Bank fees and antitrust

bank ghhiIn Slate, I discuss a new paper by José Azar, Sahil Raina, and Martin Schmalz, which argues that the institutional investors that own banks in common do not want banks to compete over the interest rates they offer to, and fees they charge, depositors. The figure above (from their paper) shows that while bank competition looks fine under the traditional HHI index, their alternative measure–the GHHI, which takes account of common ownership–shows that concentration has increased over the last decade. Like their earlier paper on airline competition, this paper offers evidence of the monopolizing tendencies of capitalism, which offers a higher return to investors who are able to circumvent the incentives to compete.

A number of people have expressed skepticism about the mechanism. How exactly do institutional investors ensure that CEOs do not compete? There are many hypotheses. Their pay structure could reward them; subtle pressures can be brought to bear through communication; there are all kinds of interlocking relationships such as board memberships; and so on.

Below is the trend in bank fees (a similar trend exists for the threshold at which fees are charged). Correlation or causation? The paper uses an instrumental variable approach to claim causation. As always, showing causation is tricky. But more research is justified.

bank fees

Neil Irwin on The Big Short

Irwin praises the film while correctly pointing out that the movie implies that only its heroes foresaw the collapse of housing prices, when in fact many people did. But the movie makes a more serious error: It implies that the heroes foresaw the financial crisis as well as the popping of the bubble. They didn’t. The movie bumbles this important distinction, implying wrongly that the bad guys either also knew that they would cause a financial crisis but didn’t care because they would be bailed out, or were too stupid to anticipate the financial crisis. Both of these claims are wrong. No one anticipated the financial crisis so no one could have expected bailouts; and if no one anticipate the financial crisis, it is a misuse of the word “stupidity” to imply that it encompasses the failure to predict what no one predicted.

However, the distinction does play a small role in the movie. In 2007, the short bets were supposed to pay off. Burry, Lippman, and the others correctly saw that mortgage defaults would increase as housing prices leveled off and ARMs reset to higher interest rates; this should have pushed down the value of mortgage-related assets. But it didn’t, not initially, causing some much-needed drama that the film makers skilfully exploit. The film implies that the “marks” did not move because of fraud on the part of the banks that set them. The banks did not adjust the marks downward because if they did, the banks would have to declare themselves insolvent. They preferred to engage in fraud.

But here things get complex. Alone among the banks, Goldman does reduce its marks. So was Goldman a good guy? Not in the movie. The explanation is that Goldman was acting in its “self-interest,” having figured out what the heroes figured out and shorted the market–in fact, acting identically to them in all relevant respects except in expressing anguish. Everyone acted in his (perceived) self-interest. Someone was right and someone was wrong–who?

The problem was that no one knew how to value the assets. Because they had stopped trading, it was impossible to “mark them to market.” Accounting rules allow banks to depart from market  values in just such  circumstances. Otherwise, panic-driven fire-sale prices get transmitted onto the balance sheets of firms that could otherwise survive a liquidity crisis and imply that the banks are insolvent when they remain sound. However, in the absence of a market, no one really knows how to  mark the assets. It was this uncertainty about market values–not the housing bust itself, which everyone expected to be self-contained–that led to the financial crisis. Goldman was subsequently criticized for marking down values too aggressively, which could have exacerbated the crisis and forced healthy firms into bankruptcy, but enriched our friends, Burry et al.

Meanwhile, we know that our heroes did not anticipate the financial crisis because if they had, the last thing they would have done is to make deals with investment banks. A brilliant bet against housing is worth nothing at all if the counterparty is Lehman. Burry and others were supremely lucky that the federal government bailed out Bear and provided life support for the other investment banks. Their investors–depicted in the movie as dumb suits–had good reason to worry.

Love your lawyer day: Federal Reserve legal division edition

I ran across this memo from the merry band of pranksters at the Federal Reserve legal division. The memo explains why the Fed could legally buy unsecured commercial paper during the financial crisis–that is, make unsecured loans to businesses–even though under the relevant legal authority the loans must be “secured to the satisfaction” of the Fed.

