Disequilibrium Economics: Algorithmic Trading Department
Ian Morris on "Social Development"

Too Big to Fail?: Yves Smith Asks a Question

Yves Smith:

A funny thing happened at the INET conference: I got to ask Larry Summers a question because Martin Wolf, who was moderating the session, is a good sport.... [M]y recollection of his long answer (which ducked my question, as various people remarked to me that evening and the next day) seems to not all be on the tape, which led me to think I was losing my mind.... I recall him citing someone (I didn't recognize the name, but I may also not have heard it clearly since I was at a table in the back) and then mentioning "socialist" and "communist."... But when I went to look at the tape, lo and behold, no mention of either dirty word that I thought I heard...

Yves is, I think, confusing Larry Summers's answer to an earlier question from Martin Wolf with his answer to her (and Louis Koch's_ question.

Here's the first exchange:

Martin Wolf: Wouldn't a reasonable non-economist conclude... [that] we have this fantastically dangerous [financial] engine... you just cannot risk deregulating it. It has to be under government control, very tightly, all the time. How would you tell a layperson that tha's not a reasonable response?

Larry Summers: Well, in some ways it probably is a reasonable response. The last time--this is an overstatement, but this was why Harry Dexter White was a communist--there were a very large number of thoughtful people who were communists in the 1930s... [because] they saw that just letting the market rip had ended in disaster... [and that] the Soviet Union that had not suffered a similar unemployment problem.... [But the Soviet model] did not prove to be conspicuously successful [in the very long run]. The question one has to ask is: There are going to be decisions that are going to be made by people... [who are] going to follow their incentives, and you want to get an outcome that is stable. You have to ask: What is meant by saying that you are going to have the financial system completely regulated and controlled by government? In some sense we had that system in the Soviet Union and it collapsed. We had that system with respect to exchange rates in the 1950s and 1960s.... We shifted from the Bretton Woods system because the Bretton Woods system collapsed, because of the internal contradictions within it, even as people tried to paper it over, did not work.

The question is: what exactly is the dirigiste approach and how will it work? Now if you ask in general has the world had too much leverage or too little leverage, I think the case is overwhelming that it has had too much leverage. The externality associated with taking on increased leverage has been under-internalized. Capital requirements should be systematically increased. There are a lot of ways to lend money in a modern economy with integrated production, and so controlling leverage is a complicated thing, and it takes a lot of thought as to how best to do it. But it is absolutely right to do so. Every time I have spoken to a financial audience for the last two years, I jave gone through some version of saying: We had the 1987 stock market crash, the S&L crisis, the commercial real estate crisis, Mexico, Asia, Russia/LTCM, the Internet bubble, Enron, and now this—one crisis every three years from a system that is supposed to minimize, diversify, and spread risk, but that has in fact been a source of risk that has led hundreds of thousands of people each time to lose jobs through no fault of their own.

So I think it is absolutely right to be worried about the outcomes that are produced. I think it is less right to assume that anger and dissatisfaction with the financial system constitutes a policy, or provides a very clear blueprint as to the directions and the ways in which it is best reformed. For my money, the best judgments that we have right now—and obviously there are ways it could be improved—are those embodied in Dodd-Frank. If you are big enough and systemic enough that your failure is a major event, you are big enough and systemic enough that it should be one institution that is competent with technical things whose job is to regulate you.

There needs to be procedures for resolving and managing the failure of eery kind of financial institution, not simply banks. There needs to be a systematic and across the board effort to make levels of leverage lower and levels of capital higher so as to make the system safe for the greed and cupidity that will eventually happen. These principles we know. But the financial institutions with which the U.S. government was most heavily involved were Fannie Mae and Freddie Mac, which arguably were the site of the greatest degree of irresponsibility.

It was commonly argued in the 1960s and 1970s that a great thing about socialism and communism was that if the government ran the factories, then the externality about pollution would be completely internalized... well managed and you’d avoid having the kind of degradation that you had when people ran them purely for profit. That didn't prove to be a good theory of public ownership. So I think one has to think very hard about alternatives. I think the type of approaches that the world’s groping towards, while very imperfect, are in the right direction.

Here is Summers's answer to Yves's question (and to Louis Koch's):

Larry Summers: Let me take both questions.... in the opposite order. Look, this is a question that I’ve been asked a lot. I don’t think it’s fair, but I’m not objective. The question is frequently put: There it was, the United States and the IMF urged austerity on Thailand, Korea and Indonesia. Then when the United States had a financial crisis, it urged the opposite of austerity &#8211. Isn’t that hypocritical and doesn’t that prove that you were wrong?

My reaction is that the medicine depends on the disease. It is very different to have the disease that no one from the rest of the world wants to lend you any money any more, and therefore your currency is collapsing than to have the disease that [risky] asset prices in your country are collapsing but that people are bringing money back to your country because they think their money is safer there. The crisis analogous to the U.S. crisis than the crisis in Thailand, Korea or Indonesia was the crisis that Japan had in the early 1990s, and for better or for worse the American advice with respect to that crisis was [for] strongly expansionary fiscal policy, and was [for] strongly expansionary monetary policy. So I think that [my] approach is consistent.

I think the idea that when your currency is... collapsing, that... printing more of it... is somehow going to be availing... I thought at the time was somewhat implausible, and I think right now is somewhat implausible. Now that’s not to defend every action the IMF took with respect to fiscal policy [during the East Asian financial crisis of 1997-1998].... I think there were some very important excesses in the beginning of some of the programs. But I think that... the United States is more like Japan and that the recommendation is Keynesian expansion in both cases.

Should finance be a public utility? One could certainly see the argument.... Notice that if you make it a public utility, it surely is going to be too big to fail. And you can’t say you want to make it a public utility because you hate “too big to fail.”... The world has seen that experiment. That’s probably a very good way to think about the Indian financial system prior to 1990.... The government tends to feel that if it controls the financial system, it should encourage it to buy the debt of the government to keep interest rates low towards that objective. That then has a set of implications for deposit rates. That then has a set of implications for the availability of credit to business.... [T]he track record of public utility operated financial systems in terms of allocating capital to entrepreneurs who are going to succeed with it rather than to incumbents who are failing with it, has to my knowledge been very, very poor around the world. So I don’t discern that there’s a lot of evidence for that kind of idea in the international experience.

Now, having said that, has the World Bank performed an enormously constructive function over time? Yes. Does the European Investment Bank perform a set of useful functions? Probably.... Are there arguments that there should be more public financial intermediation in some cases through a national infrastructure bank or some such in the United States? I think that’s a reasonable, perhaps even a persuasive argument. But to take over all the process of financial intermediation through the public sector—I think if we went down that road we would still have, U.S. Steel is one of our flagship companies, and I don’t think you would likely have seen the kind of dynamism that we’ve seen in this country.