TOPICS IN POLITICAL ECONOMY

HEALTH CARE REFORM: AN UGLY DUCKLING THAT DESERVES TO DIE

In 1993, the Clinton Administration tried to reform health care with a “White House knows best approach.”  That effort  crashed and burned, deservedly so.  

President Obama is trying the opposite tack: He is telling Congress, “Here are my general objectives – affordable health-care for everyone, ‘deficit neutrality,’ and no reduction in current benefits – and, please, Congress, you figure out how to pay for everything."

Once again, the President is all “fox” and no “lion.”  He is saying,  "Let Congress do the heavy lifting and I will market the outcome if I can say it meets my criteria."

An Ugly Duckling Emerges.  After reading the transcript of the President's July 22 news conference, it is clear he sees health care reform legislation as his ticket to re-election in 2012, just as George W. Bush used Medicare drug entitlement legislation to ensure re-election in 2004.  In other words, President Obama will sign any comprehensive reform bill so long as it purports to be "deficit neutral," increases coverage to nearly all Americans, and doesn't eliminate any benefits for current Medicare and Medicaid beneficiaries.  

The official commentary on HR 3200, the legislation jointly reported out of  three House Committees, claims that half of its costs would be paid for by "significant efficiencies and savings" in Medicare and Medicaid and the rest would be recovered through an income tax surcharge on "the wealthiest." The White House goes even further - with the President insisting that two-thirds of the cost of increased coverage can be recovered through cost savings in existing programs, and coyly indicating he will go along with most any tax increase Congress can agree on. 

The Congressional Budget Office begs to differ: its admittedly incomplete analysis of the House legislation suggests an increased deficit of $239 billion over the ten-year period 2010-2019.

Both the President and Congress seem to find beating up insurance and drug companies, doctors, and hospitals as the way to go to get their savings.  The House legislation is full of mandates telling everyone how to run their business.  It also establishes a "public health insurance" option (cost unspecified) intended to compete with private and nonprofit organizations and force them to be more efficient. (If you like the way the government runs the finances of Medicare and the Pension Benefit Guaranty Insurance Corporation, you will love this new player.)

As it stands, HR 3200 is an ugly duckling, and likely to do little to improve the dysfunctional nature of our current health care system; in all likelihood it will make it - and the budget deficit - worse. 

What Would A Lion Do?  If the President wanted to enact genuine reform, he could take a number of steps that would accomplish some of his objectives. It would mean taking on tough issues directly, rather than accepting dysfunctional Congressional legislation.  Some illustrative, common sense (but politically difficult) measures, which require no budget outlays, could include:

1. Make employer-paid health insurance premiums taxable.  Such a step is just as important for its impact on changing employee preferences for gold-plated insurance programs - which help drive up the cost of health care -  as it is for the additional revenue it would generate.  Leading Democrats such as former Senator Daschle and John Podesta, a former Obama staffer, have promoted a variation on this.

2. Permit a free market in living donor kidney sales for transplants. According to a series of articles in the peer-reviewed American Journal of Transplantation, every additional kidney transplant can save taxpayers $94,000 compared to having patients on Medicare-financed dialysis, as well as improving the quality of life and longevity of such patients. Back of the envelope calculations by Virginia Postrel suggest that giving each living donor about half of these savings would still result in a $4 billion reduction in Medicare spending. 

3. Permit nurse practitioners at a Walmart kiosk (for example) and or pharmacists to perform routine medical office tasks (many state laws place substantial barriers to such activity).

4. Play no favorites among medical specialties in subsidizing doctors' education or Medicare treatment reimbursements; as it is now, primary care and internal medicine practitioners (usually the only ones who can see the patient as an entire human being) are at the bottom of the totem pole, despite substantial evidence that they are best placed to manage patient care. The rapid growth of "concierge medicine" for wealthier individuals is the most visible sign of this fact.

These are just a small sample of the many ideas which market-oriented economists and health care policy experts have studied. Look at the Cato Institute's web site for additional suggestions.  Financially, nearly all of these ideas are cost-free - but they require genuine leadership and spending scarce political capital. Health care reform is an issue that desperately requires both.

Machiavelli wrote that leaders need, depending on the times, to be both a fox and a lion.  Now its time for President Obama to act more like a lion.

