Leviathan State

From the point of view of political economy and policy, this is the best and most relevant essay I’ve read in awhile. The Administrative State (or Deep State), no matter how much good it does, is antithetical to individual liberty, justice, and, I would argue, long-term economic and political security and stability. Be careful what you wish for with free health care or an imperial POTUS!

Reprinted from the WSJ:

The Tyranny of the Administrative State

Government by unelected experts isn’t all that different from the ‘royal prerogative’ of 17th-century England, argues constitutional scholar Philip Hamburger.

New York

What’s the greatest threat to liberty in America? Liberals rail at Donald Trump’s executive orders on immigration and his hostility toward the press, while conservatives vow to reverse Barack Obama’s regulatory assault on religion, education and business. Philip Hamburger says both sides are thinking too small.

Like the blind men in the fable who try to describe an elephant by feeling different parts of its body, they’re not perceiving the whole problem: the enormous rogue beast known as the administrative state.

Sometimes called the regulatory state or the deep state, it is a government within the government, run by the president and the dozens of federal agencies that assume powers once claimed only by kings. In place of royal decrees, they issue rules and send out “guidance” letters like the one from an Education Department official in 2011 that stripped college students of due process when accused of sexual misconduct.

Unelected bureaucrats not only write their own laws, they also interpret these laws and enforce them in their own courts with their own judges. All this is in blatant violation of the Constitution, says Mr. Hamburger, 60, a constitutional scholar and winner of the Manhattan Institute’s Hayek Prize last year for his scholarly 2014 book, “Is Administrative Law Unlawful?” (Spoiler alert: Yes.)

“Essentially, much of the Bill of Rights has been gutted,” he says, sitting in his office at Columbia Law School. “The government can choose to proceed against you in a trial in court with constitutional processes, or it can use an administrative proceeding where you don’t have the right to be heard by a real judge or a jury and you don’t have the full due process of law. Our fundamental procedural freedoms, which once were guarantees, have become mere options.” ​

In volume and complexity, the edicts from federal agencies exceed the laws passed by Congress by orders of magnitude. “The administrative state has become the government’s predominant mode of contact with citizens,” Mr. Hamburger says. “Ultimately this is not about the politics of left or right. Unlawful government power should worry everybody.”

Defenders of agencies like the Securities and Exchange Commission or the Environmental Protection Agency often describe them as the only practical way to regulate today’s complex world. The Founding Fathers, they argue, could not have imagined the challenges that face a large and technologically advanced society, so Congress and the judiciary have wisely delegated their duties by giving new powers to experts in executive-branch agencies.

Mr. Hamburger doesn’t buy it. In his view, not only is such delegation unconstitutional, it’s nothing new. The founders, far from being naive about the need for expert guidance, limited executive powers precisely because of the abuses of 17th-century kings like James I.

James, who reigned in England from 1603 through 1625, claimed that divinely granted “absolute power” authorized him to suspend laws enacted by Parliament or dispense with them for any favored person. Mr. Hamburger likens this royal “dispensing” power to modern agency “waivers,” like the ones from the Obama administration exempting McDonald’s and other corporations from complying with provisions of the Affordable Care Act.

James also made his own laws, bypassing Parliament and the courts by issuing proclamations and using his “royal prerogative” to establish commissions and tribunals. He exploited the infamous Star Chamber, a court that got its name from the gilded stars on its ceiling.

“The Hollywood version of the Star Chamber is a torture chamber where the walls were speckled with blood,” Mr. Hamburger says. “But torture was a very minor part of its business. It was very bureaucratic. Like modern administrative agencies, it commissioned expert reports, issued decrees and enforced them. It had regulations controlling the press, and it issued rules for urban development, environmental matters and various industries.”

James’s claims were rebuffed by England’s chief justice, Edward Coke, who in 1610 declared that the king “by his proclamation cannot create any offense which was not an offense before.” The king eventually dismissed Coke, and expansive royal powers continued to be exercised by James and his successor, Charles I. The angry backlash ultimately prompted Parliament to abolish the Star Chamber and helped provoke a civil war that ended with the beheading of Charles in 1649.

A subsequent king, James II, took the throne in 1685 and tried to reassert the prerogative power. But he was dethroned in the Glorious Revolution in 1688, which was followed by Parliament’s adoption of a bill of rights limiting the monarch and reasserting the primacy of Parliament and the courts. That history inspired the American Constitution’s limits on the executive branch, which James Madison explained as a protection against “the danger to liberty from the overgrown and all-grasping prerogative of an hereditary magistrate.”

“The framers of the Constitution were very clear about this,” Mr. Hamburger says, rummaging in a drawer for a pocket edition. He opens to the first page, featuring the Preamble and Article 1, which begins: “All legislative Powers herein granted shall be vested in a Congress.”

“That first word is crucial,” he says. “The very first substantive word of the Constitution is ‘all.’ That makes it an exclusive vesting of the legislative powers in an elected legislature. Congress cannot delegate the legislative powers to an agency, just as judges cannot delegate their power to an agency.”

Those restrictions on executive power have been disappearing since the late 19th century, starting with the creation of the Interstate Commerce Commission in 1887. Centralized power appealed to big business—railroads found commissioners easier to manipulate than legislators—as well as to American intellectuals who’d studied public policy at German universities. Unlike Britain, Germany had rejected constitutional restraints in favor of a Prussian model that gave administrative agencies the prerogative powers of the king.