The lovable lawyers make two arguments. Argument 1 is that the Fed didn’t actually make loans to the businesses. It made loans to a special purpose vehicle that the Fed created. The SPV then turned around and loaned the Fed’s money to the businesses. The Fed’s loan to the SPV was secured by the commercial paper that the SPV acquired from the businesses in return for its (the Fed’s) money.

According to this theory, any unsecured loan to anyone can be converted into a secured loan simply by creating an SPV. You can do it yourself. Just create an SPV, lend money to the SPV, direct the SPV to lend that money to Mr Anyone in return for an IOU from him, and then call the IOU collateral for your loan to the SPV. Voila, an unsecured loan to a person with no assets turns into a secured loan.

Argument 2 is even more clever. The lawyers grudgingly admit that their first argument might be considered specious (they don’t use exactly that word) since as a matter of function the SPV doesn’t do anything at all. So in Argument 2, the lawyers observe that the Fed charges the unsecured CP issuers an “insurance fee” or premium of 1% above the normal interest rate. The “insurance fees” from all the unsecured borrowers are aggregated into an “insurance fund,” which can then pay out to the Fed if any borrower defaults. This insurance fund gives the Fed “security.”

Of course, an unsecured loan always carries a higher interest rate than a secured loan does. That higher interest rate–or call it the “insurance fee” if you want–has precisely the function of protecting the creditor from the extra risk from lending to a borrower who cannot offer collateral. So by the Fed’s logic, any unsecured loan is a secured loan as along as the interest rate for the unsecured loan is higher, as it always is. In short, there is no such thing as an unsecured loan; all unsecured loans are secured.

Happy Love Your Lawyer day!

Bernanke’s memoir

You can buy it here. I found it interesting but also disappointing, for reasons I can’t quite identify. Maybe because:

  • Bernanke extols Fed transparency–which he calls his legacy–but on numerous occasions he mentions cases where he and his colleagues hid their motives, thoughts, and actions. Why? To avoid spooking the market, to retain leverage while bargaining with banks, to allow banks to borrow without being stimgatized, etc. All good reasons, but suggesting that transparency is a more complex ideal than he lets on.
  • While Bernanke admits some errors, they are of the minor sort–having to do with leadership and presentation. He refuses to admit the biggest one: the failure to rescue Lehman, which he continues to blame on “the law,” as I note in Slate. So the error-admitting seems more like an exercise in establishing credibility than in admitting error.
  • Bernanke mocks the Old Testament types who want to punish financial institutions, but then expresses “anger” at AIG and ensures that it is punished. Which is it?

The most interesting thing I learned, or at least that I infer from the narrative, is that Bernanke wanted above all to ensure that the Fed did not take losses and pass them on to the Treasury. At the same time, he and others have criticized Sheila Bair for taking just such an approach to the FDIC insurance fund rather than focusing on the financial system as a whole. How much of the crisis response was driven by competing bureaucratic mentalities?

The perils of financial predictions

I’m reading a 2011 book called Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance by Viral V. Acharya, Matthew Richardson, Stijn van Nieuwerburgh, and Lawrence J. White. This is a serious book by reputable scholars. I’ve made it to p. 3, where they write:

[T]he chances are slim to none that either Fannie or Freddie will be able to pay back the funds [they received from the government]…. So where is the outrage?

And yet as we know, Fannie and Freddie have paid back the government (or, more precisely, the government has made money on its investment in preferred stock).

Here is the paradox or irony or whatever you want to call it. During the financial crisis, we learned that the CDOs and other mortgage-backed securities that everyone thought were safe were based on assumptions about housing prices and underwriting standards that turned out to be wrong. Their market value plunged as people stopped trading them. The government saved the day by lending widely so people could hold onto these securities until maturity or reduce their exposure to them.

The proper inference was “these securities are hard to value.” The actual, wrong response was “these securities are worthless [or close to worthless].” Of course, if the securities are hard to value, we don’t know whether they are worthless or not. And yet it seems that nearly everyone draw exactly the wrong lesson. People had as much unwarranted confidence in their valuations of the securities after the crisis as they did before; they simply changed what they thought the valuations were–from high to low. And they were wrong again.