THE BIG, BAD ENERGY BILL: H.R. 2454

1. If you think the world is getting warmer . . . and

2. If you think that carbon dioxide emissions are a factor in such trends . . . and

3. If you think that human activity is a sufficiently significant generator of such emissions . . . and

4. If you think a warmer world has a net "bad" impact on humans . . .

Then you certainly shouldn't be supporting the massive Waxman-Markey energy bill making its way through the Washington DC sausage factory on Capitol Hill.

The reason is simple: if you want to reduce consumption of energy sources that contribute to carbon dioxide emissions with minimal impact on output and with maximum stimulus to innovation, you need to increase the relative cost of such energy. The current energy bill tries to avoid doing this - mainly by creating valuable licenses to pollute that will mainly distributed by elected politicians.  There is no better design for a political cesspool than such a mechanism. 

The gory details of the current draft can be found at http://www.thomas.gov/cgi-bin/query/z?c111:H.R.2454, but at roughly 900 pages I am sure you don't have the time (nor do I - or any Congressman or Senator) to go through it. But the basic thrust should make the Al Gore crowd very happy - and amply substantiates Vaclav Klaus's summing up of the knee-jerk environmental gang:  "the biggest threat [today] to freedom, democracy, the market economy and prosperity [is] ambitious environmentalism."

H.R. 2454 is, simply put, a "command and control"  vehicle  which is intended to promote a massive expansion of Federal government power to determine how Americans should live.

The alternative, a straightforward tax on carbon emissions, with revenue used to reduce taxes, is fairer, provides the right incentives to consumers and producers of alternative energy sources, stimulates innovation without government subsidies and provides far fewer playing fields for lobbyists seeking to game the system for their clients. 

For starters, there is a plethora of proposed federal standards - for renewable electricity, low carbon fuels, building codes, appliances, and vehicles - that are either mandated or subject to implementation by coercion, e.g. withholding federal monies raised through the sale of allowances to pollute. The bill requires that by 2012, local building codes must mandate that new buildings are 30% more energy efficient than currently. Forget local building codes that reflect local realities.

But the real "cesspool" creator is the failure of Waxman-Markey to let market forces determine the price of licenses to pollute.  Instead, in the initial year of implementation 85% of the licenses will be distribute for free under Congressionally-mandated distribution formulae, as the accompanying graphic from David Wesselman's article in the May 23 Wall Street Journal clearly shows. It reflects the efforts of more than 800 lobbyists over the past several years in wining, dining, and contributing campaign monies to your elected representatives.

 

The administration of this "cap and trade" system is full of "special reserves" and similar escape valves, the administration of which will draw in the political class like flies feast on honey, even if, as is intended the percentage of licenses auctioned off increases over the years. 

Now, let's see how President Obama responds to this monstrosity.  As he put in when he was campaigning, "If you're giving away carbon permits for free, then basically you're not really pricing the thing and it doesn't work -- or people can game the system in so many ways that it's not creating the incentive structures that we're looking for."  If he sticks to his sound analysis of this issue, he will demand that the vast majority of allowances be auctioned off immediately. And revenues accruing from the auctions will result in lower taxes for some individuals - as he also promised.

But What If . . .?    But what if any one of beliefs (1)-(4) with which I started this note are incorrect? And there are, in fact, many reputable scientists who cast doubt on at least one of the four. 

If there is legitimate doubt on these issues, then the impact of passing Waxman-Markey is likely to be similar to that of the 18th Amendment to the Constitution in 1919 establishing Prohibition. It took 14 years for Congress to grasp the magnitude of its mistake, which created millions of lawbreakers and gave rise to criminal gangs that live on today.

Waxman-Markey, in anything close to its present form, would be an even costlier piece of ill-considered legislation.

And the best that could be said for legislation that enacted a carbon tax instead of "cap and trade" is that it would do less damage.

DANGER: SAUSAGE FACTORY AT WORK

Major federal legislation dealing with our health care system is currently winding its way through the Congressional sausage factory.  Seasoned observers (and many lobbyists) feel that the probabilities of such legislation becoming law before the end of the year are considered good. 

But the legislative process is never a pretty picture in such matters, and the resulting product  could be highly dangerous to our economic health. Instead of addressing the root causes for distortions in pricing, costs, modalities in treatment and assurance of supply, Congress appears to bent on simply establishing new entitlement programs, mandates, and cost controls.

Only when there is a clear and present danger that serious economic disruption caused by the mistaken policies of the past does the Federal government seem able to identify the true underlying causes and take effective action. 

