I'm not very fond of people who claim that markets can solve all of our problems, but at the same time, I think markets can be very effective at one key economic task: setting prices.
Our current financial problems derive, at their foundation, from private transactions that weren't nearly careful enough about the prices of the goods underneath them. People mistook trends of the present - rising housing prices, the AAA ratings of investment houses, and so on - to be permanent fixtures of the economy. Then they built complex structures on top of opaque and not very stable pricing expectations, adding fuel to the fire by creating compensation structures that rewarded those most willing to misbehave.
There are a few ways to handle these kinds of problems, to ensure that they are at least less likely to occur in the future:
Assume that business folks just needed a reminder about the risks they play with, and trust them to sort it out.
Ban specific practices. No more credit default swaps, NINJA loans, or crazy levels of leverage. Maybe no more short-selling, either, or certain kinds of financial practices.
Require that financial practices be done in the open. Everyone can see your positions and evaluate them, all of the time.
Option #1 would continue and extend the practices of the last thirty years, which I figure reflects the time we've had since the memory of the Great Depression wore off. Usually, once there's a market crisis, people suddenly remember that financiers and businesspeople aren't actually omniscient, or necessarily virtuous.
Option #2 is an obvious choice. If banging your head against a wall hurts, stop doing it. If credit default swaps have damaged companies, industries, and economies, stop doing that. If short selling has results that frighten people when fear is a problem, order it stopped. Unfortunately, this option has some problems of its own. First, there actually are benefits to many of these practices. They facilitate a lot of transactions, and provide critical pricing information. Second, there are many of these things already out there, and unwinding them is not a simple project. That comes with its own costs, which is part of why governments are looking into playing the role of 'patient capital.'
Option #3 is the terrifying choice. Transparency and privacy are more or less opposites, and it seems painfully clear that markets work most efficiently, setting the best prices, when maximum information is available. What's more, we even have the systems we need to manage all of that information today - so in some sense, we're ready to move into the panopticon.
Think, for example, about an investment vehicle composed of a collection of mortgages. No one wants to touch these right now because it's not clear which are suffering and how. (Not only that, but it seems like banks have even misplaced the documentation for them.) Imagine systems which let anyone inspect that collection of mortgages, to see the most recent appraisals on the properties, payment histories, updated credit ratings for the debtors, and information about nearby and comparable properties.
That's a lot of information, a lot of it information people consider to be their business and their business alone - but it would also allow buying and selling of these vehicles with a clear understanding of what's involved. Instead of mixing and matching mortgages to try to create an acceptable aggregate risk, the pieces would explain their own risk.
Scared yet? I'm not sure how comfortable I'd be with such systems, but at the same time that's the primary market-based approach that I can imagine actually fixing these problems. Worried about your bank? Check out its loans and assets. No, really - check out its loans and assets. They'd have to actually list such things. Short selling could still be out there, but there could actually be a market for borrowing the stocks, instead of the quiet arrangements we have today. Folks who want to buy or sell stocks without actually having the money would be noticeable. Crazier yet, contracts might even be public documents rather than secret agreements that only come out in case of a lawsuit. Want to find out what your insurance really covers, and what their payments look like? Want to invest in a company, but find today's SEC filings pretty weak?
I know - it's a lot to think about. It's pretty much an inversion of my expectations growing up. At the same time, though, if we're certain that we want free markets to operate smoothly, it's a terrifying prospect we need to consider.
I spent most of this week in New York City, marveling that everything seemed so normal while the financial markets crashed around us. I've been worried that the end of the party was going to come with an incredible hangover, and was glad to hear that the Treasury Department, after years of tying its hands further and further behind its back was finally doing something.
But now it seems - well, it seems like their big idea of doing something involves making sure it's done the worst way. Maybe not quite the worst way - it's not Mellon's "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate."
It seems to be the next worst way, however, judging from what I've seen of the proposed legislation. Lots of power, and $700 billion of borrowed cash, to the Treasury Secretary, with basically no oversight unless the President feels like firing him. There's vague mention of semi-annual reports to Congress, and then there's this barrier to anything effective:
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.
Oddly, for a proposed response to a disaster in which not knowing the value of securities is a key problem, there isn't even provision for publication of the terms on which securities are purchased.
The financial situation looks dire, but it's hard to imagine that this is an even vaguely respectable solution. It looks like a promise to reinflate collapsed bond markets, with no efforts whatsoever to correct the behavior that collapsed them in the first place. It's a $700 billion spending spree on assets whose value is opaque at best, worthless at worst. The companies that bought, sold, and created them can just go on their way - it's not clear what, if any, 'haircut' they'll be getting. The "Credit Reform" section points to law regarding HUD loans, and seems mostly about bookkeeping rather than reform.
It's also hard to imagine adding to the power of an already power-mad executive branch in an administration that seems not to understand boundaries. No review, no oversight, barely even a formula for acquiring these assets. How much money has to disappear in sweetheart deals before people finally get mad?
Big problems call for bold solutions - but this seems to be very bold, without much solution.
