Two Simple Policy Goals

Maybe I'm simple minded but I don't think that policy has to be terribly complex.  

A great test of your economic policy is how easily someone can start a new business that has a legitimate chance of creating wealth and jobs.

A great test of your social policy is how easily a single mom can raise a child who has a legitimate chance to be happy and productive.

Doing well on those tests is not trivial. If you are successful at popularizing entrepreneurship you have a great education system, easy access to capital markets that are well regulated and reward people who invest well and punish people who abuse investors or borrowers, and stable, predictable laws around property and wealth. Your culture embraces disruption and protects losers enough that your community has little resistance to new companies, technologies and industries and welcomes change. You have things like universal healthcare so that would-be entrepreneurs face less risk when they take on the risk of a new business. Your culture sees social invention and product invention the same way: you keep improving what you have and looking for new ways to reach old goals more effectively, whether that goal is to store fresh food for longer like a fridge now does (and like some other technology may do in the future) or create meaning and community like a church now does (and like some new social invention may do in the future). 

If you are successful at making it easy for every parent to raise a child, this again has many policy implications. People have easy access to birth control and abortion so that they can easily control when they become a parent. Maternity and paternity leave is generous without penalizing companies that employ young people who are more likely to be starting careers and families. Childcare is affordable. Jobs can be customized. (The Netherlands has brought birthrates back up by offering more flexible job options: many parents (mostly mothers) work part-time.) You have a vigorous defense of the environment, minimizing the probability that children will be exposed to threats that might not show up for decades.

Rather than penalize entrepreneurs who would create jobs and wealth by making them jump through hoops,or ignoring the fact that their educational needs are just as real as those who would pursue a vocation or white-collar job, the community should make it easier for them in a host of ways, from mentoring programs to bureaucratic aides to help them through necessary legal, financial and regulatory hoops. Rather than penalize young mothers who would raise up the next generation of workers and citizens, the community should make it easier for them in a host of ways, from mentoring programs to childcare along with logistical and emotional support to help them through the various challenges of parenting.

If your mothers are raising the children they aspire to raise, you'll have an emotionally whole and productive citizenry. If your entrepreneurs are creating the businesses they aspire to, you'll have steadily rising wealth and income and strong job markets that enable the community to finance personal things like fine meals and communal things like beautiful parks and good roads. If you focus on making life easier for single mothers and entrepreneurs you will automatically make it easier for two-parent families and no children families. If you focus on making it easier for entrepreneurs, you will automatically make it easier for employees and investors.


The policy implications of these two goals - the various programs and initiatives that would help further us towards these goals - could be continually enhanced by - among other things - running focus groups with real and aspiring entrepreneurs and real or aspiring single moms. Asking them what would make them more successful, what obstacles and frustrations the have, what their needs are and sorts of resources they need would help to inform policies that could make a difference. Tracking the efficacy of these policy initiatives to determine what makes the most difference for the least time and money could be used as further feedback about which policies to continue and which to let die. With these two goals, a community could continuously experiment to see how best to achieve them. It's hard to imagine how such policy experiments wouldn't make the community better for everyone.

Two Financial Regulation Models: NFL or WWE

One of the most dangerous things about a Trump presidency is what it could mean for financial regulation.

This weekend millions of Americans will watch football, a sport punctuated by flags, whistles, and officials calling back a run because someone cheated when blocking or granting yards on a failed pass because someone cheated when defending a receiver. The game is fiercely competitive and highly regulated. Americans love it. The teams want your money but they also want to win. All of them. And they have to follow clear rules that ensure that the competition involves football skill, not thuggery.

Far fewer will watch World Wrestling. Entertainment. At the WWE, the officials are props who circle the fighters and hopelessly flail, even when one of the fighters grabs a chair to hit the other over the head. This game is not competitive, as winners and losers are often negotiated beforehand. It's rigged. The wrestlers want your money but winning or losing is just part of their job. It's less about competition than theater.