Case Study: Natural Gas Supply.  Consider the history of natural gas price regulation.  In 1954, bowing to political pressures “to protect consumers,” the Federal government began a process that eventually led to widespread shortages of gas and a costly, convoluted, Rube Goldberg pattern of market inefficiencies. The situation reached near-crisis stage in the winters of 1976-1977, when many schools and factories in the Midwest were forced to close due to a shortage of natural gas to run their facilities – while at the same time there was substantial supply in Louisiana and other gas-producing states.

As a result, finally, legislation was passed in 1978 that started the industry on the road to de-regulation, although the final lap was not completed until 1992.  There have been no significant problems with natural gas supplies since that time.

How to Create A Market Failure.  Federal tinkering with the U.S. health system has an even longer history, going back to World War II.  At that time, responding to union pressures for higher wages than allowed for by the wartime wage/price control system, the Federal government permitted employer-paid health insurance benefits to be considered nontaxable to the employees (and exempt from employers’ matching Social Security contributions). 

By 1982, Congress – and the public – were told clearly, in President Ronald Reagan’s first Economic Report, that the growing costs and inefficiencies in the health care industry “are due to inappropriate tax policy and inadequate incentives for both consumers of medical services and providers of health care to reduce costs.” Tax policy created excess demand and spending for gold-plated health insurance – and marginal medical services.  Medicare reimbursement schedules discouraged newly-minted MDs from primary care careers and enticed them into more lucrative specialty niches. Paying for hospital stays and treatments rather than patient outcomes provided perverse incentives for hospitals.

Clearly, not much has happened at the Federal level in the ensuing 25 years to address the problem.  Instead, it has tended to grow worse.  Economic growth and swelling tax revenues permitted politicians the luxury of adding new benefits (e.g. Medicare’s prescription drug program) without addressing the underlying problems. “No crisis?  No real problem” summed up Washington's attitude.

Current Prospects.  Two years ago, writing in this space, I was cautiously optimistic that “the laboratory of the states” was moving policy in potentially useful directions. Some of these efforts, as well as others by the Veterans’ Administration, have been bearing modest fruit and are now being imitated by others. It would be disheartening if further initiatives were put on hold or pushed aside by the prospect of “one size fits all” Federal legislation.

While the odds of new legislation that makes the current mess worse are better than even, chances appear to be brightening for at least one long overdue reform. Confronted with the costs of expanding coverage for the uninsured, the Administration uncharacteristically has told Congress that the legislation must be paid for in additional revenues. It has even intimated that it would go along with taxing employer-paid health benefits, something Obama slammed John McCain for advocating during the Presidential campaign. 

If applied across the board, eliminating this tax-free benefit would net the government well over $100 billion a year in additional tax revenues. More importantly, it would provide the incentives for individuals and their employers to rethink what kind of health insurance they really need and do away with the thicket of health savings plans based on tax avoidance dreamed up by financial advisors.  Finally, this step would eliminate the highly unfair treatment of self-employed individuals, who have to pay for their insurance with after-tax income.

It would be a pleasant surprise if, unlike the sorry history of government’s role in the natural gas supply market, the legislative sausage factory could produce one major, substantive improvement in approach to health care without the whip of a genuine crisis, presently scheduled for 2017 - when Medicare runs out of cash.

But don't bet on it.

STRESS TESTS, KEYNES AND THE BANKING SYSTEM

So, the well-meaning civil servants have dutifully ground through the numbers and their politically-attuned Treasury/White House managers have signed off on the "stress tests" of 19 major shareholder-owned financial institutions.  (Notice that the Social Security System and major public employee pension funds - e.g. the State of California's mega fund Calpers - have not had to undergo similar scrutiny.)

What do we know now that we didn't know yesterday?  Not a great deal more.  The regulators took these institutions' current balance sheets, posited a set of assumptions about future economic conditions and loan losses, and let the Excel spreadsheets generate a set of numbers and ratios. These purport to estimate the "capital buffers" each institution has to have to weather a more severe economic downturn. A fairly simple exercise for any reasonably competent MBA.

The Reality.  What has been the true purpose of this exercise?  The answer can be found in John Maynard Keynes' "The General Theory of Employment, Interest, and Money."  But it has all to do with "confidence" and nothing to do with spending and fiscal stimulus. 

