Tuesday, April 27, 2010

Dream Worlds

David Brooks retains the unique ability to alternately be interesting and infuriating. Usually the pattern is pretty predictable: one column interesting, the next infuriating. His most recent column, however, contains both tendencies at once. I suppose, overall, I’d recommend it.

But, here’s the thing. Whenever Brooks comments about policy—particularly in the Democratic trifecta years—he has a tendency to use policy proposals like Hitchcock used MacGuffins: a vague-yet-impressive-sounding proposal which can then be contrasted with the fallen almost sinful policy those Democrats have come up with. So instead of, say, nuclear secrets (Hitchcock) you have the ideal humble Burkean policy which recognizes the limitations of the technocrat and entrusts the little platoons of society in their quest to better themselves (Brooks). It’s a pretty common mistake that Brooks makes.

So, in this instance, what does Brooks propose? Well, begin with the scathing remark towards Democrats: “But, alas, we are living in the great age of centralization. Some Democrats regard federal commissions with the same sort of awe and wonder that I feel while watching LeBron James and Alex Ovechkin.”

Har. And what’s his counterproposal?
Both N. Gregory Mankiw of Harvard and Sebastian Mallaby of the Council on Foreign Relations have been promoting a way to do this: Force the big financial institutions to issue bonds that would be converted into equity when a regulator deems them to have insufficient capital. Thousands of traders would buy and sell these bonds as a way to measure and reinforce the stability of the firms.

As it happens, this is a pretty interesting proposal and worth thinking about. (Here’s Mankiw’s spin on the matter—at the bottom of the page.) But it’s always easy to design an elegant policy and far harder to get it passed. Take Brooks’s dig at commissions in the financial reform bill. The original idea of many was to abolish most of the useless barnacles of regulatory agencies—e.g. the OCC, CFTC, et. al.—and replace them with, say, two or three agencies. Rather than the clumsy system Brooks derides, you’d have a streamlined one. Unfortunately, this didn’t happen because, hell, it’s a political system. We saw the same game with health care. This is the world we live in, and anyone professing to take a careful, empirical look at the world as Brooks does should realize this. It would be great to change, but that’s an entirely different issue, isn’t it?

So keep that in mind with Brooks’s proposal. Let’s think it through: you have all these financial institutions issuing bonds. How can this go wrong? Well, for one, how will regulators determine which financial institutions to force to issue bonds? Flash back to the late 1990s—no regulator was aware of the trouble Long Term Capital Management posed to the system until it was too late. Lehman Brothers, similarly, didn’t seem in terms of assets to pose that big a problem. So already we have to move from the wisdom of crowds that Brooks is championing to the foolishness of regulators that Brooks is wagging his finger at—correctly, in many cases. If regulators don’t think regulating is worth it, then you have problems, and that’s a good description of the financial crisis.
But wait, there’s more! So, the regulators have determined which financial institutions have to issue these bonds. The next question is, how much? Who determines how much in bonds to issue? The regulators or the businesses? If the latter, then businesses will issue too small an amount in bonds and wait for the bailout, so that solves nothing. If the former, then the regulators are back to being micromanagers, exactly the problem that neither Brooks nor I want. And let’s say it’s the former. What’s the terms of these bonds? Do they mature in a year? Longer? Shorter? If the maturity is too long, then won’t banks be able to pull a Repo 105 type trick and make regulators believe that their liabilities are less than they actually are (and then, after issuing these bonds, proceed to leverage up again)?

Then there’s the problem of capital. Now, the TARP program was worth about $700 billion, and that’s without taking into account the various quantitative easing programs the Fed put into effect. So if you’re planning for a crisis, do you make banks sell that much in bonds? If so, won’t that crowd out other forms of investment? And let’s say these bonds are sold: what happens in a crisis? Well, regulators force large amounts of bonds in multiple institutions to convert to equity, right? So, if you own one of these bonds, you get nearly-worthless equity as opposed to a steady stream of income. That implies, in mark-to-market accounting, a discount in the value of your assets, right? So that would have the effect of massively devaluing the assets of the entire financial system, which might exacerbate whatever hypothetical crisis we’re facing.

The point here isn’t to be exactly accurate on every consequence of this proposal that’s being peddled. It has some attractive advantages. What should be clear is to contrast Brooks’s perfect policy with the messy realities of making policy. Brooks has the luxury of being limited to five hundred words or so per column, which means he has the luxury of not explaining himself. Brooks shouldn’t use that luxury of not having to spell out every consequence of a policy by criticizing others for having too-complicated, too-technocratic policies. I think we call that hypocrisy.

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