Mr. Hamburger believes it’s no coincidence that the growth of America’s administrative state coincided with the addition to the electorate of Catholic immigrants, blacks and other minorities. WASP progressives like Woodrow Wilson considered these groups an obstacle to reform.

“The bulk of mankind is rigidly unphilosophical, and nowadays the bulk of mankind votes,” Wilson complained, noting in particular the difficulty of winning over the minds “of Irishmen, of Germans, of Negroes.” His solution was to push his agenda using federal agencies staffed by experts of his own caste—what Mr. Hamburger calls the “knowledge class.” Wilson was the only president ever to hold a doctorate.

“There’s been something of a bait and switch,” Mr. Hamburger says. “We talk about the importance of expanding voting rights, but behind the scenes there’s been a transfer of power from voters to members of the knowledge class. A large part of the knowledge class, Republicans as well as Democrats, went out of their way to make the administrative state work.”

Mr. Hamburger was born into the knowledge class. He grew up in a book-filled house near New Haven, Conn. His father was a Yale law professor and his mother a researcher in economics and intellectual history. During his father’s sabbaticals in London, Philip acquired a passion for 17th-century English history and spent long hours studying manuscripts at the British Museum. That’s where he learned about the royal prerogative.

He went to Princeton and then Yale Law School, where he avoided courses on administrative law, which struck him as “tedious beyond belief.” He became slightly more interested during a stint as a corporate lawyer specializing in taxes—he could see the sweeping powers wielded by the Internal Revenue Service—but the topic didn’t engage him until midway through his academic career.

While at the University of Chicago, he heard of a colleague’s inability to publish a research paper because the study had not been approved ahead of time by a federally mandated institutional review board. That sounded like an unconstitutional suppression of free speech, and it reminded Mr. Hamburger of those manuscripts at the British Museum.

Why the return of the royal prerogative? “The answer rests ultimately on human nature,” Mr. Hamburger writes in “The Administrative Threat,” a new short book aimed at a general readership. “Ever tempted to exert more power with less effort, rulers are rarely content to govern merely through the law.”

Instead, presidents govern by interpreting statutes in ways lawmakers never imagined. Barack Obama openly boasted of his intention to bypass Congress: “I’ve got a pen and I’ve got a phone.” Unable to persuade a Congress controlled by his own party to regulate carbon dioxide, Mr. Obama did it himself in 2009 by having the EPA declare it a pollutant covered by a decades-old law. (In 2007 the Supreme Court had affirmed the EPA’s authority to do so.)

Similarly, the Title IX legislation passed in 1972 was intended mainly to protect women in higher education from employment discrimination. Under Mr. Obama, Education Department bureaucrats used it to issue orders about bathrooms for transgender students at public schools and to mandate campus tribunals to adjudicate sexual misconduct—including “verbal misconduct,” or speech—that are in many ways less fair to the accused than the Star Chamber.

At this point, the idea of restraining the executive branch may seem quixotic, but Mr. Hamburger says there are practical ways to do so. One would be to make government officials financially accountable for their excesses, as they were in the 18th and 19th centuries, when they could be sued individually for damages. Today they’re protected thanks to “qualified immunity,” a doctrine Mr. Hamburger thinks should be narrowed.

“One does have to worry about frivolous lawsuits against government officers who have to make quick decisions in the field, like police officers,” he says. “But someone sitting behind a desk at the EPA or the SEC has plenty of time to consult lawyers before acting. There’s no reason to give them qualified immunity. They’ll be more careful not to exceed their constitutional authority if they have to weigh the risk of losing their own money.”

Another way of restraining agencies—one President Trump could adopt on his own—would be to require them to submit new rules to Congress for approval instead of imposing them by fiat. The president could also order at least some agencies to resolve disputes in regular courts instead of using administrative judges, who are departmental employees. Meanwhile, Congress could reclaim its legislative power by going through regulations, agency by agency, and deciding which ones to enact into law.

Mr. Hamburger’s chief hope for reform lies in the courts, which in earlier eras rebuffed the executive branch’s power grabs. Those rulings so frustrated both Theodore Roosevelt and Franklin D. Roosevelt that they threatened retaliation—such as FDR’s plan to pack the Supreme Court by expanding its size. Eventually judges surrendered and validated sweeping executive powers. Mr. Hamburger calls it “one of the most shameful episodes in the history of the federal judiciary.”

The Supreme Court capitulated further in decisions like Chevron v. Natural Resources Defense Council (1984), which requires judges to defer to any “reasonable interpretation” of an ambiguous statute by a federal agency. “Chevron deference should be called Chevron bias,” Mr. Hamburger says. “It requires judges to abandon due process and independent judgment. The courts have corrupted their processes by saying that when the government is a party in case, they will be systematically biased—they will favor the more powerful party.”

Mr. Hamburger sees a good chance that the high court will limit and eventually abandon the Chevron doctrine, and he expects other litigation giving the judiciary a chance to reassert its powers and protect constitutional rights. “Slowly, step by step, we can persuade judges to recognize the risks of what they’ve done so far and to grapple with this very dangerous type of power,” he says. The judiciary, like academia, has many liberals who have been sympathetic to the growth of executive power, but their perspective may be changing.

“Administrative power is like off-road driving,” Mr. Hamburger continues. “It’s exhilarating to operate off-road when you’re in the driver’s seat, but it’s a little unnerving for everyone else.”