Martin Schmalz: How passive funds prevent competition

Guest post by Martin C. Schmalz, University of Michigan.

Last week, Nelson Peltz’s hedge fund Trian lost a proxy fight at DuPont. The outcome of the battle received much attention, among others because the “passive” investors Vanguard, BlackRock, and State Street were instrumental in making his bid fail – they voted against him. Commentators have ex-post rationalized the failure of the campaign with gaps in some of Peltz’s arguments, his personality, and other factors. Curiously, nobody seems to have taken a look at how Peltz’s and the “passive” funds’ economic incentives differed. This note takes a first look at those, and comes to rather interesting conclusions.

According to Trian’s presentation filed with the SEC, the primary goal of Peltz’s campaign was to help DuPont achieve “best in class revenue growth.” He points out that DuPont’s performance in recent years was satisfactory only because of a positive industry-wide trend, but not if measured relative to DuPont’s competitors. Note for later that the first peer mentioned for comparison in the presentation is Monsanto. A second point of critique concerned DuPont’s lack of aggressive investment in R&D and other measures to gain market share. Third, Trian criticizes DuPont’s CEO for selling a large fraction of her shares in DuPont under the tenure of the index funds, a move that weakened her incentives to make DuPont perform well as an individual firm and strengthen the firm’s relative competitive position. Fourth, Peltz criticizes that DuPont willingly violated a Monsanto patent, then chose to pay $750m more than required in a settlement, and entered a licensing agreement with Monsanto until 2023, effectively pre-committing future cash flows to the competitor. Peltz also criticizes DuPont for “paying competitors” for such licenses more generally.

Peltz’s arguments make perfect sense according to the conceived wisdom reflected in corporate finance textbooks, which assume that all shareholders are undiversified: Peltz’s motion for an increased use of relative performance evaluation, for steeper CEO incentives and against wealth transfers to competitors at the expense of DuPont’s shareholders – textbooks would consider all of these measures value-enhancing improvements of DuPont’s corporate governance. Also, Institutional Shareholder Services (ISS), a proxy advisory firm, supported Peltz’s campaign.

As we know since last week, these arguments left DuPont’s largest shareholders – the diversified investors Vanguard, BlackRock, and State Street – unimpressed. They voted against Peltz, leading to a rejection of his bid, and a multi-billion dollar drop in DuPont’s stock price (indicating the market also thought DuPont would have been more valuable with Peltz on the board). So why did the mutual funds not share Trian’s goals?

To answer that question, it is instructive to see who DuPont’s competitors are. A quick browse gives a first indication why Peltz considers Monsanto to be DuPont’s primary competitor:  Monsanto and DuPont are the two firms dominating the seeds market, and Monsanto is DuPont’s next-largest competitor in the fertilizer and pesticides market.  Conversely, these two markets generate almost all of Monsanto’s revenue.[1]

schmalz tables 1 and 2

Peltz believes competing harder would increase DuPont’s value. For example, DuPont could decrease prices in the seeds market, and thus increase its market share. The stock market, as indicated by the stock price reaction amid the news of Peltz’s failed bid, appears to agree. The lower market prices for seeds would also lead to greater output and ultimately lower product prices for consumers – for short, greater economic efficiency. However, it would hurt Monsanto’s shareholders if DuPont were to compete more aggressively: DuPont’s increase in market share would come at the expense of Monsanto’s. So who are Monsanto’s shareholders?

It turns out that the same “passive” funds that helped reject Peltz’s bid at DuPont are – in the same order – also the dominant shareholders of Monsanto. In fact, with the exception of Peltz’s Trian Fund, the two firms’ top shareholders are almost identical.

schmalz table 3

The “passive” funds have no reason to object against cash transfers from DuPont to Monsanto – it’s just a transfer from one pocket to the other. Of course, Peltz (and everyone else who has a sufficiently steep interest in DuPont’s value) should object. That is the first source of imperfectly aligned incentives between the passive funds and Trian.

