MEDIA INQUIRIES:
Clarice Z. Smith Deputy Director Communications Manhattan Institute 646-839-3318 Lauren Miklos Encounter Books 212-871-5741
(Encounter Books, 2009)
ONLINE DISCUSSION
This week Nicole Gelinas and Ira Stoll, editor and founder of FutureOfCapitalism.com, will be discussing Nicole's arguments pertaining to financial regulations.
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MONDAY | TUESDAY | THURSDAY | FRIDAY new
December 14, 2009
IRA STOLL, Editor and founder, FutureOfCapitalism.com:
Thanks for the opportunity. I've got a long list of questions about the arguments you make for more of what you say is "reasonable" or rational regulation (does a proponent of more regulation ever describe the regulation they want as unreasonable or irrational?). But I think I will just begin by asking about this line from the preface: "In their unique ability to offer executives and employees multimillion-dollar bonuses, financial companies made it difficult for companies in other industries, like engineering and technology, to compete for talent." Given the mind-blowing, world-beating successes of the American tech sector of the past 20 or 30 years—Google, Microsoft, Ebay, Intel, Dell, Apple—isn't it hard to justify your implied claim that government intervention is necessary to prevent finance from starving tech of talent? After all, the compensation in finance is actually lower, by some definitions, than in tech, which may be why the top three names on the Forbes 400 rich list include twice as many high-tech guys (Bill Gates and Larry Ellison) than finance guys (Warren Buffett). Nor is it a zero-sum game—the IPO windfalls that the finance guys make possible create incentives for people to go into high tech. If you are looking for a culprit in the supposed high-tech talent crunch, government-monopoly primary and secondary schools and government-created immigration quotas probably should bear more of the blame than free-market compensation competition from finance, don't you think?
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NICOLE GELINAS:
Dear Ira,
First of all, thank you for engaging in this discussion.
Regarding tech: Yes, the American economy has an amazing capacity to innovate and create wealth, despite, as you note, the U.S. government's immigration and education policies, and also despite the distortions that come from the government's "too big to fail" subsidy of finance. These "too big to fail" distortions do exist, though. Like all government subsidies, they thwart true free-market allocation of resources and harm the economy's ability to reach its full potential.
For 25 years, since Washington first protected the uninsured lenders to big banks from their losses, banks have been able to borrow more cheaply than they otherwise could have without such an implicit government guarantee. The financial industry has been able to use government-subsidized leverage to earn higher revenues, and use those revenues, in turn, to push up salaries and bonuses to executives as well as to skilled staff.
As early as 1987, smaller banks understood the implications of this state-subsidized capitalism. "These banks have the ultimate anticompetitive government subsidy," warned Kenneth Guenther, the executive vice president of the Independent Bankers Association of America back then. "They are too big to fail, and regardless of how mismanaged they may become, the buck will stop with the taxpayer."
Other industries have had to compete with government-subsidized finance in the same marketplace to attract executive and other top talent. Because of the distorting effects of a government subsidy, it is not at all clear that gains in executive pay across the private sector over the past two decades resulted from true free-market forces and not instead from government distortion of those forces. After all, finance often dominated profits and economic growth during this time period.
I am all for "free-market compensation competition" in finance and other industries. However, do you think that such a system is what we have had in recent years—and what we have now? Even today, firms such as Goldman Sachs can pay record bonuses in no small part because they benefit from lenders' perception that, in a future crisis, the government will not let them take losses. Unfortunately, the president's railing against "fat cat" bankers misses this point.
I'm glad that you brought up initial public offerings (IPOs) in tech. Stocks are an example of how the government can consistently, predictably regulate a financial market without micromanaging it. Washington doesn't pick and choose which stocks are safe and which stocks are not. Instead, it limits borrowing against stock purchases through consistent margin requirements. When the tech bubble burst starting in 2000, investors lost money—as they should have—but they did not leave so much unpaid debt behind every blown assumption that they bankrupted the financial system, requiring inevitable bailouts to keep the economy running.
The housing market, by contrast, as well as the credit-default swaps and securitization markets were speculative, with no consistent borrowing limits. If Washington had required a 20 percent down payment for the purchase of a home—a consistent limit on borrowing against a speculative asset—the bursting of the housing bubble likely would have looked more like the bursting of the tech bubble.
Unfortunately, in supposedly fixing Wall Street, Washington is going in the wrong direction: toward bureaucratic micromanagement in a futile effort to predict and prevent failure. Instead, they should unleash free-market innovation within consistent borrowing limits and disclosure requirements, better protecting the economy from inevitable failures in finance.
