Christopher Whalen

“[F]or many philosophers, conflict is inevitable in politics because a government should seek both to make its people equal in wealth and opportunity and also to safeguard their liberty, but it cannot do both because people can be made equal only through serious constraints on their freedom. This is not simply a statement of the obvious fact that different people and different communities hold different values. The argument claims that even a single sensitive person cannot express, either in how he lives or how he votes, all the ideals he knows he should recognize.”

Justice for Hedgehogs
Ronald Dworkin

In an article in the April 28, 2011, New York Review of Books, “For a National Investment Bank”, Robert Skidelsky and Felix Martin argue that the Obama Administration ought to create yet another state sponsored financial institution in the US to explicitly stimulate the economy by issuing debt. This is a truly bad idea whose time has come and gone.

The authors rightly describe the lack of aggregate demand in the US, something we have also discussed at some length in this space. “Few dispute that the US is not enjoying a normal recovery by recent standards,” they write. So true. But their suggestion of creating a new government sponsored enterprise (GSE) to address slack growth and employment lacks imagination and practicality. Skidelsky and Martin specifically want to use the NIB to finance public infrastructure projects, but without the new debt required showing up on the federal budget. How clever.

Nowhere do Skidelsky and Martin, nor most neo-Keynesian economists, admit that much of the nominal economic growth of the past several decades in the US was increasingly supported by debt and inflation. The national investment bank they propose would take its place alongside dozens of existing New Deal and Great Society agencies such as Fannie Mae and the Federal Housing Administration, as well as the Bretton Woods GSEs including the IMF and World Bank. Martin, an economist at Thames River Capital LLP, worked at the World Bank for two stretches between 1998 and 2008 and must be familiar with this history. The NIB is more of the same stuff in policy terms.

The NIB proposal shows just how bankrupt the American political discourse has become when it comes to economics, but especially on the left.  It also reveals the indifference of liberal economists to the political consequences of economic policy choices. This is not to suggest that Republicans are exactly fonts of economic innovation at present. Most Republicans are indistinguishable from big government Democrats in terms of their willingness to prune back the corporate state. Fiscal conservatives have been fighting this battle for decades now.

The first observation about the NIB proposal is that we are talking, once again, about using debt to create the illusion of economic prosperity. Skidelsky, Emeritus Professor of Political Economy at the University of Warwick and the author of Keynes: The Return of the Master (2009), is an unabashed advocate of the aggressive state in action. Yet what he and Martin propose promises few benefits in economic terms. Indeed, you cannot make an argument for more GSEs on utilitarian grounds.

The most offensive thing about the NIB proposal is that it pretends to rely upon Keynes. Skidelsky and Martin say that they intend some sort of pump-priming, jump starting catalyst for private sector growth. Keynes was no apologist for using debt to simulate real economic growth but he also believed in individual economic liberty, which he greatly benefited from. Living through the privation in the UK during and after WWII, Keynes understood the desperate situation facing Britain. Modern economists spend too little time considering politics when assessing the motivations of the day.

My friend Sol Sanders and William Alpert talked about Keynes in The Institutional Analyst last month (Keynes, Keynesianism — and Keynesianitis): “‘The day is not far off’, he wrote, ‘when the economic problem will take the back seat where it belongs, and the arena of the heart and the head will be occupied or reoccupied, by our real problems/the problems of life and of human relations, of creation and behavior and religion.’  In 2010 we are still waiting.”

The same lack of demand and unemployment that faced Keynes and the leaders of the Western economies after WWI and WWII, and to which Skidelsky and Martin rightly raise in alarm, has driven liberals today to embrace ever more inflation and debt. An aggressive combination of reflation by the Fed and restructuring of the housing and banking sectors is the way to restore US economic growth, but you won’t hear about restructuring large banks from adherents of the neo-Keynsian faith.

Skidelsky and Martin assess the political situation facing the Obama administration, saying “that it has become politically impossible to increase the deficit.” Quite right. But the solution offered by these two honorable gentlemen is to create yet another GSE to issue more debt off the books? Such expedients are entirely transparent to the marketplace, but Skidelsky and Martin do not seem to appreciate that more incremental debt buys less and less bang for the buck in terms of nominal economic growth.

Skidelsky and Martin, and their American contemporaries led by the likes of Paul Krugman, call for “fiscal stimulus,” but what they are really arguing for is permanent inflation. The Fed has been pursuing the reflation path via quantitative easing, but with less than astounding results, owing to the lack of benefit for US households.

The only way to fix the twin problems of deflation and unemployment is to keep money easy and restructure the insolvent parts of the banking system and economy. In both the US and EU, the policy has been implemented but the lack of financial restructuring of the insolvent banks of the US and EU is the chief obstacle to economic renewal. To restructure and renew is the alternative to the proposal from Skidelsky and Martin.

Instead, Skidelsky and Martin want to layer more state-guaranteed debt on top of an already wobbly foundation. This is not only bad economic policy, but it has truly hideous political implications. John Stuart Mill acknowledged that utilitarianism had to admit the moral superiority of classical liberalism and that, to save it, certain preferences (those the classical liberals generally would favor) simply had to be acknowledged as preferable.