He says he observed this effect during a recent conversation with a prominent legal scholar. The colleague, a longtime defender of administrative law, was discussing the topic shortly after Mr. Trump’s inauguration.

The colleague told Mr. Hamburger: “I am beginning to see the merit of your ideas.”

Blogger’s Note: I’m a member of the knowledge class and trust me, nobody really knows anything!

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Unicorns, Tooth Fairies, and Free Markets

The most frequent criticism of free markets lies in their comparison to unicorns, fairies, and leprechauns. In other words, they exist only in our imaginations and thus are unworthy of serious discussion. This is sheer nonsense. It is like denying the value of Plato’s ideal forms as a means of comparison and judgment. Democracy also does not exist in its pure, idealistic form, so, is it a useless figment of our imaginations? I don’t believe so.

Free markets should be thought of as markets for free people, much like democracy is a political market for free people. In terms of exchange, people are free when buyer and seller can either mutually agree on an exchange or walk away. This freedom obtains best when there are lots of competing and comparable alternatives to any particular good or service. Also, voluntary action is enhanced when the terms of the transaction are transparent to both parties. Some markets offer better and more options than others, while some are more transparent than others, so markets are defined along a continuum from “free” to “unfree.” The whole thrust of free market theory is to point us in the right direction.

Oddly enough, the failure of unfree, or controlled, markets is often cited as proof that markets don’t work. This is like pulling the wheels off my car and then stating that since it can’t go anywhere, cars are a poor form of transportation. Such arguments should be the butt of jokes, not serious debate. Some may qualify this argument by saying some markets are easier to manipulate or control by narrow interests or are less transparent, and thus need to be regulated by a disinterested third party such as a government bureaucracy. But that just begs the more important question over what means will insure that any particular market becomes freer?

Regulation vs. Competition

We can’t really answer this question without a careful analysis of behavioral incentives, of both the economic and political variety. It is widely accepted that economic and political actors pursue their narrow self-interests, with economic behavior determined by loss aversion and profit/utility maximization and political behavior more influenced by power, status, and control. These behaviors dovetail in real people as we all seek to survive by pursuing wealth, power, and control over our own destinies. When we scrape beneath the surface we find that survival is more about not losing (loss aversion), than winning (big rewards).

We would assume from these incentives that most actors would like to manipulate markets to their personal advantage, so how do we constrain or redirect this?

Most people would look to contract law as the explanation for what keeps us honest, but that offers only a narrow understanding of how markets work. We make dozens, if not hundreds, of market transactions every day and very few ever reach that threshold where we feel the need to consult legal counsel or call our Congressperson in Washington. Instead, we rely on more efficient means, such as trust, reciprocity, the implicit value of repeat business, and competing alternatives to guide our choices.

This point about competing alternatives is crucial because while trust, reciprocity, and relationships help ameliorate the need for transparency, competition gives us freedom of choice. Anti-competitive monopolies are considered economic evils because they control the market for their product or service, so consumers must pay their price or go without. (Likewise why we despise political tyranny.) Critics often deride market capitalism as a competitive conflictual system, but that too is a myopic point of view. Markets foster cooperation as much as competition, and many of the transactions in economic markets are win-win positive sum games rather than win-lose zero-sum games.

Think about it: Sellers compete among themselves in order to develop a long-term cooperative relationship with their buyers and suppliers. Ever wonder why a department store takes back that dress or pair of shoes you bought last week because you changed your mind? That doesn’t seem in their immediate profit interest, but it does when you consider how the retailer values repeat business against the freedom you have to take your business elsewhere.

It is not laws or regulatory watchdogs but open competition under accepted market rules that constrains most of our selfish economic behavior. In addition, market competitors have the biggest incentive to insure all play by the established rules, thus they are the watchdogs. This implies the need for transparency. Third party regulatory agencies are inadequate to the task of monitoring the multitude of transactions in markets, especially financial markets. For example, the banking industry is the most regulated industry in the US, and yet the financial crisis of “too big to fail” revealed how ineffective that regulation was. So the test should not be regulation OR competition, but regulation FOR competition. Financial markets in particular need to be open, transparent, and competitive to constrain behavior that risks the integrity of the financial system. In financial markets, failure is a big inducement for prudence.

For an illustrative case, consider the policy response to the financial crisis of 2008, the 2010 Dodd-Frank law. Under that legislation, “too big to fail” banks have gotten even bigger, while 1,500 community banks—the source of half of all loans to local businesses—reportedly have been destroyed. The remaining community banks have had to hire 50% more compliance staff just to keep up with the regulations. That means far less competition among lenders to serve borrowers and more concentrated finance that does not respond to the bankruptcy constraint. It means a far less efficient and just credit market and far more control centralized in a financial oligopoly seeking to influence the policymaking process in its favor. According to the practice of regulatory capture – where lobbyists “buy” politicians with campaign contributions to formulate policy to constrain their competitors – we’ve discovered too often that big government mostly works for big business, the powerful, the wealthy and the well-connected to the detriment of open and honest competition among free people.

One could make the same argument against health care reform under the Affordable Care Act. Has policy made the market more open, transparent, and competitive, or less? Health care provision is really about competition and abundance in the supply of health care rather than the price and distribution of access. With an abundance of competitive health care providers, price and access take care of themselves.