The answer is in Chapter 12, "The State of Long-Term Expectation."  Long term expectations, Keynes pointed out, do not depend solely on forecasts, but also depend upon "the confidence with which we make this forecast."  The state of confidence, in turn, is critical to determining the appetite for investment and enterprise. I suspect that more than a handful of Federal Reserve governors and staffers, and a few Treasury Department types, have been re-reading this classic essay in recent weeks.

In other words, since the rating agencies have been shown to be close to useless in such matters, and the credit default swap market had been so bad-mouthed by politicians and journalists, and the regulators themselves were shown to have been clueless, a hopefully credible alternative had to be immediately established.  

Washington's "stress tests" have been one in a series of actions designed to restore confidence in the financial system and among bankers.  This is to ensure that depositors and other lenders are comfortable in entrusting their funds to such institutions, who in turn will be able to extend credit.   

The Politics. The results of the stress tests rest on fairly credible assumptions: the "more adverse" stress simulation assumed a two-year loss rate of 9.1% of total loans (the highest rate in at least 90 years) and the highest unemployment rate since the 1930s. Ten of the 19 financial institutions evaluated were seen as needing to augment their "Tier I" capital to cope with such a  downturn, but the initial reaction in the market is that this should be feasible without a major problem.

As I have suggested in this corner before, "modern money is magic." Destroy my confidence in my bank - any bank - and you destroy money, as represented by that bank's deposits, as I withdraw my deposit and turn it into currency, gold, or some other borrower's liability (Treasury bills?). The stress tests, originally announced in February, were designed and orchestrated primarily to restore confidence in major financial institutions.

In short, the entertaining saga of the "stress tests"  has more elements of a long-running, elaborate Japanese noh drama than technocratic public policy - but that doesn't mean we can't congratulate the dramatists for a useful script. 

THE CHRYSLER BANKRUPTCY: ECONOMICS, POLITICS AND MORAL HAZARD

Economics and politics can make for a messy stew.  And the Chrysler Chapter 11 bankruptcy filing  ("Give them another chance!") is a pretty big kettle. 

The true tragedy is that this mess (and the forthcoming General Motors imbroglio) could have been avoided - in 1979-1980, when Chrysler was bailed out with a $1.2 billion federal government loan guarantee and a quasi-Chapter 11 bankruptcy. Rather than let a badly managed company truly go under, President Jimmy Carter bailed out the company and stiffed a lot of creditors. Detroit took note that when disaster threatened, Washington could probably be counted on, creating "moral hazard" - for taxpayers.

So, here we are again ("Groundhog Day" for you middle-aged movie fans?) with a prostrate Chrysler (plus GM) trying to avoid the cemetery.

As I wrote in this blog last November 16th, "if Chrysler, and all its stakeholders, had been eliminated as an independent automaker in 1980, much as LTV, Bethlehem, and various other American steel companies disappeared into bankruptcy over the past ten years, chances are that GM management and workers would have “seen the light.”  They would have taken the necessary drastic and painful steps to get their house in order. This is what U.S. Steel did after Wilbur Ross and Lakshmi Mittal (two rank outsiders) established  their credibility with the steel workers’ union and  reorganized much of the faltering U.S. steel industry."

Look Who's Running the Asylum. The fatal flaw with the government-assisted Chapter 11 bankruptcy filing (taxpayers will have $12 billion in loans outstanding to Chrysler) is that Wilbur Ross and Lakshmi Mittal are not on the scene.  Instead, the majority shareholder (55%) will be - the automobile workers' union! How can we expect such an organization to compete effectively, even assuming a level playing field, against Ford and foreign-owned manufacturing plants already in the U.S.?

A particularly nasty slant in President Obama's presentation of the plan (which may well be modified by a federal bankruptcy court) was his dissing of hedge funds and various smaller creditors who forced the bankruptcy filing (most of the major creditors were banks with TARP capital infusions). Maybe he forgot that a major hedge fund, Cerebus (and its shareholders, who no doubt include a lot of pension funds) has lost at least $7.5 billion.  As the Financial Times put it yesterday,

 Americans remember Washington as a far more paternalistic place in 1979, but respect for private contracts and protecting taxpayer dollars was higher given the terms of the first Chrysler rescue and today’s messier sequel.

The Politician At Work.  Throughout all his Administration's maneuvering, however, in Obama one can see a relatively, for a Democrat, non-ideological politician at work.  The rule of thumb he is following in trying to salvage Detroit's ailing giants is "the uniform distribution of dis-satisfaction," an age-old Washington formula that political foxes employ whenever needed. And cheap shots at risk takers who aren't on the Federal dole are costless.

