Kling Earns a Grain of Salt
Arnold Kling has written (at least) two posts in the last two days that I think are wrong.
1. Bank Regulation is a Political Economy Problem
I have emailed my critique of this post to Grobstein, so some of this is taken from that email.
Some background is necessary to understand Kling's point. The animating concept is the moral hazard created by government guarantees. Say the government guarantees that some class of investors will be repaid in full (or will be "bailed out") if a firm becomes insolvent. This will make it relatively easy for that firm to raise capital from that type of investor, and the normal constraints on the firm's risk-taking will be reduced (the investors will not monitor/control the firm as carefully, since the government will bear some of the risk of loss). The firm may even actively seek superoptimal risk (again, because the juiced up returns accrue to the investors, but some or all of the risk belongs to taxpayers). So we would expect government guarantees to result in excessive risk-taking and transfers from taxpayers to investors.
The classic example of a government guarantee is deposit insurance. In brief, our approach to deposit insurance is this: depositors get a very solid guarantee that the principal value of their deposits is secure, up to a limit (currently $250,000 per depositor per insured bank). This means that banks have access to fairly cheap short-term financing (very short-term in the case of checking accounts, a bit longer-term in the case of certificates of deposit) and are much less likely to suffer bank runs than previously in U.S. history (and elsewhere currently).
The deposit insurance does create a moral hazard problem, so banks are regulated and are required to pay premiums. When banks still manage to become insolvent, the FDIC steps in, seizes the bank's assets, pays off its depositors in full (up to the per-depositor limit), and gives any residual money to its other creditors (I'm a little hazy on how this last part plays out, but I don't think it matters for our purposes). This is called the FDIC's resolution authority, and it is actually quite ruthless about exercising it (arguably too ruthless).
Deposit insurance is not the only government guarantee that might give rise to moral hazard problems. Economists also worry about the implicit (imputed, not legally enforceable) guarantee of investments in institutions that are "too big to fail." What we mean by "too big to fail" is that an institution is so systemically important that its failure would cause substantial economic damage (this is a fuzzy concept that has been much debated lately). Whatever else this means, it means that when the institution looks shaky, the government has no real option but to step in and save it (bailing it out in one of a variety of ways).
It is puzzling that Kling focuses on deposit insurance. This is odd because the FDIC already has resolution authority and is shutting down banks right and left. True, one might doubt whether the FDIC would shut down Citi or Bank of America (or the relevant portions of them), but this is a subset of the "too big to fail" set of institutions, which only partially overlaps the "FDIC regulated" set of institutions. To the extent the FDIC fears to shut them down (something that has not been adequately demonstrated, I believe), those fears would apply all the more to a governmental entity with less clear-cut authority to act.
Where Kling really goes off the tracks, though, is his insistence that "it is absurd to suppose that you will exercise 'resolution authority' to close a big bank during a crisis and at the same time say that it is unthinkable to break up big banks now."
This is wrong for all kinds of reasons. First, it is unclear under what authority the government could break up the big banks now. Any legislation would seem ad hoc and unprincipled (though it would probably be worth enacting). Resolution authority, on the other hand, would apply only to insolvent institutions (or institutions on the verge of insolvency). Any bank that wants to avoid government seizure could take the prudent step of remaining solvent. Banks that fail to do so are unlikely to garner much public sympathy.
More importantly, resolution authority seeks to provide the government with a credible threat in case banks do decide to play chicken. In the status quo, the government has very little alternative - the aftermath of Lehman's collapse was simply too horrible to risk again. With resolution authority, the government can credibly tell shaky banks to sell themselves quickly, at any price they can get, or the government will exercise its duly granted powers and take the reins.
The remaining question is how effectively the resolution authority would curb moral hazard. Obviously you would want to wipe the shareholders out, but is this sufficient? Should certain classes of creditors also be expected to take a haircut? These are interesting questions, but Kling doesn't address them, because as far as he is concerned, it is less politically feasible to grant resolution authority to a government agency than it is to split up seemingly healthy banks.
2. The Job Assignment Problem
Kling's argument here is:
"The Recalculation Story is simply that the job assignment problem has become too difficult for the market to solve quickly, using its tools of price signals and incentives. Government could step in and assign lots of jobs to lots of people, but that would probably come at a loss of the productivity growth that really ought to be our focus."