Trump has hosted WWE events at his properties and has body slammed a guy whose head he later shaved. He and the Republicans in Congress largely believe that financial markets are self-correcting and don't really need regulation, suggesting that their ideal referee is more WWE than NFL.

Let's review what that means and start with a review of the Great Recession because it is so easy to forget.

The Great Recession
After January 2008, employment fell for 25 straight months - the longest streak since the 1930s. By February 2010, the "job deficit" was 12 million. (The job deficit equals the number of jobs lost plus the number of jobs that would have normally been created during that time. The economy destroyed about 8 million jobs in a period when it would have normally created about 4 million. Add them up and you're short 12 million jobs compared to any normal period.)

Long-term unemployment as a percentage of unemployment swung between 5% and 20% of total unemployment in the period after 1948. By April of 2010, it had hit 45% and would take years to drop to its old level.

GDP growth, too, was slow to recover. After the last two recessions GDP grew 6.2 and 5.6 percent in the years right after the recovery. This time it grew about 2%.

Between housing and financial assets, wealth fell about $18 trillion, an amount equal to annual GDP.

[All of these stats from Alan Blinder's After the Music Stopped: the financial crisis, the response, and the work ahead.]

These seem like cold stats. They're not. They represent millions who were made homeless, had careers and retirement plans derailed, and were unable to do things like help children with a college education or buy a car or pay a medical bill. They represent millions whose lives were set back. According to one study, the trauma of the Great Recession provoked 10,000 suicides and that is just the most extreme emotional consequence of an economy this brutal.


What Caused this Financial Crisis?

I think that a few things caused it.

Martin Wolf writes of the lead up to the 2007 - 8 Great Recession that "risk had been distributed not to those best able to bear it, but to those least able to understand it." Local bankers were less likely to own mortgage loans than remote investors.

Securitization let banks take loans and then turn them into securities that could be sold to investors who did not understand the underlying risk as well as local bankers might have. Coupled with loose regulation that allowed banks to issue NINJA loans (loans to folks with no income, no job, and no assets) that were then sold to largely ignorant third-parties who were misled by credit ratings agencies who called these good risks. (Michael Lewis tells this story in the Big Short.)

Financial innovation led to a rapid proliferation of new products that people didn't really understand. Imagine drug development that required no FDA approval or trials and you get some sense of the potential, unknown danger of these new products suddenly in circulation. The derivatives market exploded between 1998 and 2008; notional values grew from $72 trillion to $673 trillion. (If that sounds like a lot, it is. Total global GDP is about $50 trillion.) The market value of derivatives is considerably less than the notional value but even that grew from $2.6 trillion to a stunning $35.3 trillion by December 2008 at the cusp of the Great Recession. What's a derivative? It's a financial instrument whose value is derived from another, like a bet on a stock price or pork bellies. If a name like "financial derivative" makes your eyes glaze over and - at the same time - makes you feel impressed by the fancy term then it is doing its job; it is great to sell a product that is poorly understood but trusted as high-tech. Again, this is another example of risk being shifted from those who understand it to those who don't.

The rapid innovations in finance helped and was helped by the emergence of a shadow banking system. It was negligible in 1980 but by the early 2000s it had grown larger than traditional, regulated banking. In 2007 this shadow banking sector was about $13 trillion.

[Above facts are from Martin Wolf's The Shifts and the Shocks: what we've learned - and have still to learn - from the financial crisis.]

Banks had become public companies rather than private concerns. This gave them more capital to use but it also made them more accepting of risk. If you are a partner in a private bank, you want to make a good return on your money. But this is your money so you also want to avoid a lot of risk. If someone doesn't pay back your loan, you're out that amount. That was the old world. In the new world, banks were public and the money that bankers loaned was stockholders'. Bankers had incentives to originate loans in order to get big bonuses which often were paid at the time of the transaction, not slowly over time as the loan was paid back. Suddenly, the risk was someone else's and bankers wanting a bonus rather than protecting their own capital had an incentive to pursue returns with less discrimination.

