Deconstructing Judge Posner's Writings on The Bailout

Judge Posner is a favorite of mine, but I do not agree with him on very much. Herein is a good analysis of his recent writings, by Simon Johnson's sidekick James Kwak, who to me seems just as spot-on as Simon.

The Baseline Scenario
Posner, Part II: What Now?
Posted: 09 Jun 2009 04:30 AM PDT
Note: After writing this, I read Brad DeLong’s better review of Posner’s book (hat tip Felix Salmon). I won’t be offended if you go read that instead.
Part I of my comments on Richard Posner’s epic blog discussed the concept of blame. Today I am going to discuss his approach to some policy questions.
Posner’s crisis book is boldly titled “A Failure of Capitalism.” The problem is that when the lens through which you see the world is capitalism – or, more precisely, a flavor of economics that works out to justify capitalism in virtually every instance – it’s not clear what’s left over when capitalism fails.
Posner’s method is simple, and I can do it, too. Basically, for any policy, extrapolate out its effect until you can demonstrate that it will lead to a bad (and preferably non-intuitive) outcome – typically by changing the incentives for rational actors so that they no longer maximize profits and thereby social utility. When you do this enough, it becomes such second nature that you forget to spell out your arguments. Here’s a simple example:
While cramdown would have benefited some homeowners, it would have hurt lenders and thus have undermined the bank bailouts.
That’s the whole argument. Filling in the blanks, Posner is saying that because you have decided (a) to bail out banks, you cannot undertake another policy (b) - which may have its own costs and benefits – because it is in some way contrary to policy (a).
And here is Posner’s entire argument against “trillions of dollars of proposals of long-term social reform” being pushed by “the adminstration:”
Apart from creating enormous economic risks, the ambitious long-run proposals are ill timed; by further unsettling the business environment, they will further slow the economic recovery.
Leave aside the fact that the “social reform” proposals go unnamed – maybe he means health care – and that the “enormous economic risks” are unexplained. Focus on the second half of that sentence. Posner is saying that policies that create uncertainty for business necessarily impede growth. First off, this is not the situation here. Let’s assume he’s talking about health care or carbon emissions: in both cases, the uncertainty is created by the fact that everyone knows our current non-policies are unsustainable, and therefore it is precisely businesses who want systemic reform. They may not want it in the form Barack Obama wants, but they want to know what the future looks like; that’s why many major carbon emitters are lobbying for cap-and-trade (and free emissions permits), because they want to avoid a carbon tax. Second, even if uncertainty is bad for growth, Posner assumes that the benefits of those policies will not outweigh their costs; there is a tacit assumption that the benefits of government policy can never outweigh their effect on economic growth.
Obviously, I’m just warming up for the main course. Here’s Posner on fixing the banking sector:
Impatience with the [Public-Private Invesetment Program] leads some economists to advocate the government’s “nationalizing” the weak banks [I assume by this he means FDIC-style takeovers], but that would be a mistake. This is not only because of the manifest inability of the government to manage banks competently, but also because the vexing problem of valuing the overvalued assets cannot be avoided in this way. The banks are not broke; if the government takes them over, it will have to compensate the owners for the net value of the assets that the government takes, including any overvalued assets that, despite being overvalued, have some value. Perhaps what the government could do would be to take (with compensation) all the good assets of the bank, leaving the overvalued ones with the shareholders; then the bank’s balance sheet would be “clean.” But then what would it do with the bank? Run it? Sell it? The practical complications would be immense.
First, the “vexing problem of valuing the overvalued assets” does go away. If the government takes over a bank, it can transfer assets from the bank to another entity (the famous “bad bank”) at any price, or no price at all, because there is no one to negotiate with. The government does have to recapitalize the thing that is left over, and the less it “pays” for the assets the more capital it will have to add later; but how much capital the bank requires does not depend on the assets that have been removed from its balance sheet. Even if you accept that the bank in question is not broke, the amount the government might have to compensate shareholders is not the book value of their equity, but the market value – which, for Citigroup, was down in the $20 billion range at one point.
Second, and more importantly, Posner simply assumes that government ownership – in any form – is a bad thing. This is in keeping with his legacy. By contrast, though, he is relatively sanguine about the UAW’s retiree benefit trust.
Concern has been expressed that, subject to possible modifications by the bankruptcy judge, Chrysler will be controlled by the United Auto Workers and therefore managed inefficiently, as worker-managed firms typically are. But it is not true that the UAW will manage Chrysler. Not the union, but the Chrysler retirement plan, will be a shareholder in the reorganized company (in fact the principal shareholder), and it will have a fiduciary duty to maximize shareholder value rather than to increase the earnings and benefits of the current workers.
Posner clearly understands that majority owners are not managers, and that they have fiduciary duties to all shareholders. And he is willing to give the benefit of the doubt to the UAW, of all organizations. The retiree benefit trust he refers to has a board of overseers, slightly under half of whom are nominated by the UAW. But most if not all sensible advocates of bank takeovers recommended selling cleaned-up banks back into the private sector and – if that is not feasible, as would be likely for the big ones – putting the government’s stake in a trust with independent trustees. The “manifest inability of the government to manage banks competently” is just a talking point; no one thinks that pension funds, mutual funds, and life insurance companies can manage banks competently, either, yet no one is bothered by the fact that they are the primary shareholders of most public companies.
Once you recognize that free-market answers are not necessarily, unequivocally, always right, then you realize that most interesting questions can be argued one way or the other. And so Posner takes his issues on a case-by-case basis – which ends up being unsatisfying.
Take his post on banking regulation, which is full of intelligent thoughts but ultimately no recommendations. Systemic risk regulator? Bad idea, Posner says. It would deter banks from becoming big; he implies that bigness is good, without coming out and saying it – “the result may be a less efficient banking industry, if scale and position in financial markets confer substantial benefits” (emphasis added). And 100 small banks are just as risky as 20 big banks, he asserts. (I think that depends on the risk you are protecting against; it’s hard to see how five little insurance companies could have replicated the damage that AIG caused.) And it would only add to bureaucratic turf wars, because “presumably” the other regulatory agencies would be left in place.
What about going back to the old rules? Also bad. It would “reduce the availability of credit” – which is bad by assumption. And, besides, it’s impossible, because financial intermediation naturally escapes regulation through the magic of competitive markets – the activities you want to regulate will simply shift to unregulated institutions. Here’s an example:
The regulators could put a ceiling on the bank’s debt-equity ratio to limit the downside risk. But how would they determine the ratio? And would they impose a ceiling on the debt-equity ratio of all potential lenders?
This amounts to saying: (a) if there’s no perfect way to set a leverage cap, there’s no point in bothering; and (b) there’s no point in trying to regulate all institutions that could lend money.
Then Posner veers toward the theory that the Community Reinvestment Act, along with Fannie and Freddie, is really to blame. You would think he would agree, since those are forms of government intervention. But he knows that, in fact, the CRA, Fannie, and Freddie were bit players in the subprime debacle, so that can’t be the answer, either.
So in the end, Posner’s answer to the question he poses, “How Should the Banking Industry Be Regulated?,” is “not any way that anyone has suggested so far.” It seems that instead of using his talents to defend free-market capitalism, he is using those talents to shoot down any proposal anyone might make as hopelessly naive. Which is unfortunate, because I’m sure he could contribute more to the debate.
By James Kwak

