued, what would have been sold short, what defaults could have been swapped, etc.?

I don’t know the actual numbers associated with the various things that went wrong. I’m quite certain that credit default swaps should have been illegal from Day 1, and that CDS contracts unrelated to mortgage-backed securities could have done enormous harm even without the sub-prime mess. But again, if I were at a ratings agency, I would never issue an AAA-rating to any security that could be backed by a CDS: the moral hazard imposed on the securities by the very existence of CDS contracts would be enough to make the security risky. Indeed, the mere legality or, at least the apparent, and so-far untested, legality of CDS contracts should have been enough to make ratings agencies unwilling to rate any paper as virtually risk-free.

But what are we to do about the ratings agency problem? To the extent that ratings agencies were corrupted or insufficiently vigilant by reason of their business model – issuers paying for ratings – we need a new ratings mechanism, something like the Underwriters Lab, where the people with skin in the game pay for the rating and demand toughness rather than accommodation from the agency. But that may not be enough, because I’m not sure anyone at the ratings agencies should have been able to dope out the moral hazard created by naked CDS contracts, and, especially those situations where naked short selling was used as an accelerant for torching the underlying paper.

To prevent the systemic risks, we need bans on CDS contracts and naked short selling. Those bans, I submit, would be more important than a change in the agencies’ business model. Not because changing the business model wouldn’t be a good idea, but because the business model has been in place for many years, and absent systemic threats like sub-prime lending and naked CDS contracts and naked short-selling, the occasional ratings error wouldn’t bring down the whole house of cards. Because there wouldn’t be a house of cards.

So even blaming the people that I blame the most for the mess – in terms of being the weakest link in the chain – would be a distraction from the systemic changes necessary to keep the dam from breaking. And even those systemic changes would be a distraction from figuring out what caused the flood, and whether shoring up the dam would have prevented the mess, or merely changed its shape.

My earliest posts to this blog were about the water – petro- and sino-dollars, but I have not tried to figure out where those dollars would have gone if we had not created phony AAA-rated paper to receive them. The answer, I think, is to financing the Federal debt, and the consequences of that deserve their own post or two. For now, though, I only want to say about that inquiry is that nothing in the blame game leads us to it – that Mr. Angelides’s lynch mob, charged with “inquiring” into the causes of the financial crisis, doesn’t seem at all interested, and that all this talk about taxing banks and bankers is a further distraction. When the scapegoat has been slaughtered, will we still care - have we ever cared - what really happened?

Saturday, January 16, 2010

One Cheer for the Bank Tax Proposal

Politics is a messy thing. In this country, it’s the art of getting stupid people to support good ideas, and that almost always involves lying to them in some sense. I oppose the bank tax because I believe it is an ex post facto bill of attainder – an unconstitutional twofer. Here are two responses to that argument:

1. Robert Gibbs, White House Press Secretary:

If you want to be on the side of big banks, then you're certainly — this is a great country — you're free to do so.

2. Lawrence Summers, White House economic advisor:

It's surprising to me to see institutions who have benefited so substantially at a time when there is so much economic distress among others in the country to be complaining about the justice of what has happened to them from their executive suites.

Neither response is a rebuttal. Neither says “No, it is constitutional.” Both say “Any stick is good enough to beat a dog.” This is how things are done in our democracy. Politicians defend their bad actions by attacking someone, by implying that anger is argument, which, since they know better, is lying.

But, as I said, given the limited intellectual resources of the electorate, one must lie to get them lined up on the right side, so it is hardly surprising or necessarily wrong for our politicians lie to us. How else could they govern?

I believe the bank tax proposal is a lie, too, like the unconstitutional proposal to tax the AIG retention payments retroactively. No one believed that that tax would pass, but everyone wanted to be seen as “for” it. In other words, the only way our politicians can “prove” that they hate bankers as much as we all should is to appear to throw a tantrum and propose that they be fed to the lions. Eventually, other politicians, who can then be painted as bank-loving jerks, will stop them, or an “out-of-touch” Supreme Court will throw the law out. There is thus very little down side to proposing a bad law that violates our principles to attack bad people.

