The way to solve the financial crisis seems so obvious now, after reading this brilliant piece of insight from Chris Dillow, posted as “Ownership vs. Markets” (via Mark Thoma).
The main intention of Dillow’s post is to respond to concerns that “the credit crunch is undermining the case for free market capitalism.” He argues that those concerns “are eliding a crucial distinction – that between free markets and traditional capitalist ownership structures.”
The real failure came from the “traditional capitalist ownership structures” within the free market system, not the free market system itself:
“1. Banks lost money on mortgage derivatives because of principal-agent failings. Principals – banks’ bosses – didn’t understand what agents (traders) were doing, and traders had incentives to take on excessive risk, because the gains from doing so – a life-changing bonus – exceeded the benefits of prudence.
“2. Banks have been reluctant to lend to each other not so much because each bank fears its counterparty will not repay the money, but because they fear they’ll need the money themselves. This is because banks just don’t know what sort of losses they are sitting on. It’s impossible for managers of such complex organizations to know everything.
“3. Banks are under-capitalized because chief executives have traditionally had incentives to maximize earnings by using leverage. Pressure upon them to be more prudent has been absent partly because when shareholding is dispersed, no individual shareholder has much incentive to rein in management.
“4. Good financial innovation – of the sort advocated by Robert Shiller – has been lacking because it’s very difficult for anyone to own its beneficial effects; it’s a public good. By contrast, the gains from “bad” financial innovation – overly complex mortgage derivatives – are more appropriable. So we get more of it.”
The gist is that financial institutions messed up because they grew too complex for anyone to understand and manage them effectively.
The issue is not just that chief executives were (are) poorly informed about the risks their organizations were (are) exposed to; just as important is the fact that any information about possible long-term, company-wide, or industry-wide risks doesn’t get fed back to managers, traders, and agents making decisions and doing deals.
Lacking any clear and immediate sense of the risks involved — even when they might have felt “this can’t be right, this is too good to be true” — managers and traders had to act on the only clear information available, all of which would indicate the benefits of squeezing even more leverage out of even more deals using even more sophisticated instruments.
Dillow made a “deliberately vague” suggestion that “maybe banks should make more use of internal markets”…
“They should become more like venture capitalists, allocating capital to semi-independent divisions, which put in their own capital. This would restrain traders’ risk-taking, as they can not so easily hide behind the fact that losses are spread over the whole firm. And it would reduce the problem of asymmetric information between banks’ senior managers and trading desks, as there’s a simpler test of how well the latter do – whether they can hand over enough hard cash to cover their required returns.”
That’s when I realized that the big financial institutions were trying to operate like communist regimes. (And when you think about it, what’s more “proletarian” than working at the bottom of the pyramid at a massive bank?)
Capitalism doesn’t beat communism because “greed is good,” capitalism beats communism because companies and ideas often fail, leaving those that are most suited to their situation. Capitalism beats communism because the market is better than any planner or manager could be at allocating wealth, attention, knowledge, and other resources.
Communism doesn’t fail because capitalists are morally superior, communism fails because managers are unable or afraid to tell the chairmen about potential problems. Communism fails because it’s in the managers’ and workers’ best interest to maintain the appearance of strength and stability, even at the expense of truly generative and sustainable growth.
I thought I had more to say but I’ll need to sleep on it… but I’m almost certain that Dillow is on the right track here.
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