A new era of bank runs?

From the early years of the Industrial Revolution until the beginning of the Depression, bank runs were quite common. Every ten years or so there would usually be a banking panic which would generally result in an economic collapse. The result was a boom-and-bust cycle that can be seen in the first half of the chart on the right. After World War II, however, bank runs stopped happening, which was a big reason why the US enjoyed a long period of economic stability between 1946 and 2007 in which GDP never fell by more then 2% from year to year. The death of the bank run is generally attributed to FDR's New Deal reforms, which created the FDIC and significantly limited the degree to which banks could engage in speculation.

In 2008-2009, however, we saw a new phenomenon: the shadow bank run, which this New York Times columnist argues will continue to happen in the 21st century. The so-called shadow banking system--involving instruments of short-term credit that are not guaranteed or subject to the same regulations as traditional banks--now accounts for more than $15 trillion in assets, up from $4 trillion in 1990. Along with the trillion-dollar derivatives market, the shadow banking system can accumulate an enormous amount of short-term risk--not just for investors but for the entire economy. A rush to withdraw from money market funds or a sudden pulling of credit between banks can cause a crash just like in 1893, 1907, or 1929.

The solution is not to extend government guarantees beyond traditional banks, since that would create the possibility of bailouts that would dwarf the ones that happened in '08-09. But we need to figure out some way to better protect short-term credit so that we will not enter into a new era of bank runs and boom-bust cycles. A volatile economy like the one we had from 1890 to 1930 tends to hit the middle class and working class the hardest, leading to increased poverty, more economic insecurity, and more demand for welfare programs. Needless to say, that would be bad.

Maximizing shareholder value: the "dumbest idea in the world"

In his book "Fixing the Game," business school dean Roger Martin introduces the idea of an NFL coach who is paid not according to wins and losses, but instead according to whether his team covered the point spread. He pictures the coach holding a Wednesday press conference to convince analysts that the point spread should be moved up or down, or the team's quarterback apologizing for only winning by 3 points when the spread was 9 points in their favor.

In this Forbes article, Steve Denning argues that large businesses today are similar to that hypothetical NFL team, where CEO's and managers have much more incentive to focus on improving stock prices rather than improving their products and making real profits. He describes a shift that took place in the 1970's and 1980's  where companies began to prioritize shareholders over customers and employees. One thing that drives this is the fact that most CEO's are compensated largely in options or stock based incentives:
    "What would lead [a CEO] to do the hard, long-term work of substantially improving real-market performance when she can choose to work on simply raising expectations instead? Even if she has a performance bonus tied to real-market metrics, the size of that bonus now typically pales in comparison with the size of her stock-based incentives. Expectations are where the money is. And of course, improving real-market performance is the hardest and slowest way to increase expectations from the existing level." 
    Also, Denning points out an obscure accounting regulation which forces the write-down of a company's real assets if the share price falls significantly, thus mandating that CEO's give significant concern to managing expectations.

There are also the stories (which progressives love to tell) of profitable companies slashing benefits or outsourcing jobs simply to make more profit. While a movie villain might do this simply to pocket more money, in the real world it is quite valuable to have satisfied and motivated employees, so an employer who is already making money would need a very good reason to do this. One reason, though, could be concern over stock prices. If the company's managers felt like they needed to cut costs to meet quarterly numbers or raise short-term expectations, they might outsource jobs or cut benefits even when making a profit.

Ironically, the emphasis on maximizing shareholder value has coincided with a decline in corporate performance since 1976. The idea may very well have contributed to the rash of accounting scandals in the early 2000's. It also gives Wall Street an inordinate amount of power over the economy. Perhaps we should listen to Jack Welch, who called this emphasis on maximizing shareholder value "the dumbest idea in the world."

Denning recommends several actions that may convince employers to shift their attention back from the stock market to the real market: eliminating the regulation that forces the write-down of assets due to falling stock prices; forbidding executives from selling stock in their company until 5 years after leaving their posts (thus limiting the incentive of stock-based compensation); and putting more restrictions and regulations on hedge funds which benefit from market volatility. I don't know if any of these are the right solution. But I do think that this over-emphasis on the stock market is a threat to the capitalism that made America great.

Obama: A President For the Big Guys

By his own account, Obama is a protector of the little guy. However, when you look at who has actually benefited the most during his administration, the exact opposite becomes true. The two clear winners of the Obama presidency have been big government and Wall Street. The losers? Workers, small businesses, and small banks.

While Obama may denigrate Wall Street as "fat cat bankers," according to the Washington Post he has raised more from Wall Street than all of the Republican candidates combined. Not only that, Wall Street firms have earned more in the first 2 1/2 years of the Obama administration than they did during the eight years of the Bush administration. Think about that for a second. Under Obama, Wall Street has made three times as much money per year in a historically bad economy than they did under Bush in a generally good economy.

