Government's Next Lesson: Small Is Beautiful

Antitrust law needs to be updated to include "too big to fail" as a criterion for dismemberment. The alternative is pervasive regulation and/or government ownership of institutions, which control huge swathes of the economy.

Financial regulation is, as we've seen, a chimera: whether or not you blame Fannie Mae (FNM) and Freddie Mac (FRE) for being a partial cause of the current collapse, there's no question that they WERE regulated – as is Citibank (C) – and that they collapsed. All public companies in the U.S. are regulated to some extent by the SEC and have draconian external audit requirements. Neither the regulation nor the auditing warned stockholders of the potential collapse of AIG (AIG), Lehman Brothers (LEHMQ.PK), and now GM (GM). Why? It's not that all the auditors and regulators are corrupt or even incompetent, though some are surely both. The problem is black swans, as Nassim Taleb elegantly pointed out in his book of the same name: You are in more danger from the unknowable than the knowable risk; the past is an extremely misleading guide to the future. Put less elegantly, shit happens and all the regulation in the world can't prevent or predict it. The appearance of regulation is dangerous because it gives us a false sense of confidence – we even start believing financial statements.

Government ownership of finance and manufacturing is even worse. Witness the late not-lamented Soviet empire, China, or India before they shook off their socialist ways. You do need some regulation – especially safety, environmental, and fraud regulation to govern the terms of competition; government should perform that function in an adversarial role to the private sector. Government is at its worst in regulating itself. Chernobyl was a government reactor.

A century ago the continued success of capitalism required harnessing the "trusts" – especially Standard Oil, businesses that got so large that they could throttle all competition and swallow adjacent parts of the value chain. Railroads had to pay Standard Oil a fee for each barrel of competitors' oil they dared to ship. Antitrust law largely accomplished what it set out to do.

Today's problem – and tomorrow's if we don't address it – is businesses that are "too big to fail." They are certainly unfair competition to their smaller competitors who can't count on bailouts. They can make up for their size-induced lethargy and opulent lifestyles (for executives) by taking risks secure in the knowledge that it's heads we win and tails you lose. When the mortgage securitization risks paid off, AIG and Citi could reap the rewards, and when they failed, we paid.

It was hard to write and establish the law, which defined dominant market position and has been used (and misused) in the last century of antitrust enforcement. It'll be hard to write the law, which defines "too big to fail," and it'll be subject to endless court interpretation. It shouldn't be a crime to create an entity that is too big; however, the government should have the power to require the dismembering of such an institution just as it can dismember a company whose market position is too strong to allow the market to function.

If no company is too big to fail, then market discipline will be a much more potent regulator than it is today.

Comments

[patio:]

A- freakin-men!

2008 Dec 04 08:30 AM

[blacksilver:]

Isn't that what they did to the phone co.Remember Ma-Bell

2008 Dec 04 08:43 AM

[captainccs:]

Anything that is too big to fail must be broken up until it is small enough that failure is no longer an issue.

Too big to fail means they have the Congress over a barrel and can extract any kind of concession they want.

Under current procedures the Fed sells failed banks only to the biggest banks making them even bigger, just the opposite of what is needed.

2008 Dec 04 09:18 AM

[Chris B:]

Here's a radical thought: Nothing is too big to fail. The Titantic was sinkable and so are the "investment" banks and the automakers, despite their size.

The difference today is that we are scared to death that we might - gasp! - have a long recession, so we are willing to take desperate measures such as socializing investment losses and taking on ruinious public debt.

We are in denial about how the debt-funded lifestyle of the past has finally ended, as it had to. A panic has erupted as backlash to the thought that a $200k home is inherently unaffordable for working class families, as is a $40k gas-guzzling car, a 50 mile commute, $100 a month for premium cable, $6 lattes every day of the year, or $150 restaurant bills.

If this is all it took to whip this generation into a destructive panic, imagine if we had a real crisis - by historical standards!

2008 Dec 04 09:37 AM

[Bhakta:]

Personally, I would be happy to see a lot of the big corporations broker apart. I do not feel they serve the society in a healthy way in the long term.

Walmart is too big now, as are many many others...

2008 Dec 04 10:05 AM

[James Wilson:]

YADA YADA YADA !!!!!!

ALL GOOD THINGS CAN BE ABUSED IF YOU GET A PRESIDENT IN OFFICE THAT WANTS TO DESTROY ALL THE GOOD LAWS THAT ACTUALLY HELP PEOPLE.

Like the community reinvestment act where banks were encrouaged to give loans in poor neighborhoods to keep the home occupied and prevent them from becoming clums with abandonded homes and drug infested.

Then along come Country Wide who uses that law to sell home in gated communities to people who can't afford them with varible interest PREDATORY loans. The interest on those loans were tied to nothing but the company's WHIM ! Some people had interest go to 14 % on thier loans. The homes were over valued to begin with.