The more important insight, however, is that the common shareholders of the two firms would suffer from increased competition. Because prices would be lower, so would be the combined revenue and profits of DuPont and Monsanto. That outcome is in strict discord with the economic interests of Vanguard, BlackRock, and State Street. That is the second – and socially important – source of disagreement between the economic interests of Trian and the mighty mutual funds.

Here is one last nugget. Guess which company among DuPont’s competitors experienced a major change in stock price while DuPont’s price dropped in response to the news that Peltz’s bid failed. From market close on Tuesday to opening on Thursday, Monsanto’s shares gained 3.5%.

It appears that a dispassionate look at different shareholders’ economic incentives supplies a rather simple rationale for why the passive funds did not themselves enforce relative performance evaluation, protest the weakening of DuPont’s CEO’s incentives, encourage more R&D and gains in market share, and so forth.[2] Doing so simply isn’t in their economic interest. Peltz’s campaign, by contrast, aimed at increasing DuPont’s value in isolation, by strengthening DuPont’s relative competitive position. Predictably, the mutual funds voted against him.[3]

Before we conclude, pay attention to the dog that didn’t bark: Peltz’s failed campaign sends a strong signal to activists with similar goals as those Peltz tried to advance. If not before, then now they know: the combination of the index funds’ economic interests and voting power makes it unlikely that a campaign aimed at tougher competition will pass the ballot – so it might not be worth it to target a firm with these goals in mind in the first place.[4] That is how common ownership by “passive” funds can cause anti-competitive outcomes. If we want lower product prices, and higher output and efficiency, then taking a close look at the power and industrial organization of the asset management industry might be a good place to start.

[1] I haven’t gotten around to finding data on DuPont’s other product markets, which is why the following analysis is limited in scope and the external validity of its conclusions.

[2] Of course, this analysis does not prove that the passive funds voted against Peltz because he wanted DuPont to outperform the peers held by the passive funds, or because he criticized the voluntary wealth transfers to Monsanto and the lack of steep CEO incentives. Yet, whatever the reasons why the passive investors voted against Peltz, be it their economic incentives or other considerations, it is undisputable that their vote did prevent a campaign aimed at tougher competition. They thus caused less competition, compared to what it otherwise would have been.

[3] This outcome was indeed predicted. In this paper, my coauthors José Azar, Isabel Tecu, and I wrote: “owners generally need to push their firms to aggressively compete, because managers will otherwise enjoy a “quiet life” with little competition and high margins. Only shareholders with undiversified portfolios have an incentive to engage to that effect, while only large shareholders have the clout to do so. However, the largest shareholders of most firms tend to have diversified portfolios and therefore reduced incentives to push for more competition, whereas smaller undiversified investors don’t have the power to change firm policy without the support of their larger peers.”

[4] Opportunities abound for activist campaigns that didn’t or will never happen: very many U.S. firms are commonly owned by a similar set of diversified mutual funds as those owning DuPont and Monsanto. Here are a few examples.

More on mutual funds and antitrust

Last week, Glen Weyl and I published a piece in Slate that argued that mutual funds and other institutional investors were cartelizing the airline industry, and very likely other industries as well. Our piece was based on an academic paper by Azar et al., which found evidence that a merger between two major institutional investors with large stakes in the airline industry caused ticket prices to rise. To remedy this problem, we proposed restrictions on mutual fund investment within industries. (No, we did not propose banning mutual funds.)

Mathew Klein at the Financial Times and Matt Levine at Bloomberg disagree. (Klein: a “wacky idea.” Levine: “I tweeted about Posner and Weyl’s article and the reactions were, I think it is fair to say, uniformly incredulous.”) Joshua Gans does agree, and provides an extremely lucid account of the underlying theory. A few responses:

  1. We don’t oppose all mutual funds, just those that cartelize industries. Mutual funds that buy shares of firms across industries, rather than within industries, get a pass. The gains from further diversification within industries after the benefits from diversification across industries are obtained, are tiny. Moreover, small funds can buy shares within industries without harming anyone. The key is balancing the gains from diversification and the costs of cartelization.
  1. As Piketty shows, most capital is owned by the wealthy, and is far more concentrated than labor income or consumption. Reducing the returns on capital would not harm middle-class owners of capital very much, and would be offset by the reduction in prices of goods and services they buy. In an ideal world, middle-class mutual fund investors would instruct the funds not to cartelize the industry at their own expense, but obviously they cannot do that. They rationally chase the highest returns, in the process causing harm to each other.
  1. While we proposed regulation of 401(k)s, this was not meant to be an exclusive remedy. The problem is cartelization; the most natural response is enforcement of antitrust law. But a starting point is removal of a tax subsidy that benefits mutual funds that try to cartelize industries.
  1. The decline of airline prices over time does not refute Azar’s argument. The prices are still higher than they would be if the market was less concentrated. But the airline industry is not the issue. That’s just where Azar and his coauthors looked for evidence. If they are right about airlines, then the problem is general to the economy. The real puzzle is: where are the antitrust authorities?

Toward a Pigovian State

It is well-known that Congress and regulators do not use Pigovian taxes in order to deter pollution and other negative externalities. It is less well-known, or perhaps not known at all, that regulators possess the authority to impose Pigovian taxes. They just don’t use it. Why not? My colleague Jonathan Masur and I document the regulatory landscape and try to answer this question in a paper now available at SSRN.

Vigna & Casey: Bitcoin and regulation

Vigna and Casey rightly reject claims by some bitcoin enthusiasts that bitcoin shouldn’t be, or can’t be, regulated. It can and will be, and indeed already is subject to regulation in many jurisdictions, as the authors document. But they can’t help arguing that bitcoin poses a challenge to government.

Anyone who remembers the 1990s will recall the argument that the Internet poses a challenge to government. The argument then was that the government would not be able to censor people because of the decentralized structure of the Internet. Freedom would flourish, despots would fail. You can’t turn the Internet off; nor can you change its rules.

But the government can go after the “joints” of the Internet—the ISPs, the search engines, the social media sites, and they do. Authoritarian governments have discovered that the Internet provides a valuable means for social control. Ordinary people don’t take all the precautions that are theoretically possible, benefit from the convenience of large intermediaries, and in this way make themselves vulnerable to legal sanctions if they use the Internet to break the law, or–in authoritarian countries–merely criticize the government.

The same will surely be true for bitcoin. Ordinary people are not going to use “dark wallets.” They will turn to the institutions that they trust—yes, banks, or brand-name Internet companies like PayPal and Google—and the government will use these institutions as levers for regulating, just as it has for other types of Internet usage.

The authors suggest that bitcoin took hold in the wake of the financial crisis. Because people could no longer trust “money,” they would put their trust in bitcoins. If people really thought this, they made a serious error. The financial crisis was not caused by fiat money (or, as the authors insist on putting it, “centralization,” meaning the Fed). It was caused by bad investments; and one can just as easily make bad investments with bitcoins as with dollars.

Financial crises would occur in a bitcoin-based financial system just as they did under the gold standard. Centralization (in the government) is needed to address financial crises; so if bitcoin makes centralization impossible, we would be in deep trouble. Fortunately, it does not. As I argued earlier, a bitcoin-based financial system would operate through banks and other intermediaries, and the government would regulate bitcoin by regulating them, just as the government regulates Internet users by regulating ISPs, search engines, and social media sites.

Moreover, as the authors point out, bitcoin investors have already realized that bitcoin will become more stable, trustworthy, and hence profitable if the government regulates it. As money pours into the system, the pressure for regulation will increase rather than diminish.

Vigna & Casey: Bitcoin and economic decentralization

The authors argue that bitcoin reflects a wave of decentralization, and will advance decentralization as well. However, they are not very clear about what decentralization means. They use the term to refer both to the elimination of big firms, including monopolists, and the elimination of certain functions of government. This is puzzling because often it is government centralization (antitrust laws) that counters economic centralization (monopolies). I will discuss the first meaning here.