The most important argument in favor of markets is the crucial role they play in providing information feedback signals. Free markets provide the most accurate and essential signals to consumers and producers needed to make efficient economic decisions, like comparing alternatives to maximize preferences, or where to invest and how much to produce, and how to adapt to changing market conditions. These signals are embodied in prices and inventory quantities and without these, producers are operating in the dark about what people want. Hayek was the first to point out the lack of private exchange markets would make central planning under socialism untenable over time. He was right.

Market failures do exist and we don’t live in a world of idealized free markets. But in addressing those failures we should strive not to make the perfect the enemy of the good, because free markets support free people and that’s the bottom line.

Besides, it would be heartbreaking to admit to our children that this is best we can do when it comes to unicorns and tooth fairies:

adult-unicorn-costume toothfairy1

Regulatory Capture 101

GSIt has always astounded me that so many people still believe that human behavior can be perfected through the oversight of a government bureaucrat. As if Goldman Sachs didn’t get a sweetheart deal from regulator Tim Geithner. (Where’s Tim now? Oh, running the private equity firm of Warburg Pincus.)

The most efficient and just regulator in existence is an open, competitive market that cannot be captured by narrow interests. This is James Madison’s prescription for democratic government and Adam Smith’s for free markets. From the WSJ:

Regulatory Capture 101

Impressionable journalists finally meet George Stigler.

Oct. 5, 2014 5:28 p.m. ET The financial scandal du jour involves leaked audio recordings that purport to show that regulators at the Federal Reserve Bank of New York were soft on Goldman Sachs . Say it ain’t so.

The news is being treated as shocking by journalists who claim to be hard-headed students of financial markets. One especially impressionable columnist calls it “a jaw-dropping story about Wall Street regulation.” The real scandal here is the excessive faith that liberal journalists and politicians continue to put in financial regulation. The media pack is discovering regulatory capture—a mere 43 years after George Stigler published his landmark paper on the concept.

The secret recordings were made by Carmen Segarra, who went to work as an examiner at the New York Fed in 2011 but was fired less than seven months later in 2012. She has filed a wrongful termination lawsuit against the regulator and says Fed officials sought to bury her claim that Goldman had no firm-wide policy on conflicts-of-interest. Goldman says it has had such policies for years, though on the same day Ms. Segarra’s revelations were broadcast, the firm added new restrictions on employees trading for their own accounts.

The New York Fed won against Ms. Segarra in district court, though the case is on appeal. The regulator also notes that Ms. Segarra “demanded $7 million to settle her complaint.” And last week New York Fed President William Dudley said, “We are going to keep striving to improve, but I don’t think anyone should question our motives or what we are trying to accomplish.”

On the recordings, regulators can be heard doing what regulators do—revealing the limits of their knowledge and demonstrating their reluctance to challenge the firms they regulate. At one point Fed officials suspect a Goldman deal with Banco Santander may have been “legal but shady” in the words of one regulator, and should have required Fed approval. But the regulators basically accept Goldman’s explanations without a fight.

The sleuths at the ProPublica website, working with a crack team of investigators from public radio, also seem to think they have another smoking gun in one of Ms. Segarra’s conversations that was not recorded but was confirmed by another regulator. Ms. Segarra reports that she was shocked to hear a Goldman employee say that once clients are wealthy enough, certain consumer laws don’t apply to them. Ms. Segarra says she was told by a fellow Fed regulator after this conversation, “You didn’t hear that.”

In this case it appears a regulator was helping Goldman even when Goldman didn’t need any help. That’s because the securities laws have long sought to provide the most protection to investors of modest means. For example, a company offering securities is exempt from some registration requirements if it is only selling to accredited investors, such as people with more than $1 million in net worth, excluding the value of primary residences.

The journalists have also found evidence in Ms. Segarra’s recordings that even after the financial crisis and the supposed reforms of the Dodd-Frank law, the New York Fed remained a bureaucratic agency resistant to new ideas and hostile to strong-willed, independent-minded employees. In government?

***

Enter George Stigler, who published his famous essay “The Theory of Economic Regulation” in the spring 1971 issue of the Bell Journal of Economics and Management Science. The University of Chicago economist reported empirical data from various markets and concluded that “as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit.”

Stigler knew he was fighting an uphill battle trying to persuade his fellow academics. “The idealistic view of public regulation is deeply imbedded in professional economic thought,” he wrote. But thanks to Stigler, who would go on to win a Nobel prize, many economists have studied the operation and effects of regulation and found similar results.

A classic example was the New York Fed’s decision to let Citigroup stash $1.2 trillion of assets—including more than $600 billion of mortgage-related securities—in off-balance-sheet vehicles before the financial crisis. That’s when Tim Geithner ran the New York Fed and Jack Lew was at Citigroup.

Once one understands the inevitability of regulatory capture, the logical policy response is to enact simple laws that can’t be gamed by the biggest firms and their captive bureaucrats. This means repealing most of Dodd-Frank and the so-called Basel rules and replacing them with a simple requirement for more bank capital—an equity-to-asset ratio of perhaps 15%. It means bringing back bankruptcy for giant firms instead of resolution at the discretion of political appointees. And it means considering economist Charles Calomiris’s plan to automatically convert a portion of a bank’s debt into equity if the bank’s market value falls below a healthy level.

Fifty years ago, Stigler described academics in a way that might also apply to much of today’s press corps: “The economic role of the state has managed to hold the attention of scholars for over two centuries without arousing their curiosity.”