The bank tax strikes me as special because it stokes anti-Semitism. So I do not approve even of the proposal. But for the sake of philosophizing, let’s take the parallel to Nuremburg off the table. Let’s suppose no one identified Wall Street with any particular demographic other than greedy bastards. The tax would still be unconstitutional, and I would still oppose it, but I’m not sure that I would think any less of the politicians who proposed it. That’s because there will be an anti-banker residue from the process that I believe is salutary, or would be if so many bankers weren’t Jewish.

Warren Buffett said this in an interview with the BBC:

If 50 of us were on a ship and there was a shipwreck, we all swam to an island, we knew we'd never be rescued - and fortunately it was a fertile island so we could all plant rice and grow enough to take care of ourselves. We would not take the five smartest people out of the 50 and tell them "why don't you start trading rice futures and speculate among yourselves", and by the way we think that's so valuable we're going to give you the most money and probably a favorable tax rate on top of it. Hell no, we'd get everybody producing rice.

We have too many of our best minds trading rice futures, and we are diverting too much of our GNP to compensating them for doing it. In a free society, we cannot and should not single out an occupation for a legal restriction on income. The power to impose such a limit is corrupting, and the temptation to engineer society by doing so would be overwhelming. It would be a bad idea.

But there is no reason that the people cannot hold their vultures in low esteem. We can certainly feel free to shame the rice traders when there is no rice being produced, in part because the human capital essential to its production – those best brains working on financial engineering – are misallocated. It’s no accident that Buffett, who describes himself as “allocating capital” for a living, would have strong views on the allocation of human capital as well as money capital.

Nor is it wrong for the President to use the bully pulpit to foment some of that low opinion. But it’s a tricky business. It will be messy, there will be excesses. There are always excesses. Still, as I wrote earlier, there is too much money to be made on Wall Street doing too little to enable the growing of rice. And the bankers have behaved badly, as might be expected when there is so much money to be made.

On the other hand, we do need bankers. And then there’s that Jewish thing. Ain’t nothin’ easy.

Thursday, January 14, 2010

The Road to Nuremburg II

Today, President Obama, upset about the "obscene profits" being made by big banks, proposed that they be charged a “Financial Crisis Responsibility Fee” so that the American people can recover the money they lost bailing out AIG and GM. (The President is taxing banks for the same reason Willy Sutton robbed them: that's where the money is.)

The fee is, of course, a bill of attainder aimed at Wall Street bankers, and like it or not, "Wall Street" means "Jewish" to a lot of bad people. Folks blame the mess on people and firms with names like Goldman, Sachs, Blankfein, Greenberg, Lehman, and even Dimon (who who isn’t Jewish but sounds like he might be, which is close enough for the torch and pitchfork crowd). The President’s plan, and the speech announcing it, validate resentment, and in so doing, give a green light to the mob to do its worst.

I know BHO was a Constitutional Law professor. But what country’s constitution did he teach? Implicit in his proposal is the principle that it is ok to tax those people that our politicians blame for our ills. That seems to me bad medicine, but if we are to adopt that principle, we ought to do it right. Why limit the evildoer's punishment to mere confiscation of assets? Certainly, some degree of opprobrium should attach and a way be found for the rest of us to spot and shun those responsible for our problems. I suggest that anyone associated with a taxed bank be required to wear some emblem - I'm thinking a green arm-band with a dollar sign on it - to indicate that he is responsible for the financial crisis and ought not to be treated by ordinary citizens any better than he is treated by their government. That is the point, is it not?

Just a thought.

Wednesday, January 13, 2010

Wall Street Pay

This is another reductionist exercise. I don’t care what people on Wall Street make. But I am interested on why they make so much, and I want to apply a reductionist analysis. They are obviously doing something for which the demand exceeds the supply. What is that thing, and why the imbalance?

My starting point for almost all inquiries into new phenomena is “What’s changed?” Why is there so much money available and so much money paid, relative to the past? These questions assume that Wall Street pay is in fact higher than it used to be. I’m going to take that as a given. If I’m wrong, then never mind.

I have already identified one component of the problem: the trade deficit causes money that would ordinarily flow through Main Street to flow through Wall Street instead. I should take this opportunity to add a second point, which is that personal savings in this country has come more and more to mean pension accounts of some sort, and most of that money, too, flows through Wall Street and not Main Street. All of the money wants securities, so the securities industry is where the money goes. That’s why there’s so much money available for Wall Streeters to siphon off for themselves.

