Tuesday, June 28, 2011

Externalities and the Dysfunction of the Money Markets

Money is invested through mechanisms that appear to be markets. One observes supply (savings), demand (from borrowers and other people offering investments), and price (interest rates, dividends, IPO pricing, etc.). These mechanisms are even called the "money markets." But they're not really markets. At best, they're dysfunctional markets. The reason is externalities.

Externalities are costs not included in the pricing process. A familiar externality is air pollution from cars. The bad consequences of car pollution fall on people who, for the most part, are not involved the purchase of a car. That is, almost all the people who breath the pollution aren't involved in the sale of the car and can't demand a portion of the sale price to cover their damages and loss from the pollution. So cars, before the days of pollution controls, were underpriced in relation to the costs they imposed. More of them were sold because of the underpricing, and the problem of pollution was exacerbated.

The solution to this particular externality was emissions controls imposed by law. First, states where pollution was acute, like California, stepped up regulation. Then, the federal government joined the act. Cars today pollute at a tiny fraction of the rate of their predecessors 50 years ago. The muscle cars of yore were true classics, but you would literally choke if you got too near the exhaust pipes.

The externalities of the money markets have become all too apparent in recent years. Overly aggressive lending, in real estate, to municipalities, and to sovereign nations, coupled with negligence in risk management by banks, created enormous amounts of financial risk. Opaque derivatives markets multiplied these risks, and intertwined them in ways that regulators cannot comprehend. The effect of such interconnectedness is that any debt crisis must be ameliorated through government intervention, often at substantial cost to taxpayers. There no longer are market solutions to financial crises.

The potential for socialism in medicine pales by comparison to the socialism that has crept into the financial system. Prices for money are no longer set by market forces. Central banks dictate the price of money. These dictated prices do not incorporate the costs of government bailouts and other interventions. Thus, enormous externalities have emerged in the financial system. Banks, hedge funds and other financial firms lack the incentive to constrain their wilder and crazier sides, because they don't pay the price of catastrophe. How would people drive if they didn't have to pay the premiums for auto insurance?

We saw this in the financial crisis of 2007-08, when real estate lending reached maniacal levels because the rewards for mania, but not the risks and costs, were placed on the people (bankers and others) who behaved like maniacs. We see this today in the sovereign debt crisis in Europe, where the costs of high risk sovereign lending by Europe's major banks are being allocated in a mad scramble between creditors, taxpayers, government employees, retirees and other EU member nations, similar to a game of musical chairs. Except that there are almost no chairs, and the music is death metal.

Bank regulators are trying to boost capital requirements, in an effort to reduce the need for bailouts and other government aid. The FDIC has been trying to nudge up the premiumss paid by banks for federal deposit insurance. Banks, needless to say, are pulling every political string they can reach to avoid bearing the true costs of their business. After all, why be responsible if you can hire lobbyists and buy politicians to get rid of the large expense of true responsibility?

With central bankers keeping interest rates low and with bank regulation comparatively light, lenders have the incentive to be reckless, and borrowers have the incentive to be profligate. Externalities proliferate as a result. The straightforward way to internalize much of the externalized costs would be to raise capital requirements and interest rates. Fat chance that's going to happen, at least in a way that's meaningful. For the foreseeable future, we will have government administered price controls in the money "markets," with prices too low, and burgeoning externalized costs.

Externalities cannot be imposed indefinitely in ever increasing amounts. The innocent bystanders eventually get so mad about taking collateral damage that they fight back. In the case of air pollution, it was through substantial (but effective) government regulation. In the case of taxpayers and citizens looking at the high price of bailouts and austerity, political rebellion ensues. Today, demonstrators in Athens became rioters. Conservatives in Germany protest further bailouts for Greece. In America, Tea Partiers harp about federal deficits while liberals (and some conservatives) decry the government's failure to rein in too large to fail banks. The spirit of NIMBYism runs strong in these declamations. The essential point just about everyone makes is that "I" don't want to bear the costs.

Central bankers have been kicking the can down the road, hoping that their easy money policies delay the pain of the externalities long enough for the economy to revive and wash the pain away with brisk growth. But their very policies of artificially lowering the price of money makes things worse. Borrowers will borrow more to buy time, and bankers, relieved by the central banks' intervention of the need to manage risk, are glad to lend more, record more apparent "earnings" and pay themselves larger bonuses. The amount of externalized costs rises. Yet the economy responds only haltingly to these massive money prints.

It's clear there isn't going to be a singular event involving fishes and loaves. We'd probably be better off to take the pain of the losses embedded in the financial system, and get them behind us. Countries that took this approach (the "adult choice"), like Sweden in the early 1990s, have done well thereafter. Countries that externalized losses and tried to pretend they didn't exist (the "adolescent sulk") have bogged down (for further reading, see Japan). Anyone familiar with current events in Europe and America knows which way these nations are going, and it ain't toward a character building experience in the wood shed.

Central banks could start easing our way out of this mess by sharply increasing bank capital requirements and moving interest rates up. In so doing, they would begin to internalized today's virulent externalities. But experience teaches that they'll have no more than moderate success at elevating capital requirements. And by all indications, Ben Bernanke and his colleagues won't ever raise interest rates. The only central banker to bring true integrity to monetary policy, Paul Volcker, remains an outcast among his peers. The only bank regulator to emulate Volcker, Sheila Bair, is likely to share his fate. It's hard to predict how things will end. But if we keep increasing the amounts of externalized costs, the ending won't be fun.

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