Are All Losses Created Equal?

Benjamin Friedman, in a review of George Akerlof and Robert Shiller’s Animal Spirits, makes an interesting observation:

As in past financial declines, what is sorely missing in this discussion is attention to what function the financial system is supposed to perform in the economy and how well it has been doing it. Today attention is mostly focused on banks’ and other investors’ losses from buying mortgage-backed securities at inflated prices. What is neglected is the consequence: if the prices of the securities were too high, this meant that the underlying mortgage rates were too low, and so too many houses were built, and too many Americans bought them. In just the same way, when the 1990s stock market boom crashed, everyone talked about investors’ losses on their telecom stocks, not the fact that if the stocks’ prices were too high, the cost of capital to the firms that issued the stocks was too low, and so communications companies laid millions of miles of fiber-optic cable that nobody ended up using.

Yves here. This is overstated; during the dot-com bust, I read plenty of coverage of how much “dark fiber” was out there, as well as arguments that the dot-com bubble hadn’t been a total waste. Look. we got the Internet! Yes, but we had had an Internet before the mania. So there was some thought given to the real economy side of the equation. Similarly, there has been more than a bit of discussion of how much capital went into McMansions and second homes rather than productive investment. Back to the article:

In both instances, the cost was not just financial losses but wasted real resources. True, over longer periods of time the American financial system has seemed reasonably effective at allocating resources rather than wasting them. The economy’s pace of technological advance and growth in production since World War II suggest that the banks and the stock and bond markets can steer investment capital reasonably effectively to firms that will use it productively, often including start-ups trying out a wholly new idea—Microsoft, or Google, or, earlier on, Apple. But the effectiveness of the economy’s mechanism for allocating capital should be a matter for serious quantitative evaluation, not a matter of faith.

Yves here. Again, a bit overstated. Microsoft didn’t take any VC money and went public pretty late, my dim recollection is 1986. It was hardly a “start up with a good idea” then. Apple was started in 1976 and had gotten initial angel funding from a local businessman, and went public earlier, in 1980, but even then was beyond the start-up stage. And the same wonderfully efficient markers gave up Apple for dead in 1997. We also managed to air brush out the great capital allocation by the banks that led to the sovereign wealth crisis of the early 1980s, or the S&L crisis. That isn’t to say that the financial markets don’t over time get more right than wrong, but the depiction here is a tad idealistic. Back to the article:

Moreover, to ask just how efficient a financial system is in allocating capital leads naturally to the question of the price that is paid for such efficiency. In recent years the financial industry has accounted for an unusually large share of all profits earned in the US economy. The share of the “finance” sector in total corporate profits rose from 10 percent on average from the 1950s through the 1980s, to 22 percent in the 1990s, and an astonishing 34 percent in the first half of this decade.

Those profits accruing to the financial sector are part of what the economy pays for the mechanism that allocates its investment capital (as well as providing other services, like checking accounts and savings deposits). But even a stripped-down version of the cost of running the financial system includes not just the profits that financial firms earn but also the salaries, the office rents, the travel budgets, the advertising fees, and all of the other expenses they pay. The finance industry’s share of US wages and salaries has likewise been rising, from 3 percent in the early 1950s to 7 percent in the current decade.[2] An important question—which no one seems interested in addressing—is what fraction of the economy’s total returns to productively invested capital is absorbed up front by the financial industry as the costs of allocating that capital.

Further, the latest financial crisis is a sharp reminder that the simple operating expense of running the financial system—including profits of financial firms—is not the only cost if this system also exposes the economy at large to episodic losses in production and incomes, and to the need for taxpayer subsidies. Today those losses are mounting, and so are the subsidies. Many US banks, including some of the largest ones, are now insolvent. The bank rescue plans offered to date by both the Bush and the Obama administrations amount to ever more expensive fig leafs for avoiding concrete recognition of this sad development….

Another fundamental issue that the current discussion has overlooked almost entirely is the distinction between the losses to banks and other lenders that reflect genuine losses of wealth to the economy, and other losses that don’t. When the value of your house falls, that’s a loss of wealth to the economy as a whole. If you keep paying your mortgage, you bear the loss yourself: your net worth is diminished by the amount of the decline in the home’s price. If you default on your loan, then someone else—maybe the bank that lent you the money, maybe some investor to whom the bank sold the loan—also bears part of the loss. If the government steps in and reimburses the bank, or the investor, the taxpayers will bear part of the loss as well. But however this loss is divided, what is inescapable is that someone, somewhere, will bear it. What much of today’s debate is about is how these losses should be divided among homeowners, banks, loan-purchasing investors, and the taxpayers. But the loss must be borne by someone, and America’s economy is poorer because it has occurred.