“There Were Ratings That We Saw That Made No Sense To Us.”
Posted: 08 Jun 2009 07:30 PM PDT
This American Life had another good financial crisis episode by the Planet Money team this past weekend. There’s a story on regulatory holes by Chana Joffe-Walt and one on rating agencies by Alex Blumberg and David Kestenbaum. The latter had some money quotes (starting around the 40-minute mark).
Jim Finkel, Dynamic Credit, which creates structured products: “There were ratings that we saw that made no sense to us. We knew the rating agency models and metrics, and we could replicate them ourselves, and we couldn’t make sense of what they were doing.”
Felicia Grumet (sp?), Bear Stearns, who was involved in creating structured products: “It makes me feel really bad, so actually it’s very hard for me to acknowledge . . . I knew what I was doing. I knew I was doing things to get around the rules. I wasn’t proud of it, but I did it anyway.”
One of the heroes is Mabel Yu, a buy-side bond analyst at Vanguard, who couldn’t get the rating agencies to explain the ratings they were giving to structured products – and therefore refused to recommend them internally at Vanguard. Who knew? Not only do you get lower costs at Vanguard, but better fund management, too? (I have most of my money at Vanguard, but it’s in all in index funds or near-index funds, so I guess I wasn’t benefiting from Yu’s research.)
By James Kwak