Also Socialism has been forced on most of the countries in South America because of the U.S. Governments support of businesses who were stealing their natural resources.

Now Chanves is using their oil to benifit the people not a forgien Corporation. If Corporations had show respect for people then Socialism would not be an issue.

2008 Dec 04 10:11 AM

[Socialism c...:]

> ALL GOOD THINGS CAN BE ABUSED IF YOU GET A PRESIDENT IN OFFICE THAT
> WANTS TO DESTROY ALL THE GOOD LAWS THAT ACTUALLY HELP PEOPLE.
>
> Like the community reinvestment act where banks were encrouaged to
> give loans in poor neighborhoods to keep the home occupied and prevent
> them from becoming clums with abandonded homes and drug infested.
>

Wrong. CRA was *itself* an abuse!! An abuse of MY taxpayer money. It interfered with free-market housing and made it unaffordable to those who pay their own way. It extended the reach of the government's tax fingers into MY pockets. It took down the economy by promoting bad loans.

We don't do ANYONE a favor by giving loans to those who CAN'T AFFORD THEM. It hurts them and us in the long run!!

> Also Socialism has been forced on most of the countries in South
> America because of the U.S. Governments support of businesses who
> were stealing their natural resources.
>
> Now Chanves is using their oil to benifit the people not a forgien
> Corporation. If Corporations had show respect for people then Socialism
> would not be an issue.

BS!!! Our oil companies are there because THEY failed to allow capitalism to do the work themselves. In Latin America in particular, capitalism never got a foothold because political turmoil disallowed it, not corporations. And the dictators used socialism to keep the money in their coffers -- not to give it back to the people, but to keep themselves in power!

2008 Dec 04 11:31 AM

[baldguy:]

I agree. The large corps. bought their way into our congress years ago and got the deregulation they wanted and here we are.

2008 Dec 04 11:36 AM

[whocouldshebe:]

It is impossible to fathom the stupidity of both the government and investors today. We are NOT in a recession. It is much worse. We are in a GREAT DEPRESSION! It is sad to see investors returning to the market so early. Here’s the important reason why: right now the TRUE state of the US is similar to that of most 3rd world countries and getting much worse. The figures shy away from the truth because investors are so intent to force out a false hope with unreasonable inflation in market values while they try to quickly recover their losses within the next few years. But the figures obscure reality, one is is in unemployment. Initials claims dropping this month is HORRENDOUS NEWS. People aren’t beginning to claim unemployment this month because THEY WERE ALREADY LAID OFF and have been for over a year now. The government has already stated the recession began in 2007 but failed to label it as a depression. Instead, they should have looked at continued claims clearly up 200% and climbing, but even those figures lie since unemployment can only be claimed for up to 6 months, after that the government lies and removes you from the counts. The truth is, nearly everyone that lost there jobs last year are still without work, and those people that have kept their jobs are either working less hours or being laid off this month and won’t be included in the unemployment counts because they are ineligible to file for unemployment. Also not included in the counts are those that have lost their second job, since they too are ineligible to file as well. THE TRUTH IS AT LEAST 15% OF THE NATION IS CURRENTLY UNEMPLOYED AND RISING! I would expect it to reach some 25% by February with poverty reaching above 40% in addition to already rising energy and commodity pricing. Why am I the only one to see this?

2008 Dec 04 11:57 AM

[TimT:]

I wrote the following thoughts on Sept 18th...obviously much has changed since I wrote it as we see what the Gov't has done since then. However, the premise holds.

Too Big, Too Risky

Decentralize and Recapitalize our Financial System

The world changes when we choose to change the way we think about it.

We can see now more than ever that financial entities are interconnected to form a functioning whole much like computers form an interconnected neural network to form the internet. The IT industry knows full well the strategic advantages of distributed data processing as opposed to centralized processing. If you look at a conceptual map of the internet you’ll see tens of thousands of interconnected computers, some more powerful than others able to handle more processing and more data traffic, but all interconnected. The strategic advantage of a distributed system is that if any single node or computer goes down other pathways are found and used to process and move data, thereby enabling the whole (internet) to function with little or no friction, certainly without crisis. Even if a large node of the internet goes down, other computers take up the demand for data processing and data movement. The main point is that no single node is so large that its’ demise or malfunction brings down the whole internet. Knowing now how interconnected our financial system is, wouldn’t it be safer and work better if no single financial entity could significantly impair or bring down the entire system?

This discussion evokes the now familiar topic of the “too big to fail” doctrine. My point is: Why so big in the first place? While I haven’t researched the facts, at this point my gut tells me that gigantic corporate size in financial institutions has primarily benefited Management and not Shareholders. I’d like to see what the numbers show, especially after this 100 year financial storm we’ve now had. I think responsible investors should take a hard look at disproportionately large financial institutions and demand a premium for the systemic risk they pose. The problem is that when the investor knows the Government stands waiting to backstop a failure, then the opposite occurs—investors pay more for this implied reduction in risk—this “free lunch,” if you will. This is a huge problem. How do you or should you limit growth-in-size of a financial institution in a free market economy? I don’t claim to have answers to this complex issue but I wonder if a good start would be for regulators to impose higher capital requirements when financial institutions get beyond a certain size and even more so if they decide to get bigger and their risk to taxpayers becomes larger. Bill Gross and other respected financial professionals have said it, the system needs capital. I can’t agree more. The problem is where’s it going to come from now that the cows are already out of the gate and deleveraging is underway? I don’t know the answer to that either but capital must come into these large institutions. Having adequate capital would allow the free market economy to do its work without the need for government bailouts and taxpayer liability, clearly an embarrassment for Free Market Capitalism.

We (banks and financial institutions) are headed for sweeping regulatory changes in the next two years because of this mess. Let’s hope our politicians see the big picture of what would create real strength in our financial system, rather than continuing down the path of supporting essentially a centralized financial system consisting of just a handful of gigantic financial institutions that make an unstable whole. And let’s hope they are wise enough to see the value of equity capital in a free market economy and just let it work. Over-regulation is not the answer at this point.

2008 Dec 04 12:07 PM

[dw57:]

have we not learned that a wild west version of the a 'free' market (not that it has or will exist) is guaranteed to do what it has done before. we have doe this before, right before the great depression, and the one in 73 (as in 1873). the results have always been the same. many years (minimum was about 10 years) to recover. and that was caused by lax regulations. and not enforcing what did exist. i guess those who advocate this fake free market, must be taking it from the the illegal drug trade cause thats the best example of their free market!

2008 Dec 04 12:34 PM

[whocouldshebe:]

Exactly, the only reason the market rises is because we treat it like casino games, play until you win, or throw more money at it until you go broke, either way the casino still makes a killing, but if people could just see through the blanket of lies then we would have a free fall of true value correction where stock actually reflect what they are worth instead of what they might be worth if they succeed at winning the lottery. People have forgotten stocks are just virtual items that carry no real worth. The free market is such a farce these days it makes me sick.


On Dec 04 12:34 PM dw57 wrote:

> have we not learned that a wild west version of the a 'free' market
> (not that it has or will exist) is guaranteed to do what it has done
> before. we have doe this before, right before the great depression,
> and the one in 73 (as in 1873). the results have always been the
> same. many years (minimum was about 10 years) to recover. and that
> was caused by lax regulations. and not enforcing what did exist.
> i guess those who advocate this fake free market, must be taking
> it from the the illegal drug trade cause thats the best example
> of their free market!

2008 Dec 04 01:01 PM

[Glen!:]

Big business doesn't necessarily equal bad business... if a company does enough to become that huge there is no reason to punish it. There is also no reason to protect it or give it any extra protection than it's smaller competitors would get (and vise versa)

2008 Dec 04 01:14 PM

[carey_jim:]

Reference to the Antitrust law (Sherman I presume) makes me laugh.

The Sherman Antitrust Act (1890) was never enforced and in fact monopoly capitalism was created under it's nose.

The Supreme Court didn't uphold the SAA either except in one of it's monumentally reactionary decisions against the Hatters' Union strike (1909) when the benighted union innocently urged boycotting non-union hatters.

The Supreme Court ruled that the Hatters' Union was in violation of the Sherman Antitrust Act and levied fines to be payed for loss of income due to the boycott and presumably added, as a swipe at unions, "small is beautiful."

I think the AMA is in violation of the SAA too but the boys at the Supreme Court aren't listening, obviously.

You can take this to the bank and draw interest on it: The President, Congress and Supreme Court are never going to limit business unless they limit losses on profits.

2008 Dec 05 10:30 AM

[captainccs:]

> Now Chanves is using their oil to benifit the people not a forgien
> Corporation.

Not only is this not true, I know, Iive there, but you don't even know how to spell the name of your favorite despot. I guess spelling is not included in the socialist curricula.

2008 Dec 12 10:56 AM

[captainccs:]

You might want to read the truth about Chavez, "Why Chávez Will Ultimately Fail"

softwaretimes.com/file...

On Dec 04 10:11 AM James Wilson wrote:


>
> Also Socialism has been forced on most of the countries in South
> America because of the U.S. Governments support of businesses who
> were stealing their natural resources.
>
> Now Chanves is using their oil to benifit the people not a forgien
> Corporation. If Corporations had show respect for people then Socialism
> would not be an issue.

2008 Dec 12 11:09 AM