But why are money managers and traders paid so much? Why aren’t there thousands of them chomping at the bit to work for a nice six-figure paycheck? Why eight, nine or ten(!) figures? I’m thinking it’s the law of diminishing returns.

Remember The Bell Curve – Herrnstein and Murray’s book that everyone thinks was about race but wasn’t? The Bell Curve was about the skewing of rewards in our society toward the brainy end of the spectrum. For whatever reason, it appeared to the authors that we were developing a bimodal income distribution, with a big and growing divide between the manual labor class and the intellectual labor class. The divide was especially ominous because the entry of women into the workforce was reducing social mobility. Doctors marry doctors now, not nurses; lawyers marry lawyers, not secretaries. Remember when there were secretaries? Remember when smart women were teachers? But I digress…

Anyway, the world is paying more and more for smarts, and the reason, I submit, is that the law of diminishing returns applies to intellectual projects. Consider legislation. How hard is it to come up with a law against murder? Over time, just about all of the obviously necessary and easily constructed legislation has been constructed and enacted. But there is always an ongoing battle between the law and those who would avoid it (not evade it, which is a matter of policing, not legislating). So legislators need to be smarter. But they aren't getting smarter, because we'er not smart enough to raise their pay enough to attract smarter people. Read any good laws lately?

Here’s Jules Verne on two characters in From the Earth to the Moon:

“Now if Barbicane was a great founder of shot, Nicholl was a great forger of plates; the one cast night and day at Baltimore, the other forged day and night at Philadelphia. As soon as ever Barbicane invented a new shot, Nicholl invented a new plate…. Which of these two inventors had the advantage over the other it was difficult to decide from the results obtained. By last accounts, however, it would seem that the armor-plate would in the end have to give way to the shot; nevertheless, there were competent judges who had their doubts on the point.”

The weaponers vs. the armorers. The eternal struggle between problem and solution. The better the solution, the trickier the next problem. But just how smart were Messrs. Barbicane and Nicholl, or, more to the point, how smart were the people they hired to do their R&D? And how much did they pay them? How much would they have to pay them? And wouldn’t the price rise as the task got harder, as the ability to think up the next solution became rarer and rarer?

And what else could those very bright people be doing? The world is their oyster. Why gun-making or plate-making? Why banking? Why software? Some people, of course, work at what they like, and money isn’t everything. But money biases decisions:

The graduate with a science degree asks," Why does it work?"
The graduate with an engineering degree asks, "How does it work?"
The graduate with an accounting degree asks, "How much will it cost?"
The graduate with an arts degree asks, "Do you want fries with that?"

And Wall Street has the clearest path to riches for the very bright. Because the amount of money there is growing rapidly, and because the benefit of a small advantage is measurable in dollars, and because only a few people can create even small advantages now that the easier questions have long since been answered.

The easy questions are those relating to the allocation of capital. Howard Dean recently said in an interview that his family worked on Wall Street for generations, but that they were in the business of capital allocation (that’s what Warren Buffett says he does for a living, too), and now Wall Streeters are in the business of financial engineering. Dr. Dean sees financial engineering as unproductive, as compared to capital allocation, which he, rightly, considers a very important function in a capitalist system.

Dr. Dean is right and he is wrong. Many money managers do get paid to allocate capital, to keep it flowing from weaker industries to stronger ones. But there is also a lot of money to be made by exploiting tiny market-inefficiencies that are, in the scheme of things, too small to matter, but nevertheless, with the right technology, can add up to handsome profits for socially useless effort. The brains are being used not to detect inefficiencies, but to detect them milliseconds more quickly than others. As if that really matters to the allocation of capital. That, I think, is why people are so pissed off at Wall Street. You can make a lot of money there doing nothing that needs doing. Not only is it a waste of the money you make, it’s a waste of the talent you employ.

Most people who think Wall Streeters are overpaid cannot articulate why they are overpaid, because they don’t know what they do. But that’s the point. The contribution these financial engineers make to the general economy doesn’t seem to be worth the compensation. It can’t be, or there would be some tangible evidence. It’s not just that financial service companies deal in intangibles. People seem not to resent venture capitalists. They don’t even resent mutual fund managers, who really do allocate capital. No, it’s the ones who just appear to be fixing unimportant anomalies that get their goat.