Finally, the whole system was more fragile. The push for greater returns coupled with the ability to off-load risk and use someone else's money had driven the market to leverage more. Once upon a time banks had leveraged investments at a rate of 10 or 20 to 1. By 2008, they were leveraging investments at 50 to 1. That sort of leverage greatly inflates your returns on the way up but it disastrously exacerbates losses on the way down.

When the downturn hit - and downturns always hit - the system was fragile and poised for massive losses. The result has already been mentioned (13 million job deficit, $18 trillion in wealth disappeared, etc.)

"The crisis takes a much longer time coming than you think, 

and then it happens much faster than you would have thought."

- Rudiger Dornbusch

We Americans depend on Wall St. and the banks. Finance is to the economy what oxygen is to an ecosystem. The purpose of financial regulation is not to make the game noncompetitive but instead to ensure that competition is about creating value rather than hiding risk, about creating sustainable returns rather than unsustainable bubbles, and protecting the naive from the manipulative. With good financial systems, people still get filthy rich but fewer people go bankrupt. Someone like Elizabeth Warren understands the importance of NFL style regulation. Trump's sensibilities seem to run more towards WWE. That should have frightened voters last week. It should frighten you now.

As to timing of this? I don't know. Glass Steagal was repealed in 1999 and the Great Recession hit within a decade. There is a small chance that Trump and the Republicans have learned the lesson of the Great Recession and won't deregulate. It seems optimistic to assume this. There is a better chance that it takes at least two year for new regulations - or deregulations - to be put in place. And at that point the impact of the return to fragile finance could take a year to manifest or two decades. It's harder to predict than the impact of a rate hike or tax cut.

California Mortgage Market Has a Bad Hair Day (or, how to make a billion dollars a day)

As of 2000, a Californian who wanted to sell home loans could get a license without taking a single class. By contrast, to become a professional barber he or she would need 1,500 hours to qualify for a state license.

From this simple contrast, we can conclude which of the following?

1. Californians better understand the consequences of a bad haircut than they do a bad home loan.
2. Financial market deregulation became confused with financial market anarchy just before the bust.
3. Appearances are everything.

Oh, wonder why jobs still aren't coming back into the construction industry? It is possible that the market got a tad over-built as a result of sub-prime mortgages. Between 2000 and 2005, the volume of sub prime loans quadrupled. Not only did house prices rise, but so did the amount borrowed against them and the number of houses built.

One hedge fund manager who bet against this bubble began to make one billion a day in 2007 when the sub prime market began to unwind. Now, four years later, the construction industry still has not recovered.

Financial markets are competitive, and that's good. But like sports, even competition - especially competition - suggests the need for rules. Just think how much better off we'd be if we took finance as seriously as sports and properly made and enforced rules to keep play fair. Or even if we took finance as seriously as haircuts.

Facts taken from Sebastian Mallaby's More Money Than God: Hedge Funds and the Making of a New Elite, pp. 323-331.

How To Save a Trillion Dollars

One of my most awkward moments teaching seminars came in an event that included a contingent from a chain of pawn shops. The "finance" company wasn't called a pawn shop, but that is what it was and they had been making a ton of money. When I learned how they operated - a lunch time conversation - I challenged them. This did not go over well and made the next 2 1/2 days awkward. Pawn shops in Florida (and I suppose most states) can essentially charge exorbitant rates to people desperate for money. Even credit card companies cannot charge such high fees. But because they are not banks, pawn shops' interest rates are not regulated like banks.

After the Great Depression, the government regulated banks to make financial markets safer.

After World War II, nonbank corporations found a way around that regulation by offering many of the same products and services as banks. This has proven problematic. Not just to people forced to pawn their goods but to the economy as a whole as the offerings of nonbank corporations has grown to more closely resemble that of commercial and investment banks.

