Tag Archives: regulation

Some Wisdom from Henry Kaufman

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Sometimes, when you write history, you can end up feeling old. I had that feeling a couple of weekends ago, when Henry Kaufman ventured to Baltimore to talk to the Business History Conference, an organization of historians.

I’ve known Kaufman for many years, and when my neighbor in the audience said, “I don’t know who this person is,” it was hard to explain how important he was on Wall Street in the second half of the twentieth century — how he, then head of research at Salomon Brothers, and Albert Wojnilower, the chief economist at First Boston, presciently warned in 1981 that Ronald Reagan’s economic policies would drive interest rates and the dollar sky-high, or how Kaufman’s pronouncement in August 1982 that interest rates had entered a long-term downward trend awoke the stock market from years of slumber. Since then, Kaufman has come in for a good bit of criticism: he was insufficiently bullish on the stock market in the 1990s, it is said, and as a board member bears responsibility for the collapse of Lehman Brothers, a venerable investment bank, in September 2008. He remains bitter about his experience with Lehman, and he blames the Treasury and the Securities and Exchange Commission for telling the directors Lehman should declare bankruptcy. “I think it was partly a political decision to allow Lehman to fail,” he says, recalling the pressure on the Fed and the Bush Administration to force someone on Wall Street to lose big.

Kaufman is 90 now, and he continues to cast a skeptical eye on the markets. He has always been a bond guy, and bond guys, by nature, worry about risks more than opportunities. His greatest worry is the financial system itself. He thinks that regulators missed the boat in the 1990s when they phased out the rules that separated commercial banking from investment banking; they expected deregulation would lead to greater competition among banks, he recalls, but instead it brought large-scale consolidation. The Dodd-Frank law and the other reforms that followed the 2008-2009 crisis, he thinks, have reinforced that trend. “It preserved the enormous financial concentration that had taken place and even accelerated concentration. That was a mistake,” Kaufman says. The result, in his view, is a system that is even riskier, with rules that are too complicated for bank supervisors to enforce.

His recommendation is to force financial institutions to specialize. The advantage in having companies that deal only in insurance, or consumer banking, or money management, he says, is that managers and regulators could better understand their finances. “I dare anyone to tell me they can go into a large financial institution [today] and tell me the details,” Kaufman insists. “You can’t,” he says, because the companies are too complicated to comprehend. The idea that “living wills” will enable them to disentangle their affairs in the event of crisis, as Dodd-Frank commands, is fatuous, Kaufman adds. Even with a living will, the markets will devalue a troubled institution’s assets, spreading pain widely.

Kaufman knows the world has moved on, and he is not optimistic about bringing the old times back. But he distinctly remembers how, back when Wall Street firms were partnerships for which partners bore personal responsibility, they behaved differently than they do today. When he was hired at Salomon in 1962, he recalls, he was told, “Go home and tell your wife you’re going to be liable for $2 billion.” Answering to shareholders isn’t the same thing at all.

Who Owns the Curb?

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How we define a problem often affects how we think about it. Consider the question of how we deal with the demand for curb space in our urban areas. If one were to approach this question as an engineer, one might look for ways to redesign our streetscape and reallocate the curb to certain users. If one were to approach this question as an economist, however, one might ask whether there’s a pricing problem.

As discussed earlier this month at the annual meeting of the Transportation Research Board (TRB), a government-sponsored research organization, this is an engineering problem. The assertion is that new ways of doing business have left us with too many vehicles at the curb. The growth of online shopping means more trucks making deliveries, and the growth of ride-sharing services has brought Uber and Lyft drivers waiting to pick up customers. Therefore, the logic goes, we need to provide more unloading zones for trucks and more pick-up locations for ridesharing vehicles. The presentations at TRB suggested that other uses, such as bus lanes, bike lanes, and parking of passenger vehicles, may have to give way.

The underlying assumption, you may have noticed, is that because consumers want online shopping and ridesharing, our streets should accommodate these uses. But there’s another way to look at the problem. Curb space is obviously of great value in some urban areas. That value belongs to local taxpayers. Every time a UPS truck parks at the curb to provide “free delivery” from Amazon, those local taxpayers are subsidizing Amazon customers unless UPS is paying the full market value of that parking space. Every time an Uber driver idles at the curb in Midtown Manhattan, she is occupying valuable real estate without paying for the privilege, and that subsidy is reflected in the artificially low cost of the ride.