By contrast, suppose you and your neighbor have bet on whether today’s peak temperature would exceed fifty degrees. One of you was right, the other wrong. One of you won, the other lost, and the amount the winner won is identical to what the loser lost. There is no loss of wealth to the economy, merely a transfer of wealth from the loser to the winner. Many of the huge losses that American financial institutions have sustained in the current crisis are of this second kind. None of them was betting on the weather, but they were taking positions that amounted to placing bets on outcomes that represented no change in wealth to the economy as a whole. And with regard to these positions, for every loser featured in the latest newspaper story about banks posting losses and turning to the government for bailouts there is also, somewhere, a winner.

The most telling example, and the most important in accounting for today’s financial crisis, is the market for credit default swaps. A CDS is, in effect, a bet on whether a specific company will default on its debt. This may sound like a form of insurance that also helps spread actual losses of wealth. If a business goes bankrupt, the loss of what used to be its value as a going concern is borne not just by its stockholders but by its creditors too. If some of those creditors have bought a CDS to protect themselves, the covered portion of their loss is borne by whoever issued the swap.

But what makes credit default swaps like betting on the temperature is that, in the case of many if not most of these contracts, the volume of swaps outstanding far exceeds the amount of debt the specified company owes. Most of these swaps therefore have nothing to do with allocating genuine losses of wealth. Instead, they are creating additional losses for whoever bet incorrectly, exactly matched by gains for the corresponding winners. And, ironically, if those firms that bet incorrectly fail to pay what they owe—as would have happened if the government had not bailed out the insurance company AIG—the consequences might impose billions of dollars’ worth of economic costs that would not have occurred otherwise.

This fundamental distinction, between sharing in losses to the economy and simply being on the losing side of a bet, should surely matter for today’s immediate question of which insolvent institutions to rescue and which to let fail. The same distinction also has implications for how to reform the regulation of our financial markets once the current crisis is past. For example, there is a clear case for barring institutions that might be eligible for government bailouts—including not just banks but insurance companies like AIG—from making such bets in the future. It is hard to see why they should be able to count on taxpayers’ money if they have bet the wrong way. But here as well, no one seems to be paying attention.

Why has there been so little discussion of fundamental issues like this distinction among losses? Why is so little said about the trade-off between the goal of allocating the economy’s capital efficiently and the need to shrink the enormous costs of the financial industry in doing so? One obvious reason is political. There is a long arc from Roosevelt’s acceptance of a useful role for government institutions and government regulation to the conviction of Reagan and Thatcher that the government is never the solution but actually the problem. A second, closely related reason is ideological: the faith, personified by Alan Greenspan with his early dedication to the writings of Ayn Rand and his staunch opposition to regulations while chairman of the Federal Reserve, that private, profit-driven economic activity is self-regulating and, when necessary, self-correcting.

he economists George Akerlof and Robert Shiller suggest a third reason. In their view, the problem is also intellectual—a systematic failure of thinking on the part of their fellow economists. Taking the title of their new book from a phrase famously used by John Maynard Keynes, Akerlof and Shiller argue that what is missing in the worldview of today’s economists is sufficient attention to “animal spirits,” by which they mean the psychological and even irrational elements that figure importantly in so many other familiar aspects of personal choices and personal behavior, and that, they believe, pervade economic behavior too.

Friedman’s argument is in some ways more appealing that the more common argument made for limiting CDS only to holders of the underlying bonds, that of the danger of the bad incentives that result when you permit parties with no insurable interest to buy insurance. Actually, that was how the contracts were originally written, that you had to present the bond in order to collect, but the Delphi bankruptcy led to what amounted to a waiver to be issued, that the contracts could be cash settled. Delphi was the first big test of the market, and the CDS outstanding were a big multiple of the amount of bonds (my recollection is eight times). The key actors did not want the market to fall into disrepute,. However, it is worth noting how contracts were effectively rewritten on the fly to suit the interests of the big financial firms, but “sanctity of contracts” gets in the way when their wings might be clipped.