Smaller banks? They haven't fared as well. Regulations like Dodd-Frank are far too watered-down to prevent the problems that caused the 2008 financial crisis, but they are complex enough to force small banks to spend inordinate amounts of money on compliance.

And then there's big government, which now employs 140,800 more people than at the beginning of Obama's tenure. Obamacare has given unprecedented power to government officials--however, its passage in March 2010 was followed by a sudden halt in private-sector hiring. I don't see this as a coincidence. Again, big businesses have the resources to give government-approved health insurance to all their workers. But small businesses--the country's top job creators--often do not. The thing is, small businesses are only exempted from Obamacare cost burdens if they have less than 50 workers. So basically, Obama's message to small companies with 30-40 workers is "Don't expand, and stop hiring." Interesting message coming from a president who claims his top priority is jobs.

Speaking of jobs, a Canadian company wants to build a pipeline from Alberta to Texas that would employ over 20,000 workers. Obama, however, announced that he is delaying approval until 2013--after the elections. It seems that appeasing environmental activists in an election year is actually more important to Obama than jobs. I would almost understand it if he killed the project because he truly thought that a pipeline would do too much damage to the environment. But punting until 2013 just gives the impression that he is too cowardly to make a decision that might offend special interest groups. Winner? The environmental lobby. Loser? Once again, American workers.

"Occupy Wall Street" protesters call for more use of force by government

At first glance, I liked the idea of the "Occupy Wall Street" protests. I agree that Wall Street currently has way too much power (in a previous post, I compared Wall Street to Orren Boyle, the conniving crony capitalist villain from Atlas Shrugged). However, it seems that the protesters are completely misinformed about the source of Wall Street's power, and some of the "solutions" they proposed were fairly frightening.

Journalist and anti-war activist Adam Kokesh interviewed several of the protesters in DC. Many of them called for additional government regulations and the re-election of Obama. This seems a bit odd, considering the number of Wall Street operatives in Obama's cabinet, and the fact that one-third of the money he has raised so far for his 2012 campaign has come directly from Wall Street. These protesters seem to think that somehow a candidate that is bankrolled by Wall Street can effectively check Wall Street's power. They fail to understand that Wall Street has so much power largely because they have bought off so many people in government--and have received lots of sweetheart deals, loopholes, and bailouts in return.

While that is puzzling, this sign that was being carried at the protest is disturbing. It reads: "A government is an entity which holds the monopolistic right to initiate force." One of the protesters that Kokesh interviews also says that he supports the use of force by government if it will "maximize social justice...maximize freedom...and improve the lot of everyone." I believe that is very similar to the argument used by Hitler to pass the Enabling Act. And besides, how can people rail against Wall Street having excessive power...and then call for an even more powerful institution, the government, to use force? Do they actually want a totalitarian government?

Putting a leash on Wall Street

Traditionally, the function of the financial sector has been to provide capital for business. Over the last few decades, however, it seems that Wall Street has become much more than that. As William D. Cohan argues in this Bloomberg article, Wall Street has now become a huge casino--with speculation, hedging, and arbitrage instead of craps, blackjack, and roulette--where the players get to make bets that have consequences for the US economy but not for themselves.

In the past, Wall Street transactions mostly consisted of actually buying and selling shares of companies. Recently, however, we have seen an explosion in derivatives, which allow investors to speculate on the price of shares or commodities without actually buying the shares or commodities themselves. Credit default swaps, a type of derivative, played a huge role in the credit crisis of 2008. Even Warren Buffett has called derivatives "financial weapons of mass destruction."

Even worse is the concept of "too big to fail." Currently, Wall Street bankers have no consequences for making risky investments--they are rewarded with huge bonuses if the bets pay off, and with bailouts if they don't. Some people think that the banks should simply be allowed to fail. The problem is, if letting the banks fail could lead to economic disaster, that's still an awful situation. People on Wall Street should not be able to take risks that could submarine the whole economy if they fail. Banks that are too big to fail are too big, period, and need to be broken up. Reinstating Glass-Steagall would be a good start.

What is the government doing to prevent another financial crisis like what happened in 2008? Predictably, nothing. Wall Street simply donates too much money to candidates of both parties. Oh, and most of Obama's economic team has ties to Goldman Sachs. The Dodd-Frank bill claims to be "finance reform," but it specified almost nothing and left the reforms up to a team of bureaucrats. The best way to guarantee that nothing good will be accomplished anytime soon is to leave something up to a team of bureaucrats.

Some libertarians have compared the current American economic situation to the events of Ayn Rand's Atlas Shrugged. In that comparison, Wall Street--along with Fannie Mae and Freddie Mac--would be the obvious choice for the role of Orren Boyle, the incompetent businessman who keeps himself afloat by using his connections to get constant favors from the government. Although Wall Street is not incompetent, they have been taking way too many risks that endanger the whole economy. Government has only been encouraging those risks, and in some cases (e.g. housing) mandating them. It's a classic case of crony capitalism.