Can the demand for curb space be met with economic measures rather than engineering? There is enormous pressure not to find out; in 2014, when Washington, DC, imposed a $323 annual fee for a decal that permits a truck to park in a loading zone, the trucking industry howled–even though that fee, about 88 cents per day, is far less than automobile drivers would gladly pay for a space one-third that size in many parts of the city. But perhaps if trucks and ridesharing vehicles paid the full value of the public assets they use, consumers would make less use of their services and businesses would save money by accepting deliveries at times when the value of curb space is low. Such changes could help relieve traffic congestion without remaking urban streets. There’s something to be said for paying full freight.

Waiting for the Tooth Fairy

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Four prominent economists at the Hoover Institution have published a new paper claiming that President Trump’s policies could make the U.S. economy grow 3 percent a year. Perhaps it’s just a coincidence, but three of the four authors have been mentioned as people Trump might nominate to head the Federal Reserve Board after Janet Yellen’s term expires next February.

Let’s be clear: 3 percent annual economic growth would be quite an accomplishment. The U.S. economy hasn’t grown that quickly over a full year since 2005. There’s no doubt that Americans would feel much better off if the economy were to soar as the Hoover Institution economists suggest. Personally, though, I think we’re about as likely to get a visit from the tooth fairy.

The authors attribute slow U.S. economic growth to slow productivity growth and a drop in the percentage of adults who are in the workforce. I agree entirely. But they then go on to lay the blame on President Obama, without mentioning him. “Focused primarily on ‘stimulus’ in the short-term, the conduct of economic policy in the post-crisis years did little to reset expectations higher for long-term growth. That policy failure restrained those expectations, adversely affecting consumption and, especially, investment spending,” they say. The authors assert that lower taxes on businesses and on capital investment, less regulation, and slower growth of federal spending “would help turn the recent upswing in animal spirits into a significant improvement in economic activity.”

You may have caught this movie before. Back in the 1980s, President Reagan’s economic experts promised much the same. Tax rates were lowered, regulations scaled back, federal spending curtailed. Yet on average, output per hour worked in non-farm businesses — the most basic measure of productivity — grew more slowly during the Reagan years than it had during the miserable 1970s, when tax rates had been far higher. These policies were supposed to bring miraculous productivity growth, but as Reagan’s former budget director, David Stockman, said in 1986 “The fundamentals that I look at are not a miracle.” 

What’s the issue here? Our four authors claim that “economic policies are the primary cause of both the productivity slowdown and the poorly performing labor market.” But as I show in An Extraordinary Time, the connection between government policy and productivity growth is tenuous. Productivity gains stem mainly from innovations in the private sector, which work their way into the economy in unforeseen ways. Government can help by supporting education, scientific research, and infrastructure, but the productivity payoff from such investments is unpredictable. The evidence that tax rates or government deficits affect productivity growth is quite weak. This is true not only in the United States, but in other advanced economies as well. 

Some productivity experts, notably Robert Gordon, think slow productivity growth is with us permanently, which would mean Americans’ incomes will grow only modestly in the coming years. I’m not so pessimistic. Historically, we’ve seen unanticipated spurts of productivity growth as firms suddenly figure out how to take advantage of new technologies and new ways of doing business. That has happened before, as with the Internet boomlet of the late 1990s, and I think it’s entirely possible that it could occur again. But I’m afraid the claim that the government can give us faster productivity growth just by passing a couple of laws falls into the realm of wishful thinking.

A Reminder of the Joys of Regulation

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Not too long ago, I had occasion to take a trip on Metro, Washington’s subway system. My trip required a change of trains at Metro Center station, from the Red Line  on the upper level to the Orange Line on the lower. Three escalators connect the platforms. One was stopped. The other two were going up. So of course I complained to Metro, asking why, if one escalator was out of service, the station manager did not reverse one of the other two, so that one went up and one down.

