Sam Brittan and Anatole Kaletsky both worry that the credit crunch is undermining the case for free market capitalism. I fear, however, that they are eliding a crucial distinction - that between free markets and traditional capitalist ownership structures. The credit crunch does more to highlight the failing of the latter than of free markets.
I say this for four reasons:
1. Banks lost money on mortgage derivatives because of principal-agent failings. Principals - banks’ bosses - didn’t understand what agents (traders) were doing, and traders had incentives to take on excessive risk, because the gains from doing so - a life-changing bonus - exceeded the benefits of prudence.
2. Banks have been reluctant to lend to each other not so much because each bank fears its counterparty will not repay the money, but because they fear they’ll need the money themselves. This is because banks just don’t know what sort of losses they are sitting on. It’s impossible for managers of such complex organizations to know everything.
3. Banks are under-capitalized because chief executives have traditionally had incentives to maximize earnings by using leverage. Pressure upon them to be more prudent has been absent partly because when shareholding is dispersed, no individual shareholder has much incentive to rein in management.
4. Good financial innovation - of the sort advocated by Robert Shiller - has been lacking because it’s very difficult for anyone to own its beneficial effects; it’s a public good. By contrast, the gains from “bad” financial innovation - overly complex mortgage derivatives - are more appropriable. So we get more of it.
Of course, there are good reasons why capitalists’ apologists have not made the distinction between ownership structures and markets - because the former have always been less legitimate than the latter. But we should make the distinction now. What we’re seeing is not a market failure, but an ownership failure.
What’s the solution?
Not nationalization - which is a bad way of solving principal agent problems.
Perhaps instead, banks should make more use of internal markets. They should become more like venture capitalists, allocating capital to semi-independent divisions, which put in their own capital. This would restrain traders’ risk-taking, as they can not so easily hide behind the fact that losses are spread over the whole firm. And it would reduce the problem of asymmetric information between banks’ senior managers and trading desks, as there’s a simpler test of how well the latter do - whether they can hand over enough hard cash to cover their required returns.
Now, I’m being deliberately vague here. I just want to stress that ownership is the problem, more than markets.
I say this for four reasons:
1. Banks lost money on mortgage derivatives because of principal-agent failings. Principals - banks’ bosses - didn’t understand what agents (traders) were doing, and traders had incentives to take on excessive risk, because the gains from doing so - a life-changing bonus - exceeded the benefits of prudence.
2. Banks have been reluctant to lend to each other not so much because each bank fears its counterparty will not repay the money, but because they fear they’ll need the money themselves. This is because banks just don’t know what sort of losses they are sitting on. It’s impossible for managers of such complex organizations to know everything.
3. Banks are under-capitalized because chief executives have traditionally had incentives to maximize earnings by using leverage. Pressure upon them to be more prudent has been absent partly because when shareholding is dispersed, no individual shareholder has much incentive to rein in management.
4. Good financial innovation - of the sort advocated by Robert Shiller - has been lacking because it’s very difficult for anyone to own its beneficial effects; it’s a public good. By contrast, the gains from “bad” financial innovation - overly complex mortgage derivatives - are more appropriable. So we get more of it.
Of course, there are good reasons why capitalists’ apologists have not made the distinction between ownership structures and markets - because the former have always been less legitimate than the latter. But we should make the distinction now. What we’re seeing is not a market failure, but an ownership failure.
What’s the solution?
Not nationalization - which is a bad way of solving principal agent problems.
Perhaps instead, banks should make more use of internal markets. They should become more like venture capitalists, allocating capital to semi-independent divisions, which put in their own capital. This would restrain traders’ risk-taking, as they can not so easily hide behind the fact that losses are spread over the whole firm. And it would reduce the problem of asymmetric information between banks’ senior managers and trading desks, as there’s a simpler test of how well the latter do - whether they can hand over enough hard cash to cover their required returns.
Now, I’m being deliberately vague here. I just want to stress that ownership is the problem, more than markets.
Your distinction between ownership and markets is welcome, but it is not fine enough.
Mot people confuse capitalism, markets, democracy and industrialism.
In principle patterns of ownership, transactions, politics and production are independent.
In particular the first order benefits of modern economies are from industrial modes of production; usually these benefit from more markets and more democracy, but not necessarily.
Posted by: Blissex | September 12, 2008 at 03:09 PM
Definitely get them to put their own money on the line - it'll work every time.
Posted by: kinglear | September 12, 2008 at 03:16 PM
Intelligent analysis, as always.
Commentators, even the high quality ones you cite, have been rather too quick to pronounce the death of some version of capitalism, and fail to include such important distinctions. Kaletsky's article seems particularly flawed, in how it extrapolates what has happed to Fannie and Freddie, two unique institutions if there ever were, to the other, 'ordinary' banks.
Posted by: Giles | September 12, 2008 at 03:18 PM
«crucial distinction - that between free markets and traditional capitalist ownership structures. The credit crunch does more to highlight the failing of the latter than of free markets.