A word about rationality and reasonableness: the de-facto arbitrary regulatory system in which businesses currently operate is irrational. Under what rational, replicable line of reasoning did the federal government engineer a bailout for Bear, Stearns shareholders at $10 a share, wipe out Lehman Brothers shareholders entirely, and give Citigroup and AIG shareholders a chance to recover from otherwise bankrupting losses?
Regards,
Nicole
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December 15, 2009
IRA STOLL:
Just to close the circle on the compensation question—you blame “state-subsidized capitalism,” “government-subsidized finance,” and “Goldman Sachs” for driving up compensation and for competing with engineering, technology, and other industries for talent. But the compensation at Goldman Sachs is paltry compared to the precincts of Wall Street, like hedge funds, that operate without government guarantees against failure. Goldman ceo Lloyd Blankfein makes $70 million in a good year; hedge fund manager John Paulson makes $3.8 billion. I’m against state-subsidized capitalism and government-subsidized finance, too (at least we agree on something!), but I don’t think it’s a particularly strong argument against the state subsidies that they are distorting compensation upward. This New York Times article names three Goldman alums who left to start hedge funds (we could both probably name a half-dozen more), and quotes one Wall Street veteran who left to join a hedge fund as saying: “I get paid more and it’s more fun.” The compensation at Goldman isn’t driven by the government guarantees but by the need to keep people who can earn more—a lot more—at hedge funds. Please don’t say the hedge fund guys were somehow emboldened by the rescue of Long Term Capital without also dealing with the many other big hedge funds (Amaranth, Sowood) that closed without government interventions.
You cite initial public offerings as an example of “how the government can consistently, predictably regulate a financial market without micromanaging it.” In your book you cite the Securities Act of 1933 and the Securities and Exchange Commission as examples of similar reasonable or rational regulations. But both the Securities Act and the SEC impose all kinds of unpredictable, inconsistent, and micromanaging obligations on firms and individuals trying to raise capital. These laws empower and enrich a whole class of lawyers (often former SEC officials), investment bankers, and investor relations consultants who charge beleaguered entrepreneurs hefty fees to navigate the bureaucracy, write unreadable, book-length prospectuses, and advise them on what they can and can’t say. Often, the result is less-informed investors as opposed to more-informed investors. One classic example was the following statement issued by Google in 2004 in response to a Playboy interview with Larry Page and Sergey Brin that was published during the pre-IPO “quiet period”: “We do not believe that our involvement in the Playboy Magazine article constitutes a violation of Section 5 of the Securities Act of 1933. However, if our involvement were held by a court to be in violation of the Securities Act of 1933, we could be required to repurchase the shares sold to purchasers in this offering at the original purchase price for a period of one year following the date of the violation. We would contest vigorously any claim that a violation of the Securities Act occurred.” If even the geniuses behind Google got themselves ensnared in the Securities Act while advised, at great fees, by top lawyers and investment bankers, how is an ordinary entrepreneur supposed to proceed? For an example of SEC micromanaging, see this New York Sun editorial documenting the way the agency descended on at least three hedge funds in 2005 and, without a warrant, demanded to see a month’s worth of their ceo’s email. Another example was the treatment of Mark Cuban. Another was the SEC press release that highlighted Raj Rajaratnam's supposed status as a "billionaire." Wouldn’t your proposed “reasonable” regulations spawn similar unreasonable red tape and flawed enforcement?
I fear that your suggestion of limits on borrowing is just more of the same government-knows best approach: “If Washington had required a 20 percent down payment for the purchase of a home—a consistent limit on borrowing against a speculative asset…” Why not 21%? Or 19%? Or 19.5%? Why should some congressman or bureaucrat set the borrowing limit rather than the free market choices of a willing lender and a willing borrower? Shouldn’t those parties have a right to make a contract without interference from Washington? My guess is that, just as you use the bailouts as a rationale for more regulating of the banks, you use the federal mortgage guarantees as justifications of the limits. But if someone is willing to forego the guarantees, shouldn’t they be able to escape the limits, even by paying a higher rate, as a borrower does with a jumbo or nonconforming loan?
One last question, to stay with your recommended solution of limits on borrowing or leverage but to return to the technology sector. Sometimes heavily leveraged borrowers default. But sometimes they are leveraged highly because they believe in their investment, and sometimes it works out well for them. I was reminded of this the other day reading a Gretchen Morgenson article from the February 7, 2001 New York Times that ran under the headline “A Lehman Bond Analyst Paints a No-Nonsense Portrait of Amazon.” It reports that “an influential convertible bond analyst at Lehman Brothers” had “published a report arguing that this may be the year in which both time and money run out for Amazon.” The article went on to note that the online retailer had $2 billion in debt and working capital of $386 million. Are you advocating that the government set rules that would have limited Amazon’s ability to borrow? A share of Amazon stock that sold for $15 in 2001 is now worth $135, which by my rough math is a 900% return. Lehman Brothers, of course, is the bankrupt one. Amazon.com is a pretty amazing company, allowing people to buy your book and lots of other things, too, without even having to leave their desks. Anyway, this is just really an informational question, not a rhetorical one—would your leverage restrictions apply only to financial companies, or to tech companies like Amazon, too, and would the application of your rule have killed Amazon prematurely in 2001 or before without allowing the company to survive and become the success that it is today? And, again, in Amazon's case as in that of the person borrowing to buy a home, what is the justification for allowing the government to interpose itself to block a transaction between a willing borrower and a willing lender?