Elizabeth Warren, Obama's expert on consumer finance, a woman who knows her stuff, has written a piece explaining how the Obama administration is passing legislation that will regulate products and services regardless of whether they are offered by banks or nonbanks.

The great news is that the Obama administration appears to be on track on making the reforms that will make it less likely that we'll need bailouts that cost trillions. Financial market regulation has been overlooked for too long. The sad news is that they have to start by solving such seemingly obvious problems.

Soros on Free Market Fundamentalism

I think I realized one of the biggest reasons why DC has seemed to choose free markets over regulation: it is easier to opt for free markets than to do the difficult work of figuring out how to regulate them.

George Soros has written an article, The Crisis and What to Do About It.

Since [financial markets] are prone to create asset bubbles, regulators such as the Fed, the Treasury, and the SEC must accept responsibility for preventing bubbles from growing too big. Until now financial authorities have explicitly rejected that responsibility. It is impossible to prevent bubbles from forming, but it should be possible to keep them within tolerable bounds.

Soros has made a fortune in financial markets. Last year alone his income (income - not wealth) was nearly $2 billion. Soros fled eastern Europe for free markets but is a critic of what he calls free market fundamentalism.

I mostly agree with and admire Soros. (Okay, maybe even envy him. I'd work at his salary for just a week and be happy with the 30-some million.) I think it is wonderful to have markets and I think that it as silly to think that financial markets will self regulate as to think that football games or or any sports contest will self regulate.

But his words here get to the crux of why regulation is so hard and why it is so much easier to take the extremist positions of free market fundamentalism or socialism.

First of all, who wants a Federal Reserve chairman who keeps asset prices down? It sounds good in abstract, but we're actually talking about home prices and portfolios that we're keeping from appreciating too much.

Secondly, what is the tolerable bounds for a bubble? Don't we all want just one or two more percentage gains - no matter what gains we've already made? Who is to say what is too big? Someone whose annual income is $1.7 billion? Someone who is on a fixed government salary and envies anyone making more than $100,000 a year?

As anyone who has bought furniture at Ikea can attest, just because something is hard is no reason not to do it. Getting the right level of regulation is hard because what makes for best short-term conditions (stability and predictability) can make for poor long-term conditions (innovation and change at the heart of progress).

Soros is saying what a lot of us are thinking. He also seems to raise more questions than he answers. And I think that this is perhaps the biggest reason that free market fundamentalism won converts. It suggests that regulators don't have to make any hard decisions or difficult judgments. They can simply leave it to the market.

Time to Draft Spitzer?

About 18 months ago, I predicted that McCain would be president from 2008 to 2012 and that Elliot Spitzer would be president in the 8 years after, until 2020.

In spite of the obvious problems he had governing his penis, I still like that idea. As former attorney general of New York, no one did more to go after bad financial institutions and rogues and no one seemed to better understand the importance of getting financial regulation right. As the financial industry continues to make a giant sucking sound that threatens to bring the rest of the economy down with it, maybe voters will come to appreciate the importance of this kind of understanding in a politician.

Maybe some day expertise on financial regulation will be as valued as experience as a sports broadcaster.

Don't Games Usually Have Rules?

Those Republicans hate regulation. That hatred seems a little awkward to explain now that financial markets are teetering on the brink of economic catastrophe.

Conservatives more than anyone pointed out that it is ridiculous to have the referees play the game when they railed against socialist government that nationalized companies and industries. That is fine and good. But it is nearly as foolish to play a game with no referees.

McCain recently said that greed on Wall Street is the problem at the heart of the current financial market woes. That is just foolish. Greed is always there. We all want higher returns. People don’t cheat because they want to win – everyone wants to win but not everyone cheats. The problem on Wall Street is one of oversight and regulation. It should be simple: we don’t let the referees play and we don’t leave refereeing to the players. Anyone fan can tell you that competition is enhanced by good rules and fair officials. Enhanced, that is, unless you like it when your golf tournaments look like ultimate fighting matches.