Why is it that so few economists ever assess the social and political implications of their policies? Skidelsky and Martin are following the road to hell trodden by Franklin Roosevelt in the 1930s. Not only do we have the New Deal zombies like Fannie Mae and the Federal Housing Administration as examples of failure, but dozens of parastatal banks and development entities in the EU that are effectively insolvent today. The embrace of the fascist economic model proposed by Skidelsky and Martin has not saved the EU from economic malaise.

As Ronald Dworkin notes in his new book, Justice for Hedgehogs, the differences between different ethical and political systems do matter very much. Keynes believed in using temporary government action to help restore private economic activity, but I doubt he would have supported the type of debt accumulation much less the creation of permanent GSEs that Skidelsky and Martin propose.

Instead of embracing a permanent state of inflation, as has been the case in the US since the 1970s, we need to deflate the bubble and start again. It is not too late for President Obama and Congress to restructure the US financial system, fix the housing market and create the conditions for true economic growth. All we need to succeed is leadership and the knowledge that the bastard children of Lord Keynes cannot help us in the difficult task ahead.

This week I lovingly disparaged those members of the media who spent much time covering the new and improved bank regulatory scheme known as “Basel III.” As someone who was quizzed by my father about the original 1988 Basel accord, I don’t give a toasted sausage about Basel III and said so recently:

Basel III is entirely irrelevant to the economic situation and even to the banks. Through things like minimum capital levels, the Basel II rules provided the illusion of intelligent design in the regulation of banking and finance. In fact, Basel II made the subprime crisis possible and the subsequent bailout inevitable [by enabling off-balance sheet finance and OTC derivatives].

Part of the reason for my undisguised contempt for the Basel III process comes from caution regarding the benefits of regulating markets. In the 1930s, the U.S. government took responsibility for the soundness of banks and markets.  Since then we’ve had nothing but an accumulation of public sector debt and growing market volatility, begging the question as to whether the Treasury’s legal monopoly on regulating a market filled with fiat paper dollars is really a public good.

But a large portion of my criticism for Basel III and the entire Basel framework is even more basic, namely the notion that any form of a priori regulation, public or private, can prevent people from doing stupid things. Neither the failure of Lehman Brothers nor Bear Stearns were caused by a lack of capital. “When a bank goes bad, it doesn’t make much difference how much capital it has,” former Fed Chairman Paul Volcker said recently.

To me, the even more offensive thing about Basel II/III is the financial and economic assumptions which underlie the framework. This week in The Institutional Risk Analyst, we republished the written Testimony of David Colander as submitted to the Congress of the United States, House Science and Technology Committee on July 20, 2010. His views on what is right and wrong with economists and the world of economic research are very much at the heart of the problems with Basel III, at least as sold by regulators to their respective voters in the G-20 nations.

The key premise of Basel III is that the use of minimum capital guidelines and other strictures will somehow enable regulators to prevent a crises before it occurs. The only trouble is that regulators have no objective measures for compliance with Basel II/III, much less predicting market breaks. There is also the larger issue of the conflict between the Fed’s monetary policy role and its job as regulator.

Fed Chairman Ben Bernanke told Congress recently that the Fed and other regulators must rely on the disparate internal systems of the banks to monitor compliance with regulations. But this assumes that bank managers themselves understand the risks they face. Do you think JPMorgan CEO Jamie Dimon knew last week that his bank had a serious problem with its website? Risk is no more predictable than life and no more amenable to statistical forecasts than the weather.

As in past decades and crises right through to 2008, the regulators will be the last to know about a problem. The fact that the Fed and other agencies have no objective means of measuring compliance with Basel III and other regulatory norms is but your first hint of trouble. Add to that basic problem the use of suspect methodologies to measure risk and thus prescribe minimum capital levels. This is the next indication of serious issues with the regulatory status quo which is now reaffirmed in Basel III.  Then add to that the lack of a unified set of accounting rules and the de facto regime of “national treatment” that prevails within the G-20 nations, and it seems reasonable to ask whether Basel III is really worth all of the trouble and bother.

What is more important than Basel III for customers and creditors of and investors in banks? The accounting rules changes on off-balance sheet (OBS) vehicles and the fair-value crusade being led by the Financial Accounting Standards Board are top of the list for our clients.

The EU and SEC/FDIC rules processes on securitization are #2 on the important list. While everyone focuses on Basel III, the key to the future of finance is emerging now with the implementation by the EU of something called “Article 122a” regarding asset backed securities (ABS).

Article 122a is an amendment to the European Capital Requirements Directive. Specifically, it requires European credit institutions that invest in structured finance securities to know what they own. It lays out explicit penalties if a European credit institution does not obtain sufficient data regarding an ABS to satisfy regulators that the buyer fully understands the security.

Would that American regulators dared to propose anything remotely like Article 122a to bring order to the U.S. market for structured notes and derivative securities. Indeed, the divergence in goals and objectives between the EU and the U.S. over bank regulation could grow after the November election, when the Republicans are expected to win big. My prediction is that if the Republicans prevail at the polls, the U.S. may go its own way on Basel III. Stay tuned.