Learning the right lessons from financial crises is tough. The 1929 stock market crash was blamed for all the ills of the Great Depression that succeeded it and led to two decades of regulation and socialism. In 1720, the British tried to stop all new company formations while the French gave up on finance altogether and started plotting revolution. So, it is unlikely that we have learned the right lessons from 2008, but it’s worth asking what lessons we should have learned, to avoid the same mistakes again.
There are three distinct layers of lessons we should have learned but haven’t. At the narrowest, most technical level we have not learned how to manage a financial crisis without rewarding bad behavior and bailing out the wrong people. At a broader monetary policy and regulatory level, we have not learned what policies and regulations led to the crisis and how to avoid another one. Finally, at the broadest economic management level, we have not learned why our economy produces financial meltdowns at regular intervals, and what can be done about it.
All three sets of problems have the same underlying cause: misguided incentives. If bank management keeps its jobs when it makes gigantic losses and is bailed out by the state, it will have no incentive not to do so again. If asset prices are high and regulations are “flexible” in terms of how to calculate leverage, then banks will leverage themselves up to the eyeballs and invent new ways of financing overpriced assets – high asset prices will inevitably lead to high demand for loans and high leverage will lead to low lending margins, both of which increase risk. If the economy is designed with high taxes, big government and massive incomprehensible regulations, then market participants will naturally gravitate towards tax avoidance, buying off bureaucrats and gaming the regulations. This isn’t rocket science, it’s obvious. The further you get from pure free-market capitalism on a Gold Standard, the worse the system works.
More particularly, too little thought was given before 2008 to the process of resolving bank failures, with the result that it became impossible to do so properly. If an over-leveraged bank fails, with like Lehman $600 billion of liabilities and a matching portfolio of assets that are mostly of fairly low risk, then the loss in an orderly liquidation of that bank will be nothing like $600 billion. However, the loss from the market panic resulting from a failure of a bank of Lehman’s stature, which had been founded in 1850 and had one of the best “names” in the market, proved to be a very substantial multiple of $600 billion. Indeed, over the next 8 years, including the costs of dozy monetary and fiscal policies, the cost of Lehman’s failure was probably between $10 trillion and $20 trillion worldwide.
Once Lehman had failed, the U.S. Treasury and the Fed went to the opposite extreme, rescuing everything that it was possible to rescue, including serial deadbeats like Citigroup and unjustifiable speculative madhouses like the derivatives wing of AIG. Everybody kept their jobs, nobody significant went to jail, and the only losses were those inflicted on the global economy by a decade of zero interest rates and the associated productivity dearth.
The core problem is that the incentive structure is all wrong. If a bank is allowed to fail, its management, employees and shareholders are appropriately punished. However, the greatest losses in terms of dollar amount fall upon relatively innocent parties: its bondholders and on the shareholders and bondholders of other banks whose resources are tied up in the loss.
If a bank behaves badly and gets into trouble, who do we want to suffer? The shareholders, by all means, but surely above all the management. Top management should lose their jobs, the entire workforce should at a minimum lose its bonus for the year, and if there are bad actors within the organization, as there very often will be in this situation, they should face the possibility of jail sentences, as top management did at the bankrupt Enron after 2001. On the other hand, there is no useful reason why non-subordinated bondholders of the bank should suffer greatly, and we have deposit insurance in place so that small and medium sized depositors will not suffer at all. (Theoretically, the system would work better without deposit insurance, but the idea that retail depositors are capable of assessing the credit risk of a Lehman Brothers or a Citigroup is laughable.)
The solution is for any bailouts that are necessary to be controlled liquidations. The financial institution concerned will be nationalized, shareholders will lose their money, senior creditors will be paid out in full and subordinated creditors will be paid with only a modest haircut, with everybody’s payouts being guaranteed by the state, as happened in 2008. Thus, the huge confidence cost and market seizure that occurred after Lehman would be prevented.
There would however be no question of the bank continuing to operate once it had been taken over. Instead, it would be wound up, with all employment contracts cancelled by the nationalization. Thus, top management and most of the staff would lose their jobs and probably several years’ income, as they did at Lehman. Most important, a badly run organization would be taken out of the market, so that it could not infect it in the future. This would eliminate the likes of Citigroup, poorly managed since 1910 but always too big to fail and therefore requiring bailouts every couple of decades. The likelihood of meeting such a fate, and not a mere cost-free recapitalization as was done in 2008, would provide stern incentives to management and staff not to over-extend themselves in search of a quick buck.
In addition, after a nationalization a forensic audit would be undertaken of the mistakes that had led the bank into default, and appropriate details would be passed on to prosecutors. Jail sentences imposed would be moderate, unlike those imposed after the Enron bankruptcy, which were grossly excessive, but they would include top management if appropriate. The 2008 disaster led to no jailings of top management, merely jail sentences for a few traders caught fiddling LIBOR, an altogether ancillary problem which should arguably not have been a crime since the LIBOR system was set up with weaknesses that became apparent to all once trillions of dollars in derivatives contracts were involved.
With that structure in place, bank management would be incentivized not to go bust, and complex gameable capital limits could be eliminated — since bank management would be properly incentivized, they would be unnecessary. There is then only the problem of bank managements bankrupting their banks through sheer bloody incompetence, notably in their risk management. This problem could be addressed by introducing regulation of risk management systems, at least for large banks, with a view to weeding out Gaussian risk management systems and ensuring that properly designed fuzzy logic and Cauchy systems were in place, removing the incentive for banks to engage in pathological products like credit default swaps.
The other regulatory-level change that needs to be made, is to eliminate negative real interest rates, which incentivize excessive asset prices, excessive risk taking and bad behavior generally. If we can’t have a gold standard, let us at least have a Congressionally monitored requirement for each FOMC meeting to include a statement certifying that, in the opinion of the FOMC, the Federal Funds interest rate they are setting exceeds their 1-year forecast for consumer price inflation. This would have stopped Alan Greenspan’s foolish stimulus after the 2000-02 recession; more important, it would have stopped the decade of Bernanke/Yellen stimulus after the 2008 recession, the long-term costs of which have still nowhere near fully appeared.
Financial meltdowns have three causes: (i) misaligned incentives and sheer boneheaded stupidity (in the risk management area) among bank top and middle management (ii) excessive money creation that overinflates asset prices and causes bubbles, the deflation of which is bound to be damaging and (iii) regulatory and tax policies that distort the free market and turn it into a version of crony-capitalist government-directed socialism.
The last problem is the most difficult to solve because the incentives for government itself, imposed on it by an economically unsophisticated electorate, are so skewed. If the electorate wants to combat global warming, then it must do so by means of a carbon tax, which incentivizes clean energy production but does not impose dozy lobbyist-inspired ideas on how to achieve that. If the electorate wants to give money to charity, it should do so directly by government grant, not insert giant loopholes in the tax code which give freebies to the rich and create infinite left-wing lobbies and pressure groups. If the electorate wants to encourage home ownership (an economically doubtful objective anyway) it should remove zoning controls that prevent the construction of cheap housing, not create home mortgage behemoths and cheap money policies that turn homes into speculative vehicles and ATM machines for witless spending sprees. These policies were available; this column recommended them, but unfortunately its readers do not yet run the country.
With the above policy changes, the 2008 bust could have been avoided and most future crashes could be avoided. Millennials clamoring for socialism should be told: it wasn’t capitalism that failed in 2008, it was regulatory, policy and legal structures, all of them designed by governments. Let’s try for an economic system that works, before destroying all our futures with an economic system that has been tried again and again, all over the world, and inevitably fails.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)