Vigna and Casey think that if bitcoin became a worldwide currency, banks would go out of business. This is wrong. Banks would stay in business; they would accept bitcoins as deposits and make bitcoin-denominated loans. We know that this is the case because banks existed on the gold standard; indeed, gold was the original basis of fractional reserve banking (by goldsmiths who stored gold for customers and made loans backed by a portion of that gold). Theory tells us this as well. People won’t want to hold bitcoins in their wallets if they don’t plan to use them immediately. They will deposit them with banks, and banks will turn around and lend most of their bitcoins to borrowers while retaining reserves to service the short-term depositors. Banks exist not because of some property of fiat money; they exist because people with short-term money surpluses gain by lending them through an intermediary who can check the creditworthiness of borrowers and monitor repayment.

The effect of technological change like bitcoin on economic centralization is unpredictable. The home computer was supposed to be a great decentralizer: anyone could afford one and so computing power was no longer monopolized by giant firms like IBM. But then came Microsoft. The Internet was supposed to decentralize, but then came Google and Facebook. Bitcoin might weaken banks (because people wouldn’t need check-writing services and credit cards), but it also might strengthen banks or bank substitutes (because people need a service to keep track of their bitcoin transactions, and to insure them against mistakes and fraud).

Vigna & Casey: Bitcoin and the law

Vigna & Casey argue that the technology underlying bitcoin may make the legal system unnecessary (though they later express some reservations about this argument). Whatever their view, bitcoin (or what they mean is the technology underlying bitcoin) will not do away with the law.

The authors suggest that a credit default swap could be automated using bitcoin technology; this would eliminate the need to rely on lawyers, judges, and bureaucrats. The authors make an important error. Let’s use the more familiar example of life insurance to show why. If the insured party dies, 99.999% of the time lawyers and judges do not need to be called upon. The insurer simply pays the beneficiary. Automating this process would reduce transaction costs by exactly zero.

Now consider a more difficult case. The insured party disappears while on a trek in the Amazon, or on an around-the-world boating trip. Must the insurer pay the beneficiary if death is ambiguous? Or suppose that the policy excludes liability in case of suicide, and the death of the policyholder looks like a suicide but it is not clear. What then?

There is no way around this problem: if the language of the policy is unclear, or the facts are unclear, someone must make a judgment. This cannot be automated.

Similar problems arises with CDSs. Sometimes, it is not clear whether the underlying bond has defaulted or not. In those cases, the legal system is needed. And where the legal system is not needed because the contract language is clear and the facts undisputed, bitcoin technology provides no advantage.

Maybe someday AI will enable computers to make judgments currently entrusted to lawyers and judges. Until that happens, bitcoin technology will not replace the legal system.

Vigna & Casey: Bitcoin and trust

Vigna and Casey make much of the claim that bitcoin is trustless. If I buy a cup of coffee using bitcoins, the café doesn’t need to trust me, or a bank. The blockchain ensures that I own the bitcoin I send. Under the current system, one must trust banks; and if a bank doesn’t trust you, then you can’t use a credit card and are shut out of the system.

But there are many reasons to be skeptical of this account, and also of its import. First, one cannot access the network and store coins without using an intermediary. People can download wallets, but ordinary people—as opposed to experts—will worry that the wallets cannot be trusted, indeed, may not know where to go on the Internet to find safe and reliable wallets. Thus, as V&C describe, intermediaries have been developed so that ordinary people can use bitcoins. These intermediaries are just companies with websites that offer bitcoin-related services. But people need to trust these intermediaries, and intermediaries will charge them one way or another. So it turns out that bitcoin is a version of our payment system that cuts out some intermediaries but by no means all.

Second, as V&C describe, bitcoin itself relies on trust. One must trust that the code has been well-designed, and that the five guys with access to it will use their access wisely to tweak the code when it falls short (as it already has). One must trust that these guys and others like them, their chosen successors, will continue to develop the bitcoin to address new, unpredictable challenges as they arise. One must trust that they can ensure that no one ultimately corners the bitcoin supply. Trust is not eliminated; it is just displaced to a new set of people, who will supposedly act in our interest. If bitcoin ever becomes a currency, these five guys will be seen as the J.P. Morgan of bitcoin—a private individual who everyone depends on to save the system. This situation will not be tolerated any more than Morgan was; the code will be entrusted to the government.

