Stephen Gandel Rana Foroohar and Felix Salmon Read Larry Summers's Endorsement of Dodd-Frank as a Call for Deregulation?
Damned if I know. Felix Salmon and
Stephen Gandel Rana Foroohar, I think, gets it wrong. Felix writes:
Larry Summers has had enough financial regulation: The financial crisis? Regrettable, obviously. But let’s not rush to judgment here. Our financial system, pre-crisis, worked pretty well. Let’s not break it just because there was a crisis. That’s the message being peddled by Alan Greenspan, predictably, sadly, and hilariously. And now he has a high-profile bedfellow from the other side of the aisle: Larry Summers....
Stephen GandelRana Foroohar summarizes:
One of the other big questions was what, if anything, Summers would have done differently in terms of regulating the banking system. The answer – not much. “I’ve been more cautious than many about constraining financial innovation,” he said, adding that he didn’t believe the financial crisis had its roots in “new-fangled financial instruments” but rather in a simple real estate bubble. Hmmm—tell that to Iceland. One thing Summers said that most of the crowd could agree with is that “anger and dissatisfaction with the financial system doesn’t constitute a [coherent regulatory] policy.”
There’s much more where that came from. This, for instance, is classic Larry:
It’s common in a moment like this to go into a general bash on economics. And everyone who hates economics because they don’t like markets in any context, or because they don’t do math, and so if you do a subject with math you have a bias towards believing that math is useless — everyone who doesn’t like economics has piled on at this moment to regard this crisis as a repudiation of economics. And I don’t think that’s right...
How we think about the design of regulatory institutions... the public choice school has taken that very seriously, but they have driven it relentlessly towards nihilism.
Larry’s keen on saying that “we’d make a serious mistake if we threw the baby out with the bathwater here.” But it seems to me that most people talking about babies and bathwater — and Summers is a prime example here — tend to be much more keen to protect their precious babies than they are constructive when it comes to the big questions of how to drain away the poisonous bathwater. In this case, Summers has gone so far as to launch ad hominem attacks on reformers, calling them angry people who hate economics and don’t do math. At one point in his talk, Summers explains that people who want to regulate the financial system are very much like the smart people who became communists and who went on to create the Soviet Union.
Gandel's Foroohar's glosses on what Summers said seems to me to be largely wrong--not that I was there (I was stuck at the Philadelphia airport on a USAir jet whose engine would not start), but I watched the video.
First, the passage that Salmon calls "classic Larry" is the second half of a single answer to a question from Martin Wolf about whether economists simply do not understand what is going on. In fuller context, Summers says:
There is an enormous amount that is essentially distracting, confusing, and problem-denying in the stuff that is the substance of the first year course in most [economics] Ph.D. programs. I think economics knows a fair amount [about financial crises]. I think economics has forgotten a fair amount that is relevant. And it has been distracted by an enormous amount. I don’t think in general macroeconomics kept up with the [behavioral-noise] revolution in finance, as it was realized that asset prices show large volatility that does not reflect anything about fundamentals. I do not think contemporary macroeconomics adjusted or adapted to [model and understand] changes in the patterns of financial intermediation and the ways in which that took place.
I think people who were practical understood [the] concepts of liquidity finding its way into price inflation or into asset price inflation and being problematic either way. But I think those concepts of [how] liquidity [generated] into asset price inflation were at the very edge of, and in many cases not even at the edge of, contemporary macroeconomics, to the great detriment of contemporary macroeconomics.
On the other hand, it is common in a moment like this to go into a general bash on economics, and everyone who hates economics because they don’t like markets in any context, or because they don’t do math--and if you don't a subject with math you just have a bias towards believing that math is useless. Everyone who doesn’t like economics has piled on at this moment to regard this crisis as a repudiation of economics. And I don’t think that’s right. I think the wisdom that is in Bagehot, Minsky, Kindleberger, Eichengreen, Akerlof, Shiller, mand any, many others, actually runs way ahead of those who mostly bring negative attitude about economics. And I think that we make a serious mistake if we threw the baby out with the bathwater here.
It reads rather differently if you understand that the passage Salmon quotes (i) comes after a general bash on economics Ph.D. programs as they are currently constituted, (ii) starts with an "on the other hand" to mark the passage as a secondary point that Larry thinks does not have the force of the earlier, primary point, and (iii) that the baby that Larry does not want thrown away is not the policy of financial deregulation but rather the behavioral finance analyses of Bagehot, Minsky, Kindleberger, Eichengreen, Akerlof, and Shiller.