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NICOLE GELINAS:
Dear Ira,
I will address your point about "unpredictable" and "inconsistent" regulations first, since it gets to the core of my argument. As the world has seen over the past two years, the absence of proper rules does not make for freer markets. Instead, it leads to nationalization, as society will not accept the full consequences of intense free-market corrections. Yes, the SEC and other regulators do all kinds of stupid, arbitrary, investment-killing things, which I don't support. The answer is not to get rid of financial rules altogether, any more than the answer to government's many errors is to have no government at all.
What are the right rules? Ones that create a level playing field for private-sector competition and free-market discipline, rather than picking winners and losers. As you say correctly about today's inconsistent, micro-managerial regulations, "if even the geniuses behind Google got themselves ensnared in the Securities Act while advised, at great fees, by top lawyers and investment bankers, how is an ordinary entrepreneur supposed to proceed?" What President Obama and Congress are proposing, through their "Wall Street Reform and Consumer Protection Act of 2009," would place "ordinary entrepreneurs" at an even greater disadvantage. The act would give "systemically important" financial firms certain privileges, including the right to a bailout in a crisis, that other firms don't have.
The right rules, too, make the economy as a whole more robust and better able to withstand financial firms' and instruments' failures. To this end, instead of institutionalizing certain firms as too big to fail, Washington should craft rules that set consistent limits on borrowing. With such limits in place, failure of even a big firm won't leave so much unpaid debt behind that it bankrupts the entire system, requiring arbitrary bailouts.
As for your point about what the "perfect" percentage of cash down for any asset class under such limits would be: there is none. Margin requirements on stocks—that is, limits on borrowing—are currently 50 percent; they could be 40 percent or 55 percent. It's the consistency that matters. Predictable application of rules allows markets to innovate while offering protection to the broader economy.
An illustration of what not to do: for decades, Washington allowed investors in AAA-rated, mortgage-backed securities to hold just one-fifth of the capital normally required for debt securities. These inconsistent rules gave the ratings agencies their outsized power in the economy, because financial firms had an incentive to reach for the AAA rating, gaming the capital requirements to earn higher profits. When it turned out that the government was catastrophically wrong in its command-and-control assessment of what constituted risky debt securities, the economy had no protection against that mistake.
The government should not decide what's risky, security by security, from the top down, which is what it has done since the eighties in the above manner. Instead, with consistent borrowing limits across any asset class, the markets can decide what are acceptable levels of risk, through the rate of return that investors demand for each potential investment. Such rules leave some room for error when one large asset class turns out to be much riskier than anyone had thought. When hundreds of billions of dollars of AAA-rated mortgage-backed securities tottered, the economy had no such room for error, because the government had decreed that these securities were perfectly safe.
These rules should not exist to protect government from any guarantees it offers, including mortgage guarantees. I don't think that we should have government guarantees of mortgages or other housing subsidies. The rules should exist to protect the entire economy from any one party's failure. For that reason, no institution or individual should be able to opt out of the rules as long as he agrees to forego any theoretical future bailout. The "justification for allowing the government to interpose itself to block a transaction between a willing borrower and a willing lender" is that a financial company's right to borrow ends when its borrowing poses such a threat to the economy that bailing out the firm becomes inevitable for the economy's sake.
To answer your question about non-financial companies: A company that exists to operate a business, not to engage in financial speculation, does not pose a systemic risk to the economy. Amazon's 2001-era $1.6 billion in net debt posed a risk to Amazon and its investors, not to the $10.1 trillion U.S. economy. A non-financial firm wouldn't have to operate within the kind of limits I describe, but its investors would.
That is: Amazon could raise as much debt as the market would bear, but the banks and other financial firms that invest in such debt would have to hold a consistent level of capital against the risk that the debt will go bust. Similarly, Amazon could sell as much stock as the market would bear, but people couldn't borrow 100 percent to purchase it; they could only borrow half.
So GE Capital, General Electric's financial arm, would fall under financial-company rules, but General Electric itself would not. If Amazon opened an investment firm, the investment unit would have to operate under the same rules as Goldman Sachs. But crucially, neither financial unit would have an advantage over the other, because the playing field would be level, and each financial firm would operate under the credible threat of failure.
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