Tuesday, November 24, 2009

A Failure of Imagination

Robert Nozick said somewhere that, "Lack of invention is the mother of necessity". As a philosopher, he was talking about the existence of necessary metaphysical truths, but I love this quote and I think it applies perfectly to our current economic and political situation as well. Despite all the things that have happened to our country over the last decade to highlight the problems with our system, we seem completely incapable of imagining any other way of doing things. We are nothing but a tired and fading empire too set in its ways to make substantive change or adapt to the rise of the new forces we ourselves have unleashed. At best we can hope for the dignified senescence of Europe or Japan. At worst we can expect the cycles of repeated collapse common to the rest of the colonial world. In either case, we should admit that we have marched West as far as we can, till we piled up huge castles made of sand on the coast of California and watched its bloated dream topple into the ocean.

The great American experiment is over.

From such an introduction you might expect that I have something profound and new to say about our culture. In truth, though, it's the same story as ever; we have simply run out of steam, and the apparatus has been captured by those seeking to enforce the status quo. This capture goes very deep, and has many faces, ranging from the mechanism by which we elect our politicians, to the ideology of our conception of governments and markets, to the way in which we desperately cling to our bankrupt financial system. But today it's this last bit of capture that serves to best illustrate all these aspects at once.

Morgan Stanley has spoken, and Simon Johnson has talked back. They argued that higher capital requirements for our banks would serve to limit economic growth. And he points out that this is a huge load of shit for three very good reasons.

The essential premise of the Morgan Stanley reasoning (heard much more widely on Wall Street) is that the size of our biggest banks cannot be constrained – because it would raise the cost of equity for these smaller units. This misses three points:
  1. If you are sufficiently small, you can take more risk without jeopardizing the system. So the expected risk/return combination can attract investors and be fine for society. Most successful venture capital funds, hedge funds, and private equity funds are in the right size range from this perspectives and don't have trouble attracting capital – except when the big banks blow up. As long as you are small enough to fail, go for it.
  2. Morgan Stanley's pricing of risk model implicitly assumes that big banks still exist as a comparison point and an alternative for investors. But if you put a size cap on the largest banks (e.g., assets cannot exceed 1% of GDP), this defines the asset class available – so investors don't choose small vs. medium vs. large; they choose small vs. medium. Yes, this removes a choice for investors, but we routinely constrain investors ability to put money into activities that are potentially dangerous for society (e.g., try proposing a "new" high risk/high return approach to nuclear power).
  3. There will always be financial shocks, but these do not always need to have such devastating effects. Our financial system worked fine in the post-World War II period, with a great deal of risk-taking and much nonfinancial innovation – our biggest banks were much smaller, in absolute terms and relative to the economy. The notion of "let us take any risks we want and, if it all goes bad, bail us out so we can make it up to you later" is simply preposterous and completely at odds with the historical record of US economic development.
But look what's going on in this argument. It's easy (and obvious) to observe that this is just Morgan Stanley talking its book. It goes way beyond that however. For one, them talking their book is going to become a Republican talking point almost instantaneously, illustrating the capture of our political system. For another, the idea that we need a modern banking system for economic growth is theoretically questionable, and practically, just plain proven wrong by the breakneck growth of China, who doesn't have one. And finally, even if you gave up those first two points, you can see how the whole things revolves around the premise that Morgan Stanley has to be one of the profitable necessary banks underwriting our economic growth.

In fact, we could need a banking system that has the potential for high returns, that finances high growth, and yet that, in aggregate and over time, can't turn a profit. In other words, even if we need a banking system as big as the one we have, there's nothing indispensable about the individual banks, and indeed, the best system is probably one so competitive, so commoditized, that they never turn a profit as a group. Consider the airlines. Plenty of flights. No net industry profit over time. Some are good, some are bad. New firms come and old ones go, and ... well .. that's what we call a market. So now you have finally reached total ideological capture, where the idea of market has become synonymous with a government guaranteed return for a chosen set of 'necessary' firms.

Like I said, the great American experiment is over.

No comments: