You may have noticed my “I Support The Occupation” banner in the upper right corner of my site. This, of course, refers to the Occupy Wall Street (“OWS”) protests that have now spread around the world. I realize that this banner entered in the dark of night (I write from Hong Kong, when most of my readers are fast asleep) with nary an explanation. After a few emails, I now feel compelled to explain myself.
First, as regular readers of this site will note, I am the furthest thing from being anti-corporate. I spend my time analyzing companies purely from the perspective of potential investment returns, and I pay little (or often no) attention to environmental or other social concerns. I will merrily invest in cigarette companies or businesses in the gambling industry but, like all of my investments, only if they are cheap enough. I am an ardent supporter of free trade and deregulation, and I believe wholeheartedly in free market capitalism. It is from this perspective that I find many reasons to support the OWS protesters.
“How’s that?” you may be wondering. In this post, I hope to clarify my position, and as always, I appreciate your comments.
While much of the media attention has been focused on this concept of the 1% versus the 99%, and bandying about terms such as "class warfare," I find this disingenuous and argue that beyond the fringes these protests have little to do with this. Americans (really, everyone) love the wealthy. We find them fascinating and we hang on their every word. Admit it or not, we all aspire, even if in just a small way, to achieve that level of success. Whether it be movie stars or celebrity athletes, internet entrepreneurs or media tycoons, there is an endless supply of examples of 1%ers (really 0.001%ers) who have captured our imaginations, and no one is picketing their homes or places of business. This is true in Zucotti Park and across the United States, and is no less true in Toronto or Tel Aviv, Sydney or Singapore, and it is equally as true twenty, fifty or 100 years ago. We all love winners, and we always have.
This isn’t class warfare, and no one really cares about the false 1% versus 99% debate. This is a red herring meant to distract from the real underlying problems. For this reason, increasing taxes on the wealthy will achieve nothing to solve the real issues at the heart of OWS.
So why are they protesting, and why in particular are they protesting Wall Street and what it represents? They are protesting because there is a general feeling that something has gone wrong with the financial system. Though I suspect that, for many of the protesters, this feeling is as deep as they’ve cared to dig, I believe it is correct.
Back to Basics
In assessing the problem, I think it is essential to start with the basics and build from there. I will start with what works about capitalism. Capitalism’s self-organizing nature creates incentives for entrepreneurs to satisfy the needs and wants of the people, effectively coordinating interests and leading to the most efficient solutions to excessively complex problems. The reason free market capitalist economies are able to do this is that firms that produce too much or too little, or do so with too much waste are driven out of the market by more efficient competitors. Profits provide an incentive for some to take risk, and it is in this pursuit that some businesses fail while the best survive. Schumpeter called this creative destruction, and pointed out that it drives progress and innovation.
A key element to the efficient functioning of this system is that some businesses fail in the face of more efficient competitors. I believe the fact that this largely did not take place in the financial crisis is the primary issue underpinning the OWS protests.
Banks exist for the sole purpose of earning returns on investor capital. In generating these returns, they put investor capital to work by lending it out, or otherwise investing it. The bank’s core concern is (supposed to be) the riskiness of the bets that it is making in earning its returns. Since banks employ leverage to enhance their returns, the riskiness of their investments is of paramount importance, as relatively small losses have disproportionately large negative effects on equity and returns.
It stands to reason that banks that make bets that prove to be too risky should fail, while banks that properly manage their risk should succeed. This did not happen. Instead, when the banks’ bets proved to be far riskier than initially expected, they were bailed out.
Nouriel Roubini, in Crisis Economics: A Crash Course in the Future of Finance (highly recommended), does an excellent job of detailing the full extent of the bailouts which far exceeded previous monetary efforts with some interesting and innovative strategies that likely avoided another depression. However, as Roubini points out, we have known since Walter Bagehot in the mid 1800s that the key to avoiding financial crisis like the current is for the government to step in to assure the market that counterparties (to trades) will be made whole. This type of action allows for trade to continue without fear, and prevents a far deeper crisis from occurring.
To go beyond this and implicitly (or explicitly, as the case may be) indemnify creditors in addition to trade counterparties needlessly introduces moral hazard. While counterparty indemnification also introduces moral hazard, it is necessary given the negative repercussions that would occur should banks no longer trade with each other. Creditor indemnification, on the other hand, makes whole creditors who were “asleep at the switch” and making due bets that shouldn’t have been made in the first place.
As a free market capitalist, I subscribe to the notion that gains and losses equally should go to the ones making the bets, and the only way to reduce moral hazard is to ensure those creditors who made bad bets feel the consequences. In this regard, I agree with OWS. Those who made bad bets should live with the ramifications of their actions.
Too Big To Fail
So why did the government indemnify creditors? The answer lies in another issue at the core of the OWS protests: Too Big To Fail. When you have a highly interconnected system of parties that are also highly (40x – 60x) leveraged, the failure of a single participant can send shockwaves through the rest of the system as the bonds of the failed institutions plummet in value, leading to falling asset values in other institutions which are then forced to sell other assets to reduce leverage. This can create a downward spiral as parties’ efforts to delever necessitates further delevering. Thus, large institutions become too systemically important to be allowed to fail, and so (as we’ve seen all too clearly in the recent crisis) the government is forced to step in to help out. If the government will step in when your bets go bad, then what incentive exists to make good bets? It is obvious to anyone that too big to fail leads to moral hazard.
Given what we’ve been through, one would expect that serious action would have been taken to ensure that no institution could never again be too big to fail. This is the only way to reduce the associated moral hazard. Unfortunately, this has not happened. Not even a little bit. As some have chanted, too big to fail is too big to exist, and I cannot help but agree that action must be taken to reduce the systemic importance of any institution currently considered too big to fail, until no institution is too big to fail. Again, I find myself in the OWS camp and I have not come across a compelling reason why this should not happen.
It is important to recognize that these indemnifications come at a real cost. This leads us to the next issue for OWS protesters: profits are privatized, whereas losses are socialized. This is not a new phenomenon, and as far back as 1834 drew the ire of President Andrew Jackson:
I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the Bank. … You are a den of vipers and thieves.
While in some cases (predominantly with counterparties to trades), it is better to socialize the losses than to allow a crises to spiral, the issue is the fact that profits and losses are generally not treated in the same fashion. Take for example, the fact that in 2009, when many firms were living thanks solely to government largess, Wall Street bonuses rose 28%.
Yes, firms were by and large more profitable in 2009 than in 2008, and so bonuses should logically have risen. Or should they? It is worth noting that a good portion of the banks’ improved profits was the direct result of government intervention. As an example, let’s consider interest on excess reserves. Banks are forced to deposit with the Fed their required reserves. This acts as an implicit tax on the industry, and so the Fed pays interest on these required reserves. Then, on October 3, 2008 (and coming into effect three days later), the Fed decided to start paying interest on any amount that banks deposits over and above the required minimum – so called Excess Reserves. Let’s take a look at a neat chart showing excess reserves over time.
Excess Reserves of Depository Institutions
From the 1950s through to October 6th, 2008, excess reserves were essentially zero. Then the Fed decided to start paying interest on these reserves, and the amount of excess reserves skyrocketed to north of $1.6 trillion. Yes, the amount paid is a paltry 25 basis points, but this still works out to $4 billion. To be clear, this level of excess reserves only occurs where there exists a source of funding that exists that is cheaper than 25bp. That source is the Fed itself, which dropped its short-term borrowing rate to zero, ostensibly to encourage lending.
Unfortunately this did not occur, as bank balance sheets expanded by far less than excess reserves (suggesting the asset base shifted from stimulative loans to business to fallow deposits with the Fed). Allowing banks to borrow at zero and invest at 25bp is essentially saying “I’ll let you take money out of my right pocket and put it in my left pocket, and I’ll pay you for the privilege of doing so.”
So while the banks were more profitable in 2009 and 2010 than in 2008, perhaps the source of these profits does not warrant such a quick rebound in bonuses. Again, I can see why the OWS protesters would be angry about this. To be clear, I have no problem with massive bonuses being paid for good work, but it certainly seems like the profit of these banks was at least in part thanks to the government.
I support the OWS protesters because the system appears to be broken. I see only a faint impression of the free market ideals that I believe the financial system is built upon, and instead it appears the government has gone out of its way to circumvent the natural course of creative destruction, ensuring that the losses fall disproportionately on the public while every effort is made to improve the financial position of the banks and their creditors. What’s worse is the fact that no effort has been made to ensure that this won’t repeat itself, so moral hazard and Too Big To Fail are as (or more) prevalent today than prior to the crisis. We need change, and this is why I support the Occupation and you should too.
What do you think of the OWS protests?