Second, Felix implies that Larry is stupid in not believing that the financial crisis had its roots in new-fangled financial instruments. But that is not what Summers said. What Summers said is:
[T]here’s a debate to be had about the extent to which the financial innovation has been [in general] stabilizing or de-stabilizing, and that’s an important set of questions. I have tended to be more cautious than many about condemning financial innovation, [but] not because [I think] it is unassociated with all sorts of problems. My observation... [is that] the Japanese financial crisis... [and] the Nordic financial crisis--the two examples preceding this one that were biggest in the industrial world, both of which were actually far more costly for their countries than this one looks likely to be--involved, overwhelmingly, [not fancy new-fangled instruments but simple] bank lending to real estate. And that is what the Irish crisis involves. The Greek crisis is mostly about an excessive budget deficit. Most financial crises do not seem to have their roots in new-fangled financial institutions and new-fangled financial instruments. So I am in less of a hurry to condemn the innovation as the cause of the crisis than many.
He did not say that this financial crisis did not have its roots in new-fangled financial instruments. He said that the biggest financial crises before this one did not have such roots, that the severity of the Irish and Greek crises does not spring from such roots, and that most financial crises do not have such roots. Those observations seem to me to be perfectly correct.
Third, Felix does not get what Summers says about financial regulation. Salmon thinks that Summers endorses the nihilism toward regulation of the public-choice school. Summers does not. What he says is:
We have a bunch of people who kind of assume that the regulators are smart and that the private sector is greedy and that [regulators] will figure things out right. We have a bunch of people who assume that the government always gets coopted and the regulators always end up working for the regulated. And we have sort of a dialogue of the deaf between them.
The truth is, the regulators haven’t done a terrific job. The truth is, we have a broad social problem that covers everything from finance to deep sea drilling to nuclear--in all kinds of areas that are technical and hugely important to society, there’s roughly nobody who knows about them who doesn’t have some set of deep interest in them. That creates all kinds of questions of legitimacy and knowledge. We don’t really want regulation by the coopted. But we also really don’t want regulation by the ignorant. And there’s hardly anybody who is both knowledgeable and un-coopted.
How we think about the design of regulatory institutions to address those structures--we economists have a tendency to spend too much time on whether the Basel system should say 7 percent or 7.8 percent. [We do not spend] enough time thinking about how over many years do accounting conventions [come] to be set. There are all kinds of interactions between the regulated and the regulator [in] how the system will adapt in terms of incentives of all the actors.
The public choice school has taken that very seriously, but they have driven it relentlessly toward nihilism in a way that is not actually helpful [for] those charged with designing regulatory institutions. But their recognition that regulators are people who have incentives too is, I think, a very important one. So that would be an additional area that I would highlight for research.
That, too, reads very differently when you realize that Summers is not endorsing but rejecting the nihilistic conclusions of the public-choice school about financial regulation. Just after Salmon cuts off the quote, the very next words are "in a way that is not actually helpful [for] those charged with designing regulatory institutions."
Fourth, Salmon's reference to how "Summers explains that people who want to regulate the financial system are very much like the smart people who became communists and who went on to create the Soviet Union" once again misses the context and the meaning. The context is a response to a question from Martin Wolf:
[W]e have this fantastically dangerous [financial] engine... the obvious conclusion is 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 that’s not a reasonable response?
And what Summers says is:
Well, in some ways it probably is a reasonable response. The last time [we had such a big crisis]--this is an overstatement--this was why Harry Dexter White was a communist. This was why there were a very large number of thoughtful people who were communists in the 1930s. They looked and they saw that just letting the market rip had ended in disaster. They convinced themselves that having not just the financial system but the processes of production be controlled and planned as they were in the Soviet Union, [which] had not suffered a similar [Great Depression] unemployment problem, would produce a better outcome. And that did not prove to be conspicuously successful.
So I think the question one has to ask is: there are going to be decisions that are going to be made by people, those people are going to have incentives, they 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’re 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.
[W]e did not move away from the Bretton Woods system because a bunch of economists got in a room and convinced everybody that fixed exchange rates were a bad idea, [that] capital mobility was a good idea, and so we needed to shift monetary systems from a system that was working well. 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, it didn't work.
And so the question about more dirigiste approaches 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 has the world had too little leverage, I think the case is overwhelming that it has had... too much leverage; that the externality associated with taking on increased leverage has been under-internalized; that capital requirements in various ways 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. It takes a lot of thought as to how best to do it. But it is absolutely right. Every time I’ve spoken to a financial audience for the last two years, I’ve 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. [We have had] one crisis every three years from a system that is supposed to minimize, diversify, and spread risk. [It] has in fact been a source of risk that’s led hundreds of thousands of people each time to lose jobs through no fault of their own.
So I think it’s 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 to promote stability. 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 [single government] institution that is competent with technical things whose job is to regulate you.
There need to be procedures for resolving and managing the failure of any 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 [in spite of] the greed and cupidity that will eventually happen. I think these kinds of principles we know. But if you [look], 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 [of] pollution would be completely internalized... if you just could have the government run the factories, then the externality would be well-managed and you’d avoid having the kind of [environmental] 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...