I've been thinking lately about the different styles of the Clinton and Obama campaigns. Doonesbury had some fun with the "poetry of Barack Obama" vs. the "prose of Hillary Clinton", but I think there's something more complicated underneath.
Both candidates promise change, but their rhetoric - or what I hear in it - offers a very different perspective on the power needed to make change happen.
To me, I hear Hillary Clinton asking voters for the power she needs to make the change that they want. I hear Barack Obama calling us all together to make change with the power that we have together.
I could be totally off-base, and this may be as simple as the number of times Barack Obama says "we" having some effect on my mind.
(And I hear John McCain mostly asking for power to do, well, whatever he and his friends want to do. I'm not sure why we're supposed to give it to him, but then I wasn't particularly sympathetic to him anyway.)
In business history, there are a few industries that especially stand out for their lack of interest in the welfare of their workers, the places where they work, or pretty much anything except the bottom line. Mining of all kinds is historically awful, as are oil and gas drilling. Related industries - refining, smelting, and electricity generation, aren't particularly beloved either. All of these can be called extractive industries, as they seek to get something out of one place and bring it to another place.
The basic problem with extractive industries is simple: they try to serve their customers, while making the most profit they can. Since the results of extractive industries are usually generic commodities, it's historically been hard to seek premium prices from customers for better quality or behavior. Profits need to come from reduced production costs. There's often a geographic separation between their customers and the place the goods come from. The more drastic the separation, the less likely it is that the customers will care about the consequences of the extraction, freeing companies to cut their costs of production.
I should pause to be clear that I don't mean to say that extractive industries are evil by their very nature. However, economics suggests and history by and large supports the idea that the internal forces that drive decisions for these business don't always feels so good to those on the outside.
Wind energy is often cast as a key technology that will rescue us from other, more polluting, extractive industries. This perspective makes a lot of people more willing to dismiss people who aren't thrilled by wind power as the occasional crank, while they'd happily support the same kinds of people if, say, mountaintop-removal was at issue.
Assuming that windmills are perfectly clean and that they have no side effects (uncertain), how could they possibly hurt the places in which they're installed? It's not a coal mine spewing tailings, right?
It's not. However, there are still a lot of factors worth contemplating. Wind farms tend to be out in the middle of nowhere, and generate power that needs to go to homes and businesses in denser areas. That means more transmission lines. Transmission lines, however ugly, have become a standard part of the landscape, though, so how can you complain about those?
Well, again, the investors developing these megaprojects want to get the maximum return on their investment. That means selling power where power is most expensive - typically not the places where the power is generated. In New York State, for example, electricity generally costs considerably more than it does in other states. Not only that, but power costs more Downstate - New York City and its suburbs - than it costs Upstate - where the wind farms are likely to go.
The answer, for smart investors? Build a huge powerline connecting the cheaper power to the more expensive power, and sell the same electricity at a significantly higher price. The side effect of that arbitrage will of course be higher prices in the area that used to have the cheaper prices - but that's not the investors' problem.
Sure, there might be local opposition, but that's what friends in Washington are for. Just like the other extractive industries, energy businesses of all kinds have some very nice support from a federal government that lately doesn't have much patience for federalism.
And hey, look at that - there's lots of money pouring into wind, lots of it coming from oilmen and power companies.
I don't mean to rain too hard on wind energy's parade. It's an important component of our future energy generation. At the same time, though, I think we need to give the promises of all kinds of energy investors the same kind of scrutiny we give the promises of oil companies. There's a lot more going on here than free energy.
Making capitalism really work - not just supply and demand, but the rich level of investment that really powers the system forward - requires a sophisticated finance system.
The human fuel that drives capital, epitomized in Gordon Gekko's classic phrase "Greed is Good," is good at building up that financial system. People would generally prefer to have their money making money for them than to be laboring directly for a wage. It's easier.
Unfortunately, that same fuel that drives people to create such systems also erodes the systems they build.
Why?
Because sophisticated financial systems - even just a bank - require a massive amount of trust in their operation. Financial systems aren't perfectly transparent, and thrive in large part because people don't wonder why their deposits aren't sitting in the bank vault at all times.
In the very long term, of course it makes sense for a self-interested financial operator to build and maintain trust. The returns will be more reliable because the many systems connected by the operation will have a much smoother and more predictable set of opportunities.
However, humans don't tend to live in the very long run. That same greed that drives the creation of financial institutions can undermine them severely when short-term profits are readily available, and when ethical or outside regulatory frameworks aren't strong enough to keep operators focused on the very long term.
To make matters much much worse, human trust doesn't go up and down smoothly. Trust tends to accumulate slowly, but collapse suddenly. The discovery of one lapse leads to suspicions of other lapses, especially in a sphere where transparency isn't always possible.
Right now, it seems very clear that a large part of the recent American economy was driven by fraudulent operators seeking short-term profits. Those operations were then sold to a much larger group of investors thanks to creative repackaging that freed those operators from the risks they had incurred and paid them well. The hard question is just how poisonous that breakdown of trust will be to the larger system - not simply in the numbers on the balance sheets, but also in the trust that lubricates markets overall.