The answer I received surprised me. Here’s what it said: “Metro’s policy states that the majority of our escalators are set so that in the event of an emergency we can get as many customers out of the system as quickly as possible. In addition, all station escalator configurations were evaluated and modified to reflect the most efficient usage of these assets. Metro Center station was included in this analysis. We now have a set direction for each escalator and the set configuration cannot be changed by the station manager.”

As I read and reread this response, it made me think of nothing so much as the days of rail regulation. Back then, before railroads were deregulated in 1980, they didn’t much care what their customers thought. They offered what they offered,  and customers could pretty much take it or leave it. Rigidity was the norm. The concept that some flexibility and customer sensitivity could build business was foreign.

That’s the type of attitude Metro seems to have. Its experts have determined the most efficient way to do business–which means, at Metro Center, two escalators going up and one going down. That’s how Metro will operate, and it’s not going to change just because circumstances have changed and the down escalator isn’t working. And Metro is not going to give its employees the flexibility to make changes as conditions change. The rules are king, not the customers.

Once deregulation came, the railroads figured out that they needed to take a different attitude toward freight shippers. By doing so they turned their very stodgy industry into a growth industry. Regrettably, there’s no such competitive pressure on Metro. I don’t expect either its attitude or its escalator service to improve soon.

Keep It Simple(r)

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In the last couple of weeks, banking regulators in the U.S. and Europe have tightened rules concerning a financial measure known as a leverage ratio. The rules should make the banking system stronger, but that is only part of their appeal. One of their virtues is that they reverse half a century of increasingly complicated regulation by asserting a new idea: keep it simple.

A bit of background. Starting in 1974, regulators from a dozen countries came together in Basel, Switzerland, to find ways to make the world financial system safer. One of the subjects they discussed was capital, which is shareholders’ funds that are available to repay depositors and trading partners if the bank goes bust. Capital doesn’t produce a return for shareholders, so banks have an incentive not to hold a lot of it. By the 1970s, many banks, especially in Japan, had very little, and regulators responded by requiring banks to hold more, measured as a percentage of their assets.

Predictably, banks objected to this idea. One objection was that setting a higher capital-to-asset ratio would create a perverse incentive for banks to own riskier assets, such as loans to dodgy borrowers, which yield much higher interest rates than government bonds. If regulators were going to treat all types of assets the same way, the banks argued, banks would inevitably favor junkier borrowers to earn more money with a given amount of capital, and this would make the financial system less stable, not more.

The regulators came up with a compromise: the amount of capital required would depend on the types of assets a bank owned. At one end of the spectrum, loans to most businesses were deemed to be high-risk and had to be backed by a lot of capital. At the other extreme, loans to rich-country governments were deemed low-risk and required no capital at all. Over time, this seemingly sensible idea was taken to remarkable extremes. “Risk-based” standards were put in place, and were applied to banks’ trading businesses as well as their lending. This got so complicated that banks were allowed to figure out for themselves how much capital they should have, and clueless regulators couldn’t do much more than say “amen.” For more about this unfortunate development, you can see an article I wrote a couple of years ago.

Then, when the crisis came in 2008, regulators and bank investors discovered that banks had much less capital on hand than they were thought to have. The problem became acute in 2010, when Greece was unable to service its bonds. French and German banks had gorged themselves on Greek bonds precisely because they did not need to hold capital against which had been deemed “low risk” government debt. Had Greece not received an international bailout in May 2010, several big European banks could have gone bust.

The new rules on leverage ratios are meant to stop banks from gaming the system. They require most banks to add up their loans, their exposures to credit derivatives, and certain other commitments, and then to hold a certain percentage of that amount in capital, without adjusting for risk. The biggest banks will have to hold even more. This means that banks can’t get away with minimal capital by claiming they have low-risk businesses. Owning dubious Greek debt in order to avoid capital requirements will no longer make sense.

You’ll hear words like “crude” and “imprecise” thrown around by critics of the new leverage ratios. And there’s no question: they are crude. But what matters more is that they are relatively simple to enforce and harder for banks to manipulate. Banks businesses will continue to be very complex, but having some simple regulatory limits is worth a lot.