Third, trust is not, in fact, a big issue currently. People trust banks except during financial crises, and (as I will discuss) a bitcoin economy would be subject to financial crises as well. Trust returned to our financial system quickly after the financial crisis, thanks to government intervention.

So it’s not true that bitcoin does away with trust. And if bitcoin reduces reliance on trust a bit, there is little reason to think that matters.

Part I here.

Vigna & Casey’s The Age Of Cryptocurrency

age of cryptocurrencyThis book, written by two Wall Street Journal reporters, is the first journalistic account of the rise of bitcoin and related cryptocurrency technologies. The authors write well and clearly, and the book is illuminating. And the authors try hard to bring journalist objectivity to the extreme claims of bitcoin proponents. But they mostly give in. One can only cringe at sentences like this one:

 We may well be on the verge of a profound societal upheaval, perhaps the most significant since the sixteenth century…. (p. 278)

 We’re not. Or if we are, it’s not because of bitcoin. Even if the most extreme and implausible claims of bitcoin proponents (or “evangelists” as they are aptly called) came true, and bitcoin became a worldwide currency, we’d just be back in the nineteenth century, when countries were on the gold standard, albeit a digital version of it. Bitcoin just is the gold standard with bits rather than gold. (The authors, who gently mock goldbugs, don’t seem to realize that they are themselves “bitbugs.”) To be sure, transactions would be cheaper—we’d save some of the 1 to 3 percent that we now pay to use credit cards. That would help out a lot of people, but most people wouldn’t notice. And we wouldn’t worry about inflation (but we would worry about deflation and financial panics). Maybe life would be a bit better, or (as I suspect) a bit worse, but it wouldn’t be much different.

The book revolves around a number of themes: the role of trust in the financial system; the forces of decentralization; and the relationship between cryptocurrencies and the law. These are interesting issues, and all deserving of careful thought. But while the authors have sensible things to say about them, and try to carefully weigh the arguments on each side, in the end I believe they come down on the wrong side on nearly every issue. I will post some observations about this book over the course of this week.

Reply to Coates on financial cost-benefit analysis

Glen Weyl and I have been going back and forth with John Coates on the question whether financial regulators should use cost-benefit analysis. Weyl and I defended CBA of financial regulation here and here. Coates wrote an article criticizing CBA here. Our response is now posted, as is his reply to our response. Below is our reply to his response to our response to his response to our earlier arguments.

In his (latest) response, Coates usefully narrows the focus to the crucial issue: is there any reason to think that CBA of financial regulation and CBA of other types of regulations (like safety or environmental regulations) are different? Weyl and I agreed with Coates that lots of efforts to perform CBA of financial regulations have been shoddy, but that’s just because the methodology is at an early stage. Early environmental CBAs were shoddy as well, but they have improved greatly over the years, thanks to pressure from the White House, which ultimately forced regulators to enlist economists to help them improve environmental CBA.

Weyl and I think that, on theoretical grounds, CBA should be a lot easier for financial regulations (which are, after all, all about money, with tons of data) than environmental regulations (which involve many difficult-to-monetize valuations). Coates makes the opposite argument. In his latest reply, he makes the following points.

1. Coates rejects our merger guidelines as an example where cost-benefit principles have informed market regulation. His major point seems to be that those guidelines are not themselves instructions to perform CBAs, or the result of formal CBAs that were reviewed by courts, and that they are implemented loosely rather in a rigid way. We just don’t understand the force of this argument. The guidelines are the result of economic analysis (Weyl participated in writing them), and they basically enable the government to do cost-benefit analyses of mergers by creating certain economically informed presumptions. Mergers generate the same kind of problems about cost and benefit estimation that financial regulation does. At a minimum, this suggests that these valuation problems are not insuperable.

