Thursday, October 08, 2009

Big, Bad, Financial Institutions

Posted by Neil H. Buchanan

In my new FindLaw column, "Financial Market Reform: Two Goals, No Frills" (available later today), I offer a few preliminary thoughts on the big upcoming legislative battle over how to change this country's system of regulating financial markets. I argue against nuance, suggesting that we need to simply say that enough is enough, that there really are such things as financial institutions that are too big and salaries that are too high. I further argue that the new regulatory system should not try to be cute by saying, in essence: "Well, we're not saying too big is really too big, just that big is OK only if the following checklist of safety measures is met." Instead, we should simply choose a plausible way to measure "big" and then set an arbitrary maximum size, forbidding financial institutions from exceeding that size. The same approach should apply to the salaries of those institutions' employees (with the additional issue of possibly limiting the forms in which such compensation may be paid -- stock options, etc.).

In this column, I will offer two further thoughts. First, I will suggest an additional reason that the new financial regulatory law should eschew nuance. Second, I will describe why it is legitimate for the government to "meddle" in the financial markets in the first place.

In the FindLaw piece, my basic argument against a complicated, standards-based approach to determining the maximum size of financial institutions is that size really is the problem. Because we now know that big is too big, we should just say so and be done with it. In addition, however, it is worth noting that the current experience with medical care legislation strongly suggests that the U.S. political system has reached a state where it cannot handle anything that is even slightly complicated.

In my argument this past summer against the so-called Public Option, for example, I argued that Congress could provide better outcomes in both the short run and the long run by carefully and aggressively regulating private insurers than by trying to set up a non-profit insurance company to offer coverage to anyone who might prefer publicly-provided health insurance. The subsequent months have shown that my suggestion, whatever its other merits, assumed incorrectly that it is currently possible to put together a coherent bill that covers a large sector of the economy in a way that handles subtle issues.

This suggests that we might not be able to accomplish anything more than a crude law that says "Big is Bad" -- and even that might be beyond our current legislative capacity. Passing something truly ambitious -- like the Tax Reform Act of 1986, or the Clean Air and Water Acts -- might simply be currently impossible. Fortunately, as I argue in my column, there might well be some advantage in this case to being as crude as the political culture currently requires.

More fundamentally, it is important to think about why it is acceptable to have the government do something so seemingly aggressive as to tell private financial institutions how big they can be and how much they can pay their employees. The answer is simple, and it ties back into my most recent FindLaw column and related Dorf on Law post regarding the "Murphy/Nagel point." Specifically, a government is the necessary predicate to even having an economy, because it creates and enforces the laws of property, contract, etc. that make a modern economy possible.

This means that it is not only meaningless to describe before-tax income as "my money," as Murphy and Nagel demonstrate so well; but it means that any attempt to pass a new law to "regulate" a business is in fact always a matter of changing the existing regulatory scheme that makes it possible to operate that business in the first place, not an exercise in creating regulation where none existed before.

In the case of financial institutions, the role of contract law is especially important, because the fundamental product for sale in financial markets is promises. I have extra money, so I deposit it in a bank in return for the promise that it will pay me interest and return the principal under a certain set of agreed conditions. A bank lends money to a manufacturer, believing that it will be able to collect that money if the manufacturer does not live up to its promise to repay. A stock trader shorts a company by engaging in a series of agreements that must be enforced in the future. Unlike a transaction where, say, I give a kid fifty cents now in exchange for a cup of lemonade now, financial transactions almost by definition involve not current exchanges but promises by at least one party to make future payments.

This means that financial institutions are the least well-situated businesses in the country to say that they merely need the government to get out of their way. Moreover, the extra benefit of limited liability -- essentially, a rule that grants businesses an extremely valuable exception to the rule that they must honor their contracts -- means that businesses are benefiting uniquely from government's rules of the game. (Bankruptcy law is another part of this.) Finally, we now know (as if we shouldn't have known it before) that large financial institutions, and the financial system in general, are so fundamental to economic prosperity that they cannot be allowed to fail. This government-provided insurance puts financial institutions in an even more dependent position vis-a-vis government -- not because the government has induced their dependence, but because the government's rules and guarantees are part of the very foundation of a modern financial system.

That does not mean that any form of regulation is a good as any other. Far from it. It does mean, however, that the way to evaluate proposed changes in the laws governing financial markets is not to say that one approach is "regulation" and the other is "deregulation" or "less regulation." We should weigh each form of regulation on the merits, understanding that the exercise of reconsidering financial market regulation is fundamentally legitimate and appropriate.


Bob Hockett said...

Great post as ever, Neil -- many thanks. The salutary observation that 'too big to fail' ought to mean 'therefore, too big,' calls to mind another nice Keynes quote. Paraphrased, it went something like this: Borrow a thousand from someone, and you fall into his power; borrow a million, and he falls into yours.

All best,

Neil H. Buchanan said...

Thanks, Bob. I like your paraphrase. I've heard a different version: "If I borrow $100,000 from a bank and can't pay it back, then I'm in trouble. If I borrow $100 million from a bank and can't pay it back, then the bank's in trouble." Not a terrible formulation, but clearly not as good as yours.

Tam Ho said...

Great post, Neil. The nuance issue you raise is yet another instance of a recurring theme in your posts: problems created in the political process by the apparent inability and unwillingness of people in contemporary American society to think or to engage in reasoned discourse.

I agree that the state of this country is such that nuance is a thing of the past. The Republicans have realized this for a long time now, hence their success, as Mike previously noted, in phrase-making (although they obviously take it quite a few steps beyond simple abandonment of nuance). And I agree that the Dems too have to abandon nuance in the short term if they are to achieve their policy goals.

But since you are a social scientist as well as a lawyer, I'd like to hear your thoughts in a post or article some time on how (or if) we can address the other end of the problem, or at least what conditions have to obtain in order to have a society that can sustain semi-intelligent political discourse on a national level. That seems to me to be the only sustainable and viable solution unless we are to start talking about the post-democratic world; do you agree?

Paul Scott said...

1. Agree 100% on the "too big" - or maybe 90% (in that I think allowing things to fail no matter how big is not necessarily a terrible idea - but I am sure it is one that no one would risk).

2. On the National Discourse and Subtly thing - on that I am not so sure. We have one party that has essentially abandoned discourse. With that I completely agree. We have another party who can best be described as cowards. They are so frightened of being effectively blamed for bad results of their own policies that they are unwilling to proceed with them alone - even when they have the power to do so.

So I think the solution is not to give up, but instead to just start acting unilaterally without regard to input or consensus from Republicans.

Neil H. Buchanan said...

I agree with Paul Scott's description of the Democrats as cowards and with his suggestion of how they should change their behavior.

I also agree with Tam Ho's third paragraph. I'll definitely take the bait and put this on my to-do list. I'm not sure if it will be a law review article, book, FindLaw column, op-ed, DoL post, or some combination thereof, but I'll give it a shot.

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