There are no lions in the White House.

"FINANCIAL CRISIS MANAGEMENT 101" FOR POLITICIANS - AND THE PUBLIC

A short course in current financial market realities is badly needed for most members of Congress and a fair number of the chattering class, many of whom are threatening to exacerbate the current situation.

1. Please don't forget that the primary objective of nearly all of the money that has been pumped into commercial and investment banks and AIG, as well as the expansion of government deposit/money market fund insurance by the FDIC and the Treasury was intended to stop a massive and highly dangerous run on the nation's banking system in the last six months of 2008.

2. That effort has been successful. Give the Treasury and the Federal Reserve some credit for what they did, even if their public explanations were unsatisfactory - as they still are.

3. Stop asking the banks "Where did the TARP money go?" The complexity and daily volume of multimillion dollar transactions on any large bank's balance sheet makes this essentially a rhetorical question. Stopping the run on bank and money fund deposits was the first and most important step in avoiding an excessive contraction of the banking system.

4. Stop trying to get the banks (and the government mortgage agencies) to lend or guarantee more loans. In a recession, such as we are now experiencing, lenders quite properly become more cautious, as do potential borrowers. Wasn't it the combination of loose lending standards and over-leveraged lenders and borrowers/buyers that made this downturn so serious?  The need to generate income will provide sufficient incentive for lenders to extend new credits. (No bank can cover its overhead investing in Treasury bills at 1%.)

5.  Understand business cycles. All recessions are characterized by sharp slowdowns in credit extensions. In fact, in March loans outstanding at large commercial banks to both business and consumers were still at higher levels than a year ago.  At some point in the near future, we should expect them to be below year earlier levels, as they normally are at later stages of the business cycle.   

6. Stop bad-mouthing bankers and threatening to impose regulatory burdens on hedge funds. You need them (1) to sort out the mess of bad assets still on banks' balance sheets and (2) to restart the markets for securitized mortgages and loans if you want the credit markets to open up fully.

7.  Study what recently happened in Iceland where a politician was appointed to head up the Central Bank and was instrumental in creating a real financial disaster.

CHINA, CONVERGENCE, AND MARKET CAPITALISM

Most of the noise coming out of this week’s meeting of the  G-20  heads of state in London will be about regulation,  “stimulation” and new barriers to international trade.   But there Is very likely to be one truly significant long-run political outcome: the functional acceptance of China by “the West” as a major financial and economic power.

This acceptance will take the form of communiqué  language that makes it clearer than ever that China’s share of voting power in the International Monetary Fund (and, perhaps, in the World Bank) will be increased substantially within the next two years.  This shift in voting power will be facilitated by a large increase in IMF resources contributed by member governments, most prominently the Chinese.  

The Death of Market Capitalism?  At the same time, noisemakers at the G-20 meetings will add decibels to the continuing funereal chorus from the chattering classes about “the death of market capitalism.” This, despite the fact that China owes its rise to global power thanks to its embrace of the key elements of market capitalism:  market prices to provide incentives to producers and letting individuals own the means of production and grow rich.

Market capitalism is not going to wither away just because financial regulators around the world decide to insist on less risk-taking by (government-supported) financial institutions, such as FDIC-insured banks, “too big to fail” investment banks, and government real estate lending agencies (FNMA and Freddie Mac). 

It was a form of market capitalism that lifted 400 million Chinese out of dire poverty in the fifteen years between 1990 and 2005, and which now makes some pundits muse about turning global leadership over to the “G-2” – the United States and China. 

Why Losing Market Share May Be Progress.  If market capitalism is not dying, then perhaps the U.S. is threatened by China because of a shrinking share of global economic output?  This notion surfaces in numerous discussions about China’s extraordinary economic achievements as well as international comparisons  of spending on research and development,  patents issued, educational achievements and a myriad of other measures.

But the emphasis on “market share” is simple-minded and incorrect, if the absolute level of economic well-being continues to improve.  In this situation, which certainly describes the past 15 years or so, a smaller market share for #1 simply reflects more rapid growth by lower-ranked countries. 

Furthermore, as Nobel prize winning economist Edward Prescott and Stephen Parente have suggested, if all countries would dismantle “barriers to experimentation”  (ranging from civil strife to monopolies to trade protectionism), “there is no reason why the whole world should not be as rich as the leading industrial country.”  In short, China’s progress over the past two decades is a strong argument in favor of what is known as the “convergence” hypothesis among economic growth theorists – as well as market capitalism.