Really this comes down to my rejection of the "Austrian" or "real business cycle" theory of mass unemployment (which I think of as an application of the economic calculation problem). The idea is that it is very difficult to assign jobs to all members of society in an optimal (or close-to-optimal) way. So what you get is a period of time in which these things need to be sorted out, and in the meantime you have lots of unemployed people. But it's very important not to give those people aid in the meantime (and certainly you shouldn't give them jobs), or you will retard/skew the market's allocation of talent.
One quick observation is that, as often seems to happen, while defending the market Kling has written a fairly scathing indictment of it. Unemployment (not seasonally adjusted) stood at 7.1% in December of 2008 and has been above 8% ever since (currently it is over 9%) - and Kling remains "doubtful that the solution will arrive quickly." The market is taking its sweet time, apparently.
But the more important thing to note here is how crazy the underlying theory is. After all, why did the recalculation problem become so severe in late 2008? Was it so much simpler back in 2006 and 2007? Have we broken through some kind of complexity threshold that compels ~10% permanent unemployment? To put it another way, why did things suddenly get worse, and why should we expect them to get better?
I believe that Keynsians have a fairly good answer to these questions. They would argue (apologies for oversimplification and likely errors, it's been a while): this isn't a "recalculation" problem, it's an "inadequate aggregate demand" problem. If structural adjustments caused frictional unemployment, then we should have high unemployment during both booms and busts (a point made by Paul Krugman and Tyler Cowen. Aid to the unemployed and jobs programs are likely to be helpful because they increase aggregate demand, avoiding the waste of resources that results from unemployment (and, importantly, providing income to people who might otherwise suffer greatly).
Kling cautions against viewing high unemployment in "conventional Keynesian terms, where we all work in the GDP factory making GDP units." But this hardly disposes of the cogent critique presented by Krugman and Cowen. I would like to see Kling address the glaring problems with his theory. The evidence for Keynesianism seems very strong to me. A tremendous amount is at stake - are we really supposed to allow unemployment benefits to expire, cut the minimum wage, and call a halt to stimulus spending based on a "recalculation story" that doesn't seem to be coherent?
1. Bank Regulation is a Political Economy Problem
I have emailed my critique of this post to Grobstein, so some of this is taken from that email.
Some background is necessary to understand Kling's point. The animating concept is the moral hazard created by government guarantees. Say the government guarantees that some class of investors will be repaid in full (or will be "bailed out") if a firm becomes insolvent. This will make it relatively easy for that firm to raise capital from that type of investor, and the normal constraints on the firm's risk-taking will be reduced (the investors will not monitor/control the firm as carefully, since the government will bear some of the risk of loss). The firm may even actively seek superoptimal risk (again, because the juiced up returns accrue to the investors, but some or all of the risk belongs to taxpayers). So we would expect government guarantees to result in excessive risk-taking and transfers from taxpayers to investors.
The classic example of a government guarantee is deposit insurance. In brief, our approach to deposit insurance is this: depositors get a very solid guarantee that the principal value of their deposits is secure, up to a limit (currently $250,000 per depositor per insured bank). This means that banks have access to fairly cheap short-term financing (very short-term in the case of checking accounts, a bit longer-term in the case of certificates of deposit) and are much less likely to suffer bank runs than previously in U.S. history (and elsewhere currently).
The deposit insurance does create a moral hazard problem, so banks are regulated and are required to pay premiums. When banks still manage to become insolvent, the FDIC steps in, seizes the bank's assets, pays off its depositors in full (up to the per-depositor limit), and gives any residual money to its other creditors (I'm a little hazy on how this last part plays out, but I don't think it matters for our purposes). This is called the FDIC's resolution authority, and it is actually quite ruthless about exercising it (arguably too ruthless).
Deposit insurance is not the only government guarantee that might give rise to moral hazard problems. Economists also worry about the implicit (imputed, not legally enforceable) guarantee of investments in institutions that are "too big to fail." What we mean by "too big to fail" is that an institution is so systemically important that its failure would cause substantial economic damage (this is a fuzzy concept that has been much debated lately). Whatever else this means, it means that when the institution looks shaky, the government has no real option but to step in and save it (bailing it out in one of a variety of ways).