Coates also says that academics and practitioners admire the guidelines because they prefer rules (“constrained discretion”) over ad hoc judgments. But there is no reason to think that rules in general are better than discretion. Bad rules are worse than discretion, at least if discretion is used in good faith. The guidelines are good both because they are rules (or presumptions) and they are good rules grounded in economic principles.

2. Coates also repeats his argument that (if we understand it correctly) the natural sciences play a greater role in other forms of regulation than in financial regulation. The merger guidelines example was intended to show that this assumption is false: “market regulation” under the rubric of antitrust law is social science all the way down. But let’s consider his argument from safety regulation: the rear-facing camera. Coates argues that the main issue is one of natural science and engineering, which makes it easy to determine whether a mandate is cost-benefit justified.

A simple response to this argument is just to acknowledge that some kinds of regulation are easier than others. We certainly do not deny that. We do doubt whether the camera mandate is as simple as he says. Everything depends on how people respond to the new technology, and we know that how people respond to new technology is often difficult to predict. And, of course, safety regulations raise difficult issues about valuing human life. But the broader point is that many types of regulation seem easy just because we’ve already advanced down the learning curve. That will be true for financial regulation just as for any other type of regulation.

3. Finally, Coates seems to back off from his claim that financial regulation is special, and to argue that, across all areas of regulation, we need to distinguish between areas of regulation that have what he calls “non-stationary” (which seems to mean rapidly evolving) features and those areas that do not. And so his critique may turn out to apply to regulation of drugs, for example, or regulation of any activity where technology is changing at a rapid pace. Maybe he thinks that non-stationary features dominate the financial system but not other systems, but he doesn’t show this. Weyl and I are much more optimistic, based on recent developments in academic economics, including IO and antitrust, where (to repeat) the object of regulation is an incredibly non-stationary phenomenon–the market itself.

But if Coates is right, what does this mean? He advocates regulation based on “conceptual CBA,” which as far as we can tell, means CBA based on guesses rather than reasonable estimates.  We suspect that a more plausible response to his skepticism is not regulation but deregulation. If the government cannot explain why it is imposing costly constraints on the market, then regulation will be difficult to defend politically as well as legally.

How Do Bank Regulators Determine Capital Adequacy Requirements?

Ever wonder what the answer to this question is? If so, read my new paper at SSRN. I make four claims:

1. Bank regulators have used a process which I call “norming,” by which I mean choosing capital levels that weed out the worst banks but leave most of them untouched.

2. Norming is self-evidently (as a matter of the theory of financial regulation) a bad way to regulate banks, guaranteed to produce excessively generous rules that allow most banks to take excessive risks.

3. Inadequate capitalization of banks contributed to the financial crisis of 2007-2008.

4. If regulators had been required to use cost-benefit analysis rather than norming, they would have issued stricter capital adequacy rules.

Reply to Coates’ Cost-Benefit Analysis of Financial Regulation: Case Studies and Implications

John Coates wrote a valuable paper criticizing the use of cost-benefit analysis for financial regulations. Glen and I have now written a response, which is posted on SSRN. We make six arguments:

1. The uncertainty of valuations–the major reason Coates cites for his opposition to financial CBA–is not an argument against CBA but a reason to support research to produce better valuations.

2. The “centrality” of the financial system, which for Coates is a reason not to use financial CBA, is in fact a reason for using it. The greater the impact of a proposed regulation, the more likely that an expensive CBA is cost-justified.

3. Against Coates, we argue that the focus on people (rather than things) does not distinguish financial regulation from other types of regulation.

4. Also against Coates, we argue that the speed with which financial markets change does not distinguish it from other types of regulation for which CBA is used (notably, antitrust regulation).

5. Ultimately, the objections that Coates raises to financial CBA are really objections to CBA (in general) or even regulation (in general). They are too broad to single out financial CBA.

6. Alternatives to CBA proposed by Coates–reliance on “expert judgment” or “conceptual CBA”–are either circular or not that different from CBA after all.

All that said, we share Coates’ skepticism about judicial enforcement of financial CBAs, and prefer instead to see development of institutional capacity in the executive branch.