GS4

Land of the Free?

Sebastian

Good to take note of these things…from the WSJ:

America’s Dwindling Economic Freedom

Regulation, taxes and debt knock the U.S. out of the world’s top 10.

By Terry Miller
World economic freedom has reached record levels, according to the 2014 Index of Economic Freedom, released Tuesday by the Heritage Foundation and The Wall Street Journal. But after seven straight years of decline, the U.S. has dropped out of the top 10 most economically free countries.For 20 years, the index has measured a nation’s commitment to free enterprise on a scale of 0 to 100 by evaluating 10 categories, including fiscal soundness, government size and property rights. These commitments have powerful effects: Countries achieving higher levels of economic freedom consistently and measurably outperform others in economic growth, long-term prosperity and social progress. Botswana, for example, has made gains through low tax rates and political stability.Those losing freedom, on the other hand, risk economic stagnation, high unemployment and deteriorating social conditions. For instance, heavy-handed government intervention in Brazil’s economy continues to limit mobility and fuel a sense of injustice.

It’s not hard to see why the U.S. is losing ground. Even marginal tax rates exceeding 43% cannot finance runaway government spending, which has caused the national debt to skyrocket. The Obama administration continues to shackle entire sectors of the economy with regulation, including health care, finance and energy. The intervention impedes both personal freedom and national prosperity.

But as the U.S. economy languishes, many countries are leaping ahead, thanks to policies that enhance economic freedom—the same ones that made the U.S. economy the most powerful in the world. Governments in 114 countries have taken steps in the past year to increase the economic freedom of their citizens. Forty-three countries, from every part of the world, have now reached their highest economic freedom ranking in the index’s history.

Hong Kong continues to dominate the list, followed by Singapore, Australia, Switzerland, New Zealand and Canada. These are the only countries to earn the index’s “economically free” designation. Mauritius earned top honors among African countries and Chile excelled in Latin America. Despite the turmoil in the Middle East, several Gulf states, led by Bahrain, earned designation as “mostly free.”

A realignment is under way in Europe, according to the index’s findings. Eighteen European nations, including Germany, Sweden, Georgia and Poland, have reached new highs in economic freedom. By contrast, five others—Greece, Italy, France, Cyprus and the United Kingdom—registered scores lower than they received when the index started two decades ago.

The most improved players are in Eastern Europe, including Estonia, Lithuania and the Czech Republic. These countries have gained the most economic freedom over the past two decades. And it’s no surprise: Those who have lived under communism have no trouble recognizing the benefits of a free-market system. But countries that have experimented with milder forms of socialism, such as Sweden, Denmark and Canada, also have made impressive moves toward greater economic freedom, with gains near 10 points or higher on the index scale. Sweden, for instance, is now ranked 20th out of 178 countries, up from 34th out of 140 countries in 1996.

The U.S. and the U.K, historically champions of free enterprise, have suffered the most pronounced declines. Both countries now fall in the “mostly free” category. Some of the worst performers are in Latin America, particularly Venezuela, Argentina, Ecuador and Bolivia. All are governed by crony-populist regimes pushing policies that have made property rights less secure, spending unsustainable and inflation evermore threatening.

Despite financial crises and recessions, the global economy has expanded by nearly 70% in 20 years, to $54 trillion in 2012 from $32 trillion in 1993. Hundreds of millions of people have left grinding poverty behind as their economies have become freer. But it is an appalling, avoidable human tragedy how many of the world’s peoples remain unfree—and poor.

The record of increasing economic freedom elsewhere makes it inexcusable that a country like the U.S. continues to pursue policies antithetical to its own growth, while wielding its influence to encourage other countries to chart the same disastrous course. The 2014 Index of Economic Freedom documents a world-wide race to enhance economic opportunity through greater freedom—and this year’s index demonstrates that the U.S. needs a drastic change in direction.

Mr. Miller is the director of the Center for International Trade and Economics at the Heritage Foundation.

How Finance Goes, So Goes the Nation

House of cards

From the WSJ:

The Government Won on Financial Reform

The financial system is more regulated than ever, but also no safer.

‘Your No. 1 client is the government.” So former Morgan Stanley CEO John Mack told current CEO James Gorman in a recent phone call, according to a September 10 story in the Journal. He’s exactly right, which more or less sums up how American finance has evolved in the five years since the 2008 financial crisis. Far and away the biggest winner is the government.

This isn’t the conventional view in media and politics, where the spin is that Wall Street has triumphed. This is politically convenient because it maintains Washington’s self-serving fiction that the banks alone caused the crisis, and that after bailouts they have emerged richer and less regulated than ever. This leaves politicians free to bash the banks in perpetuity even as they constrain their business and fleece them at regular intervals.

The truth is that across the U.S. economy the government has far more power than it did five years ago, especially in finance. The same politicians and regulators who pulled every lever they could to force capital into mortgage finance have not only escaped punishment for their role in the 2008 crisis. They’ve also awarded themselves more authority to allocate credit. Consider some prominent realities:

• Most of the big banks survived, but at the price of becoming regulated utilities. A sensible reform would have been to require more capital as a bumper against losses, and to use a basic definition of capital that can’t be gamed. Instead, the regulators are requiring more capital while adding vast new layers of regulation.