Cut the Bad-Mouthing.  So, when China sits down in a much bigger chair at IMF board meetings in 2011, there is no reason to bad-mouth either the U.S. or market capitalism.  Instead, congratulate the Chinese and remind yourself that it was a form of market capitalism that got them there.

THE SIREN CALL OF FINANCIAL MARKET REGULATION

At the recent meeting of G-20 finance ministers in London it seems "more regulation" was on everyone's lips as the way to avoid a repeat of the current financial mess.  The only difference between the U.S. and most of the other countries was "how much?" 

The Europeans are hung up on bringing hedge funds under much tighter regulation.  Why is this so?  At first glance, it is hard to understand: no huge "too big to fail" fund had to be bailed out by any government - although a lot have simply folded up and returned a few cents on the dollar to their original investors.  It is true that hedge fund managers became very nervous when their "prime brokers" such as Bear Stearns and Lehman Brothers started looking sickly.  These funds started pulling out their money and securities - or buying credit default swaps to protect themselves if their broker went bust. Were they wrong to behave in this manner?

The standard European politician's complaint is that hedge funds are secretive and disruptive, especially for the managements of old-line, sleepy corporations. That would help explain the push for regulation - along with the fact that they pose a long-run competitive threat to already over-regulated traditional financial institutions. 

Who's the Biggest  Problem?  The fact is that it was the most regulated institutions in the U.S. that have caused us the most problems: investment banks and money market funds overseen by the SEC plus commercial banks and bank-holding companies overseen by the FDIC, the Comptroller of the Currency and the Federal Reserve. 

With respect to the rating agencies (who made a major contribution to the 'perfect storm' of the current financial mess), the SEC has plenty to answer for. They required money market funds to structure their portfolios around S&P and Moody's credit ratings as a substitute for the funds' own due diligence. And anyone who studied the models used by  credit agency analysts to rate complex mortgage securities had to take a dim view of their robustness (i.e. using less than 10 years loss experience). All this, plus the well-known weakness in the agencies' current business model, where issuers, not investors, pay for the rating.

While the new SEC Chairwoman has talked obliquely about moving the agencies towards an "investor pays" model, the major government initiative at the moment seems to be to impose regulation and its attendant costs on the only honest canary in the credit rating coal mine - the unregulated credit default swap market.

And then there's the shadowy links between Bernie Madoff and the SEC staff, and the failures to follow up on credible suspicions of a long-standing Ponzi scheme.

AIG's Regulator: Asleep at the Switch.  Only just coming to light - and lost in the uproar over AIG bonuses -  is the failure of Federal government oversight of AIG's disastrous bets on derivatives.  In an extraordinary "mea culpa" in recent Congressional testimony, the Acting Director of the Office of Thrift Supervision has conceded that his agency (which had authority to examine all parts of AIG due to its ownership of a federal savings bank) fell down on the job despite "continuous, consolidated supervision of the AIG group."

You would think that thoughtful politicians and public officials would understand that it wasn't too little regulation that contributed to the financial mess, but a combination of clueless regulation, perverse incentives (e.g. for rating agencies and financial firms' compensation arrangements) and an inability by the federal government to effectively address the "too big to fail" issue that are the central regulatory issues.  Addressing these subjects effectively is where real leadership in Congress and at the agencies is needed - and sorely lacking.

"MARK TO MARKET" ACCOUNTING: GASOLINE ON THE FIRE?

To understand the importance of the "mark to market" issue that is causing so much anguish in the financial markets  ("gasoline on the fire," in the words of Warren Buffett), here's a homely example.

Personal "Mark to Market" Accounting. Let's say a year ago I drew up a personal financial statement in the form of a balance sheet.  On the asset side, I have a very enjoyable Picasso portrait passed on by a deceased aunt.  Her estate valued the painting at $300,000 and that's what I put in my statement. After making all the other entries, my net worth (assets minus liabilities) came to $200,000.

But I read in the paper today that similar Picasso portraits are now selling for only $100,000. If I updated that financial statement, I would show a net worth of zero.  Should I  (1) declare bankruptcy or (2) ask a still-alive rich uncle for an immediate cash infusion?

Or (3) should I just go on as if nothing much had happened, continuing to admire the painting every time I passed it.  (Although I might advise my future heirs that if the market didn't turn around before I died, the painting wouldn't be as valuable as they had counted on.)