It is puzzling that Kling focuses on deposit insurance. This is odd because the FDIC already has resolution authority and is shutting down banks right and left. True, one might doubt whether the FDIC would shut down Citi or Bank of America (or the relevant portions of them), but this is a subset of the "too big to fail" set of institutions, which only partially overlaps the "FDIC regulated" set of institutions. To the extent the FDIC fears to shut them down (something that has not been adequately demonstrated, I believe), those fears would apply all the more to a governmental entity with less clear-cut authority to act.
Where Kling really goes off the tracks, though, is his insistence that "it is absurd to suppose that you will exercise 'resolution authority' to close a big bank during a crisis and at the same time say that it is unthinkable to break up big banks now."
This is wrong for all kinds of reasons. First, it is unclear under what authority the government could break up the big banks now. Any legislation would seem ad hoc and unprincipled (though it would probably be worth enacting). Resolution authority, on the other hand, would apply only to insolvent institutions (or institutions on the verge of insolvency). Any bank that wants to avoid government seizure could take the prudent step of remaining solvent. Banks that fail to do so are unlikely to garner much public sympathy.
More importantly, resolution authority seeks to provide the government with a credible threat in case banks do decide to play chicken. In the status quo, the government has very little alternative - the aftermath of Lehman's collapse was simply too horrible to risk again. With resolution authority, the government can credibly tell shaky banks to sell themselves quickly, at any price they can get, or the government will exercise its duly granted powers and take the reins.
The remaining question is how effectively the resolution authority would curb moral hazard. Obviously you would want to wipe the shareholders out, but is this sufficient? Should certain classes of creditors also be expected to take a haircut? These are interesting questions, but Kling doesn't address them, because as far as he is concerned, it is less politically feasible to grant resolution authority to a government agency than it is to split up seemingly healthy banks.
2. The Job Assignment Problem
Kling's argument here is:
"The Recalculation Story is simply that the job assignment problem has become too difficult for the market to solve quickly, using its tools of price signals and incentives. Government could step in and assign lots of jobs to lots of people, but that would probably come at a loss of the productivity growth that really ought to be our focus."
Really this comes down to my rejection of the "Austrian" or "real business cycle" theory of mass unemployment (which I think of as an application of the economic calculation problem). The idea is that it is very difficult to assign jobs to all members of society in an optimal (or close-to-optimal) way. So what you get is a period of time in which these things need to be sorted out, and in the meantime you have lots of unemployed people. But it's very important not to give those people aid in the meantime (and certainly you shouldn't give them jobs), or you will retard/skew the market's allocation of talent.
One quick observation is that, as often seems to happen, while defending the market Kling has written a fairly scathing indictment of it. Unemployment (not seasonally adjusted) stood at 7.1% in December of 2008 and has been above 8% ever since (currently it is over 9%) - and Kling remains "doubtful that the solution will arrive quickly." The market is taking its sweet time, apparently.
But the more important thing to note here is how crazy the underlying theory is. After all, why did the recalculation problem become so severe in late 2008? Was it so much simpler back in 2006 and 2007? Have we broken through some kind of complexity threshold that compels ~10% permanent unemployment? To put it another way, why did things suddenly get worse, and why should we expect them to get better?
I believe that Keynsians have a fairly good answer to these questions. They would argue (apologies for oversimplification and likely errors, it's been a while): this isn't a "recalculation" problem, it's an "inadequate aggregate demand" problem. If structural adjustments caused frictional unemployment, then we should have high unemployment during both booms and busts (a point made by Paul Krugman and Tyler Cowen. Aid to the unemployed and jobs programs are likely to be helpful because they increase aggregate demand, avoiding the waste of resources that results from unemployment (and, importantly, providing income to people who might otherwise suffer greatly).
Kling cautions against viewing high unemployment in "conventional Keynesian terms, where we all work in the GDP factory making GDP units." But this hardly disposes of the cogent critique presented by Krugman and Cowen. I would like to see Kling address the glaring problems with his theory. The evidence for Keynesianism seems very strong to me. A tremendous amount is at stake - are we really supposed to allow unemployment benefits to expire, cut the minimum wage, and call a halt to stimulus spending based on a "recalculation story" that doesn't seem to be coherent?
posted by James | 12:41 PM
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