The regulation micromanages bank decisions down to the kind and quality of loan. Regulators have ordered a top-to-bottom overhaul of foreclosure processes even after extorting more than $25 billion in payouts for exaggerated past offenses.

The Consumer Financial Protection Bureau can veto some products while all but dictating certain kinds of lending. The bureau already has 1,297 employees and an automatic budget tied to Federal Reserve System expenses, not to Congressional appropriations.

The Dodd-Frank Act’s great reform conceit is that the same regulators who missed the last crisis, and who tolerated Citigroup’s off-balance-sheet vehicles hiding in plain sight, will somehow prevent the next crisis. It won’t happen. Regulators somehow missed J.P. Morgan’s “London whale” trades even after they were reported in this newspaper. But they sure know how to punish ex post facto, extracting $920 million in a settlement with J.P. Morgan this week.

The policy of too big to fail has been codified and expanded. Dodd-Frank lets Washington’s wise men define “systemically important” institutions subject to stricter regulation, and they are dutifully expanding this safety net. Insurance companies are already in this maw (AIG, Prudential) or may be soon (MetLife). So are clearinghouses for derivative trades, which have emergency access to the Federal Reserve’s discount window.

Dodd-Frank’s second great conceit is that in a crisis these firms will be wound down without a rescue. They even have to provide “living wills” that are supposed to plan the funeral. But the law also gives regulators the freedom to protect creditors as they see fit, which they will surely do in a panic. The difference next time will be that more firms will be deemed too big to fail.

The government roots of the crisis are unreformed, especially easy credit and the bias for housing. The Federal Reserve keeps buying mortgage securities to lift housing prices. Fannie Mae and Freddie Mac continue as ever, even after losses resulting in $188 billion in bailouts. Taxpayers now guarantee close to 90% of all new mortgages either through Fan and Fred or the Federal Housing Administration, which may also need a bailout.

Now that Fan and Fred are making money again amid the housing recovery, political pressure is growing to release them from federal conservatorship. This would recreate the same toxic mix of private profit and public risk that made them so dangerous when we were warning about them a decade ago.

Dodd-Frank did mandate that credit-rating agencies be reformed, but regulators still haven’t finished the job. The same goes for money-market mutual funds, which continue to benefit from a government rule that lets them declare a $1 net asset value even if the value of the underlying assets has changed. This is systemic risk caused by government that government could but won’t fix.

Even the new Basel capital standards are suspect because they include a carve-out for sovereign debt. So the same regulators that claimed mortgage debt was AAA safe now say that debt from various governments is solid gold.

The simpler, better reform would have been to require much tougher capital standards for banks that take insured deposits, set clear rules that limit risk-taking at such institutions, and let other companies innovate and take risks knowing they get no taxpayer protection. Instead, five years after the panic we have a financial system that is more heavily regulated, and thus is less able to lend and innovate, yet is paradoxically no safer. The government won again.

Ronald Coase

cop

On public goods and regulation.

From the WSJ:

The Man Who Resisted ‘Blackboard Economics’

Nobel laureate Ronald Coase taught that economists should study real markets.

 By DAVID R. HENDERSON

Ronald Coase, who died on Labor Day at age 102, was one of the most unusual economists of the 20th century. He won the Nobel Prize in 1991 for his insights about how transactions costs affect real-world economies. In a 75-year career he wrote only about a dozen significant papers, and he used little or no math. Yet his impact was profound.

In his early 20s, Coase was a socialist, but he had a trait that few socialists have: curiosity about how economies work. On a trip to the United States from his native Britain in 1931 and 1932, he dropped in on perennial Socialist Party presidential candidate Norman Thomas, and he visited Ford and General Motors. How, he wondered, could economists say that Lenin was wrong to believe that the Russian economy could be run like one big factory, when some big firms in the U.S. seemed to run well?

Coase’s answer, in his widely cited 1937 article “The Nature of the Firm”: Companies are like centrally planned economies, but unlike the latter, they are formed because of people’s voluntary choices. But why do people make these choices? Coase wrote that the answer is “marketing costs,” or what economists now call “transaction costs.” If markets were costless to use, there would be no point in forming companies. Instead, people would make arm’s-length transactions. But because markets are costly to use, the most efficient production process often takes place within a company. His explanation of why companies exist spawned a whole literature.

His 1960 article “The Problem of Social Cost” gave rise to the field called “law and economics.” Before Coase, most economists had accepted British economist Arthur Pigou’s idea that if, say, a cattle rancher’s cows destroy his neighboring farmer’s crops, the government should stop the rancher from letting his cattle roam free or tax him for doing so. Otherwise the cattle would continue to destroy crops because the rancher would have no incentive to stop them.

Coase challenged that view. The rancher, he wrote, would be ignoring an opportunity: the chance to be paid by the farmer not to destroy the crops. If transaction costs were zero—Coase was clear that he wasn’t assuming they were—the farmer and rancher could come to a mutually beneficial agreement.

For example, if the rancher’s net return on a steer was $20, then the rancher would accept some amount over $20 to give up the additional steer. If the steer was doing harm worth $30 to the crops, then the farmer would be willing to pay the rancher up to $30 not to raise the steer. So the case for Pigou’s taxation was no longer so clear.

George Stigler, who won the 1982 Nobel Prize in economics, thought the exciting part of Coase’s insight was what happened when transactions costs were zero. Stigler labeled that insight the “Coase Theorem.” If transactions costs were zero, no government intervention was needed.