Financial Institutions, Regulators and "Mark to Market."   If you are like most regulated financial institutions these days and it's "subprime" mortgage securities instead of Picassos that we are talking about, your choice is generally limited to (2). Of course, there is no functioning market in such securities, so the valuation numbers are guesses, given an air of authority by complicated formulae. 

The application of "mark to market" accounting to all manner of assets was intended by the regulators to reduce the ability of managements to "cook the books" by demanding an "objective"  and transparent valuation method. But anyone who is familiar with the accounting issues in, say, money market funds, knows how complex and seemingly arbitrary some of these issues can be.  Indeed, in many respects, required accounting approaches are as much philosophical or political as they are technical  (just ask an energy company executive about accounting for oil and gas reserves).

As explained clearly by Holman Jenkins in The Wall Street Journal, because of "mark to market" accounting, the regulatory agencies consider many mortgage-heavy banks as insolvent, or close to it, and demand that they raise new equity capital (or provide it via the U.S. Treasury, with politically generated constraints).  Without this pressure from the authorities, most banks with "toxic assets" could probably earn their way out of the current mess so long as the profit spread between their (government insured) deposits and lending rates remains extremely wide.

It's Called Forbearance.  We've been down this road before - in the early 1980s when every major U.S. international bank had a pot full of developing country debt on their books that was in default. Strict application of regulatory accounting rules at that time would have forced several of the majors out of business. The regulators and the Treasury Department decided to look the other way and concentrate on letting the banks earn their way out of the mess (with a little help in the form of renegotiations with the debtors). All the details are in an excellent FDIC paper of several years ago.

Forbearance increasingly seems to make considerably more sense (and drastically reduce taxpayer investment in the banking system) than the current policy mish-mash - which has every would-be investor in new bank equity issues uncertain about how government action will affect their investment.   

 

BANKERS, BONUSES, AND ADAM SMITH

Throwing spit balls at bankers, their bonuses and their golden parachutes is today’s favorite sport for op-ed pundits and ink-hungry politicians. What is the rationale for paying mega-buck bonuses to managers who took so much risk that they now need public funds to bail out their institutions?

The straightforward answer should be “because paying large bonuses is the way publicly-held, large, aggressive banks have been doing business for several decades.” Senior management and boards of directors, in most cases, simply didn’t recognize that once you accept cash from taxpayers via  Congress and the U.S. Treasury, the rules of the game change.

Three Issues.  The underlying problem, however, is not mega-buck bonuses, but the way in which compensation and risk management have evolved in most large financial institutions.  The problem has three dimensions:

1.       How to compensate individuals when recent risky and initially profitable decisions turn out, a year or two later, to be financially disastrous.  The easy answer is, “make total compensation a function of several years’ performance.”  But what, among a variety of issues, if a competitor is prepared to lure away your star performers by promising a signing bonus that compensates them for any future expected payments from their bonus pool or loss of stock options?

2.       At another level, when an institution has federally-insured deposits, managements tend to take on more risk.  The academic literature is fairly clear on this.

3.        Finally, there is the age-old issue of the separation of firm ownership from management. As James Glassman and William Nolan put it in a recent Wall Street Journal op-ed,  “bankers need more skin in the game.”  When banks are organized as partnerships, like Brown Brothers Harriman, they borrow less and take less risk.  That’s because the owners, partners and risk managers are the same people – and  have most of their wealth invested in the firm.

Of course, Adam Smith, in “The Wealth of Nations,” said it first – and best:

“The directors of [joint stock companies] being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own . . . Negligence and profusion, therefore, must always prevail, more or less in the management of the affairs of such a company.”

Modern society has struggled with political (“the managerial revolution”) and economic issues inherent in the ownership-management conundrum for decades.  It was the intellectual underpinning, as developed by Berle and Means in “The Modern Corporation and Private Property” (1932), for establishing the Securities and Exchange Commission.

Since the current crisis has demonstrated the inherent limitations of the SEC, a strong case can be made for encouraging more partnerships in the financial sector.  As Glassman and Nolan summarize the argument:

“In the end, the partnership – not more regulatory intrusion – is an efficient, even elegant, answer to the thorny risk-mitigation problem.  Partnerships are less likely to make big mistakes, but, even if they do, their smaller size means they pose less of a threat to the financial system as a whole, and to the taxpayers who have to pay for the clean-up.”

Now there is real regulatory reform - and an answer to the "too big to fail" dilemma!