Of course, there is always a baby in the bathwater. There is something harder than the allocation of capital that is also an essential function of Wall Street: the transmogrification of capital. Investment bankers used to match up risk-takers with risk-creators. Now they match up risk-avoiders with risk-creators. That’s a very much more difficult thing to do.

It started with ERISA, the Employee Retirement Security Act of 1974. That law required that all defined benefit pension plans be funded and that virtually all retirement plans of all kinds be prudently invested. By fiat, a major portion of the capital of the United States was being told what level of risk it could take. But that did nothing to change the kind of risk that entrepreneurs were creating. The capital structure of American business had to be reshaped so that the demand for capital matched the capital available, not only in amount, but in style, where the style was changing rapidly from risk-taking to hyper-risk-averse.

A review of the 1970’s and 1980’s will reveal, I think, capital structures divided into two parts: (i) as much low-risk, senior paper as could be generated, and (ii) a high-risk common stock element. And the LBO was born – leveraged buy-outs, where the (relatively) careful money took the debt and risk takers remaining in the economy – the rich getting richer – took the risk. Of course, the risk was nowhere near as great as the price it could command with so much of the money tied up in “prudent” investments. So there was lots of money to be made by the common shareholders, and so lots of money available to pay the investment bankers who created the debt. Junk bonds were everywhere, and the paychecks were fat, indeed.

In the last decade, the sovereign wealth funds of our trading partners have augmented the pension funds, taking even more risk capital out of the system and also preferring to buy as much safe paper as possible. As the law of diminishing returns teaches, the more prudent capital there is to invest, the harder it gets to find prudent investments. Really, really smart people were needed, people who could demand a lot of money for putting together really complex deals. And they could get a lot of money because the investors were more concerned with safety than return.

This sort of financial engineering is really quite valuable to the economy, because the idea of “allocating capital” per se begs the question of how risk tolerance, and if there is a big mismatch between the risks being created and risks investors will take, financial engineering is the only solution. ERISA and the trade deficit created the need for that engineering, and the more money flows into those capital pools, the more money there is to be made allocating it, and the harder it gets to do so. The natural result is that the people who are ready, willing, and, above all, able, to perform these feats stand to earn enormous amounts of money.

But that's just the baby. There’s still that nasty bathwater of useless trading and the corruption that attends so rich a pot. This post has run on too long already, though, so…

Financial Crisis Inquiry Commission

What joke!

I don’t even know if there was a Katrina commission, but if there was, and I was on it, I would first ask “why were the levees inadequate?”  If the guys running the FCIC were running that commission, their first question would be “Well, Brownie, what was the worst thing FEMA did?”  At least that’s what Chairman Angelides thought the world most wanted to kno about the financial crisis: “Specifically, Mr. Blankfein, what two negligent or wrong things do you most have to apologize for?” or words to that effect.

The whole idea that this commission starts with organizational issues at the investment banks, rather than the macroeconomic environment in which they operated, blows my mind.  Of course, the day is young, and only the most political members of the commission have spoken as I write this.  But the fact remains that the first panel of grillees consists entirely of scapegoats, when it should, of course, consist of scholars.  We can get to the bad actors – some people certainly misbehaved – but no one operates in a vacuum, and this Commission’s indifference to macroeconomics, or, to put it more bluntly, its lust for fault, is simp0ly embarrassing.


Friday, January 8, 2010

The Road to Nuremburg

CNBC reports that Goldman Sachs has been sued by a pension fund and an individual in Illinois over the bonuses it plans to pay (has paid?) for 2009. These are odd suits, filed by shareholders in a company whose stock doubled in 2009.

I’m not much of an alarmist, but I must say that the focus of the financial mess on firms with Jewish names or Jewish leaders has been, as we say, very bad for the Jews. I cannot help thinking that in the same way that right-thinking Americans have gone to court to fix things that legislatures won’t touch – think Brown v. Board of Education – wrong-thinking ones are doing the same thing, trying to do in the courts what Hitler did with the infamous Nuremburg laws.

As a wise man once said, our weaknesses are just our strengths taken to excess: we all have the vices of our virtues. A court system that remedies social injustice is such a strength; it is an important national virtue. As such, however, it is a cause for vigilance lest it be subverted, and this suit sets off alarm bells for me.