Deirdre McCloskey, an economist at the University of Illinois at Chicago Circle, thought the no-transactions-cost insight was trivial. The interesting part, according to Ms. McCloskey, is what happens when reality intrudes in the form of positive transactions costs. Then it matters how courts assign liability. If, in the above example, a court gave a rancher the right but the rancher valued the steer at less than the damages to the farmer’s crop, transactions costs could prevent the efficient solution from emerging.

Coase himself rejected both the Stigler view (that zero transactions costs are the important case) and the Pigou view, both of which he derisively called “blackboard economics.”

Another famous Coase article, “The Lighthouse in Economics,” was published in 1974. Economists often use lighthouses as an example of a public good that only government can provide. But Coase showed, with a detailed look at history, that lighthouses in 19th-century Britain were privately provided and that ships were charged for their use when they came into port. There were ships that didn’t come into port, but enough did to make lighthouses a paying proposition.

Coase’s investigation undermined economists’ previous view that the free-rider problem would put the kibosh on for-profit lighthouses. It also strengthened his view that economists needed to study real markets rather than settling for blackboard economics.

In 1959, Coase wrote that the Federal Communications Commission was unnecessary; electromagnetic spectrum could be bought and sold in a free market. There was nothing special about the scarcity of spectrum, since all economic goods are scarce. This view was derided at the time, but is now almost standard fare among economists.

As editor of the Journal of Law and Economics from 1964 to 1982, Coase published articles that were critical of government regulation. Not, Coase emphasized, because regulation could not work but because, in virtually all the cases examined in that journal, regulation did not work. Regulation led either to cartels or to other negative effects.

Coase made many intellectuals uncomfortable by pointing out an obvious implication of their belief in government regulation: If regulation works so well in the market for goods, then it should work even better in the market for ideas.

Why? As Coase said in a 1997 Reason interview, “It’s easier for people to discover that they have a bad can of peaches than it is for them to discover that they have a bad idea.” Many intellectuals thought Coase was arguing for government regulation of ideas. He wasn’t. His point was to get intellectuals to see that their case for regulating goods is weak.

The Cost of Regulation

A competitive market, if we can keep it, is certainly the most efficient and least corruptible form of regulation. Stelzer exposes the problem with using bureaucratic agencies to regulate behavior when it disadvantages that competition.

Economist Irwin Stelzer writing in the Weekly Standard’s July 23 issue:

For big business, a new regulation means hiring a few more lawyers; for small businesses, it means trying to hurdle still another barrier to entry. Take the case of Barclays, the leading Libor rate-fixer (so far as we know). Britain’s bank regulator complains that Barclays always leads the charge for more regulation: “Barclays has a tendency continually to seek advantage from complex structures or favorable regulatory interpretations.” Pharmaceutical companies promised support for Obamacare in return for provisions that protect them from competition from reimported drugs and generics. Insurance companies accepted costly provisions of Obamacare in return for regulations that allow them to roll those costs into the expenses they will be permitted to recoup in rates and, more important, penalties (oops, sorry Chief, taxes) that deliver to them millions of unwilling, healthy new customers. Big banks are allowed to shelter under Fed regulations when the going gets tough in return for muting their opposition to regulations that will do more to hurt their small competitors than prevent them from going about their business in the good, old fashioned way. Campaign contributors are allowed to short-circuit capital markets and obtain subsidies for their uneconomic green enterprises, sopping up capital that markets would surely allocate to more promising ventures.

How to Get the Rich to Share the Marbles

This is a NYT article that presents some interesting findings from behavioral studies of cooperation and conflict. We can see from the results that our concepts of fairness are related to our perception of effort and chance. If we expend effort to receive an award, fairness dictates that we keep that reward. Also, if fate happens to smile upon us, there is no obligation to share the luck – sharing is purely by choice. This has many implications for the current political discussion over “fairness” in a free society. It is doubly significant given the technologically-driven trend towards “winner-take-all” in the economy. The policy implications are that we eschew envy and seek to create a balanced playing field. Our rules and regulations should be targeted to prevent cheating of the “heads we win, tails you lose” variety, and that especially applies in politics. The Tea Party and OWS movements have been incited by the perception of widespread cheating among elites in control of our institutions. But if we don’t get the policy adjustments correct, these same elites are clever enough to use envy to divide and conquer. We can observe much of this today in the presidential campaigns.

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By JONATHAN HAIDT

Suppose scientists discovered a clump of neurons in the brain that, when stimulated, turned people into egalitarians. This would be good news for Democratic strategists and speechwriters, who could now get to work framing arguments about wealth and taxation in ways that might activate the relevant section of cerebral cortex.

This “share-the-spoils” button has been discovered, in a sense, but it may turn out to be harder to press than Democrats might think.

Pretend you’re a three-year-old, exploring an exciting new room full of toys. You and another child come up to a large machine that has some marbles inside, which you can see.  There’s a rope running through the machine and the two ends of the rope hang out of the front, five feet apart. If you or your partner pulls on the rope alone, you just get more rope. But if you both pull at the same time, the rope dislodges some marbles, which you each get to keep. The marbles roll down a chute, and then they divide: one rolls into the cup in front of you, three roll into the cup in front of your partner.