I say this for four reasons:
1. Banks lost money on mortgage derivatives because of principal-agent failings. Principals - banks’ bosses»
No, that's not capitalism, that's corporatism. In theory under capitalist ownerships, the owners of capital are the principals. If the bank bosses are the principals, then it is no longer capitalism. Capitalism died in the western world at least 50 years ago.
«- didn’t understand what agents (traders) were doing, and traders had incentives to take on excessive risk, because the gains from doing so - a life-changing bonus - exceeded the benefits of prudence.»
But that applies to the bosses too: they too benefit enormously from beta, as both CEOs and traders get with their jobs enormous, free, call options.
«2. Banks have been reluctant to lend to each other not so much because each bank fears its counterparty will not repay the money, but because they fear they’ll need the money themselves. This is because banks just don’t know what sort of losses they are sitting on.»
But "banks" don't know anything; they are just fictions. Bank managers usually do know, but try to dissemble on that, and it is the job of the bank bosses to look beyond the dissembling.
«It’s impossible for managers of such complex organizations to know everything.»
That is a half truth: surely it is impossible to know everything, but the goal is to have reliable estimates of aggregates, and that is certainly possible. But the bosses are heavily into the dissembling game themselves, as they try to collect their dissembled winnings for as long as possible.
«3. Banks are under-capitalized because chief executives have traditionally had incentives to maximize earnings by using leverage.»
That's because they are not principals.
«Pressure upon them to be more prudent has been absent partly because when shareholding is dispersed, no individual shareholder has much incentive to rein in management.»
But individual shareholders are rare, because most capital is provided by the "cattle", small savers, as either collective or individual retirement accounts, managed by their agents, which provides another layer of principal-agent conflict.
You know all this very well I guess, so why prevaricate? Why still talk of capitalism as if it existed instead of corporatist/statist control of capital? Can capitalism exist without capitalists?
In the USA a very large section of the finance system has been nationalized formally after having been turned into a pretend-private off-balance sheet vehicle:
http://www.rgemonitor.com/roubini-monitor/253529/comrades-bush-paulson-and-bernanke-welcome-you-to-the-ussra-united-socialist-state-republic-of-america
http://www.howestreet.com/articles/index.php?article_id=7423
Is that capitalism? In part it is crony capitalism. In part it is just theatre.
«I just want to stress that ownership is the problem, more than markets.»
Maybe, or maybe instead it is a large unacknowledged (except perhaps in papers/books read by few people) shift in the power structure related to ownership patterns, and *that* is what matters.
Posted by: Blissex | September 12, 2008 at 03:26 PM
"Perhaps instead, banks should make more use of internal markets. They should become more like venture capitalists, allocating capital to semi-independent divisions"
It's already happening, to an extent. I know of a number of proprietary trading desks that were packaged up and remodelled as hedge funds (making "punting" into "investing"), as much because the traders - or the ones I talked to at least - wanted their remuneration to be more closely aligned with their individual performance, not constrained by other peoples' losses.
The old "core" banking operation then becomes a service provider to, as well as an investor in the decoupled profit centres.
It's probably a good model for a non-hierarchical 21st-century banking operation, but it'll take a major upheaval and a company in great pain to actually make it happen. Hmmm, Lehmans...
Posted by: Mike Woodhouse | September 12, 2008 at 04:17 PM
No matter how you organize the financial institution it will never be the traders money at stake. His or her incentives will always be the bonus versus unemployment. These incentives are horribly out of balance. The trader will get a fat bonus and live a life of extravagance if the risk pays off. If it flounders he loses his current $100,000 job and finds a fairly comfortable job somewhere else - possibly as a trader in a another firm. He will never lose the billion dollars he put at risk because it was never his to begin with.
Posted by: Scott Ferguson | September 12, 2008 at 04:33 PM
"a crucial distinction - that between free markets and traditional capitalist ownership structures": yep, and it probably does matter that firms operate under government monopoly of fiat currency, and government-controlled Central Banking and regulation. Untangling all the lessons is very difficult, even in the unlikely event that untangling were attempted in a spirit of intellectual enquiry rather than a spirit of sucks-boo. However, you can hardly go wrong if you jail lots of CEOs and politicians.
Posted by: dearieme | September 12, 2008 at 06:52 PM
yes but yes but isn't ownership structure a large part of modern capitalism? and aren't markets largely about how participants get to put their wares in front of clients? Not sure you can split markets and ownership so neatly.
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Posted by: 电炉 | September 27, 2008 at 06:32 AM
I do believe that the philosophical constructs of ownership need to be illuminated by thoughtful discussion. I see the dangers involved in viewing ownership in the financial arena as simple 'dominium' or simple and complete at some point. Property ownership is never the simple thing that some folks, especially those who are enriching themselves by constructing pyramid schemes on Wall Street, are wont to tell us it is. Property is always owned inside of a social fabric that channels, constricts in various ways and places limits in other directions. One is barred from pouring toxic waste down deep wells in the back yard to dispose of it. Yet that is exactly what Wall Streeters are doing, thinking if they bury debt somewhere down a conduit far enough its toxicity will not harm them.
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