This is the scenario created by developmental psychologists Michael Tomasello and Katharina Hamann at the Max Planck Institute in Leipzig, Germany. In this situation, where both kids have to pull for anyone to get marbles, the children equalize the wealth about 75% of the time, with hardly any conflict. Either the “rich” kid hands over one marble spontaneously or else the “poor” kid asks for one and his request is immediately granted.

But an experiment must have more than one condition, and the experimenters ran two other versions of the study to isolate the active ingredient. What had led to such high rates of sharing, given that three-year-olds are often quite reluctant to share new treasures? Children who took part in the second condition found that the marbles were already waiting for them in the cups when they first walked up to the machine. No work required.

In this condition, it’s finders-keepers. If you have the bad luck to place yourself  in front of the cup with one marble, then your partner is very unlikely to offer you one, you’re unlikely to ask, and if you do ask, you’re likely to be rebuffed. Only about 5% of the time did any marbles change hands.

But here’s the most amazing condition — a slight variation that reveals a deep truth. Things start off just as in the first condition: you and your partner see two ropes hanging out of the machine. But as you start tugging it becomes clear that they are two separate ropes. You pull yours, and one marble rolls out into your cup. Your partner pulls the other rope, and is rewarded with three marbles. What happens next?

For the most part, it’s pullers-keepers. Even though you and your partner each did the same work (rope pulling) at more or less the same time, you both know that you didn’t really collaborate to produce the wealth. Only about 30% of the time did the kids work out an equal split. In other words, the “share-the-spoils” button is not pressed by the mere existence of inequality. It is pressed when two or more people collaborated to produce a gain. Once the button is pressed in both brains, both parties willingly and effortlessly share.

Tomasello has found that chimpanzees doing tasks similar to this one do not share the spoils, in any of the conditions. They just grab what they can, regardless of who did what. They don’t seem to keep track of who was on the team. Tomasello believes that the “share-the-spoils” response emerged at some point in the last half-million years, as humans began to forage and hunt cooperatively. Those who had the response could develop stable, ongoing partnerships. They worked together in small teams, which accomplished far more than individuals could on their own.

So now let’s look at a key line in President Obama’s State of the Union address: “we can restore an economy where everyone gets a fair shot, and everyone does their fair share, and everyone plays by the same set of rules.” The president is making three arguments about fairness in this one sentence, but do any of them press the “share-the-spoils” button? If you think that the economy is like a giant marble dispenser with a single rope, then you’d probably agree that if everyone does their “fair share” and pulls on the rope as hard as they can, then everyone is entitled to a “fair share” in the nation’s wealth. But do Americans perceive the economy as a giant collaborative project?

My parents were teenagers in New York City during the Second World War. The home front really was a vast and sustained communal pull. My mother remembers saving up nickels and dimes to buy a war bond. She lingered by her aunts and uncles, waiting for them to finish packs of cigarettes, so that she could grab the foil wrappers for the aluminum recycling campaign.

My parents were part of the generation that went through the depression, a world war, and then the cold war together. This generation accepted federal controls on wages during the war as being necessary for the common good. In the years after the war, the combination of high taxes on top earners, social norms against exorbitant pay, and an increasingly sturdy safety net brought income inequality down from a peak in 1929 to a long valley from the 1950s through the 1970s. It’s a period known as “the great compression.”

The compression went into reverse in the 1980s, and since then, inequality has risen to levels approaching those of 1929. Democrats have long sounded the alarm about rising inequality, but for decades they got little traction among the electorate. It’s only in the last few months, since Occupy Wall Street popularized the concept of the 1 percent, and since we all learned that Mitt Romney pays less than 14% in federal taxes, that the nation’s attention has been focused on the earnings of the super-rich. Will the Democrats’ new emphasis on fairness be enough to rally the nation to raise the top tax rates? Will Obama’s new progressivism press the right moral buttons?

America is in deep fiscal trouble, and things are going to get far worse when the baby boomers retire. Normally, when a nation faces a threat to its very survival, a leader can press the shared-sacrifice button. Churchill offered Britons nothing but “blood, toil, tears and sweat.” John F. Kennedy asked us all to “bear the burden of a long twilight struggle” against communism. These were grand national projects, and everyone was asked to pitch in.

Unfortunately, President Obama promised he would not raise taxes on anyone but the rich. He and other Democrats have also vowed to “protect seniors” from cuts, even though seniors receive the vast majority of entitlement dollars. The president is therefore in the unenviable position of arguing that we’re in big trouble and so a small percentage of people will have to give more, but most people will be protected from sacrifice. This appeal misses the shared-sacrifice button completely. It also fails to push the share-the-spoils button. When people feel that they’re all pulling on different ropes, they don’t feel entitled to a share of other people’s wealth, even when that wealth was acquired by luck.

If the Democrats really want to get moral psychology working for them, I suggest that they focus less on distributive fairness — which is about whether everyone got what they deserved — and more on procedural fairness—which is about whether honest, open and impartial procedures were used to decide who got what. If there’s a problem with the ultra-rich, it’s not that they have too much wealth, it’s that they bought laws that made it easy for them to gain and keep so much more wealth in recent decades.

Sarah Palin gave a speech last September lambasting “crony capitalism,” which she defined as “the collusion of big government and big business and big finance to the detriment of all the rest – to the little guys.” I think that she was on to something and that she was right to include big government along with big business and big finance. The problem isn’t that some kids have many more marbles than others. The problem is that some kids are in cahoots with the experimenters. They get to rig the marble machine before the rest of us have a chance to play with it.