Sackcloth and Ashes?
As banks collapse under the weight of their bad debt, the global credit system strangulates itself, and stock markets across the world appear to be in their death throes, people are lining up to denounce the lack of regulation.
The more regulation bandwagon is apparently very broad and welcoming. Next to some of the usual suspects calling for aggressive regulation, there are some surprise names. For example, in his written and oral testimony at a recent Congressional hearing, Lehman Bros. CEO Dick Fuld, in addition to criticizing the ineffective control of “naked short selling”, called for the development of a new regulatory scheme that reflects the complexity of the current global financial world order.
Even more curious were the recent comments in this area by the legendary Alan Greenspan. Greenspan, Chairman of the Federal Reserve from 1987 to 2006 and one of the high priests of the free-market deregulation movement testified in writing and orally (and here and here) at a Congressional hearing on 23 October 2008, that he was shocked at the actions of investment banks that assumed so much risk and threatened (in some cases destroying) shareholder equity in the process.
There was a flaw in his ideology he said. He erred by:
…presuming that the self-interest of organisations – specifically banks and others – were such that they were best capable of protecting their own shareholders and their equity in the firms.
With even the might Greenspan throwing his arms up in disbelief, is this the end of the free market ideology? Is it the death knell for self-regulation? Is this the beginning of the age of “re-regulation”. Will government ride in and rescue us. For those of us concerned with the shape and character of environmental regulation, these questions are crucial. And, if we hope to get through the next 25 years and see substantial improvement in our environmental outlook, we had better hope that government does not rush in blindly to stamp out risk and greed. We will probably need a little of both.
The Greenspan Ideology
It should be noted that, once we dig at it, Greenspan’s surprise that banks self-immolated through taking on too much risk because of an insatiable demand for sub-prime mortgage derivatives is a little disingenuous.
Greenspan’s ideology is premised on the notion that individual rational self-interest can serve as a more effective driver for economic activity than some (but not all) government regulation. As a result of this self-interest, people closer to, or directly involved in voluntary transactions, are often better able to understand complicated financial transactions than are the people, or agencies, that regulate them. Accordingly, people involved in the transactions are better able to appreciate and guard against risk. Greenspan’s legacy is not one of complete deregulation. Rather, he can be seen as a champion of a regulatory regime that sought to protect the judgment and freedom of these sophisticated rational actors from undue interference and preserve “self-interest” as a motivator. Greenspan’s justification has been that for at least 40 years, the evidence, on balance, shows this approach has created economic growth.
Not that there have not been bumps along the way. No system is perfect. The risks inherent in light regulation of complex financial trading have played themselves out innumerable times and did so under Greenspan’s watch. Perhaps the most telling example, in light of the current crisis was the collapse of the hedge fund Long-Term Capital Management in 1998. In Greenspan’s own words in The Age of Turbulence:
Hollywood could not have scripted a more dramatic financial train wreck. Despite its boring name, LCTM was a proud, high-visibility, high-prestige operation in Greenwich, Connecticut, that earned spectacular returns investing a $125 billion portfolio for wealthy clients. Among its principals were two Nobel-laureate economists, Myron Scholes and Robert Merton, whose state-of-the-art mathematical models were at the heart of the firm’s money machine. LTCM specialised in risky, lucrative arbitrage deals in U.S., Japanese, and European bonds, leveraging its bets with more than $120 billion borrowed from banks. It also carried some $1.25 trillion in financial derivatives, exotic contracts that were only partly refelcted on its balance sheet. Some of these were speculative instruments, and some were engineered to hedge, or insure LTCM’s portfolio against every imaginable risk. [Even after the smoke cleared, no one ever knew for sure how highly leveraged LTCM was when things started to go wrong. The best estimates were that it had invested well over $35 for evey $1 it actually owned.]
Leverage. Debt. Derivatives. Massive assumption of Risk. Crash. Sound familiar? In the case of LTCM, the Federal Reserve acting under Greenspan’s authority, co-ordinated a private sector bail-out in order to avoid a chain reactive market crash.
This is but one of many examples of market failure under Greenspan’s watch. It is difficult to believe that it took him until the collapse of Lehman Brothers to appreciate that firm’s can collapse under the weight of taking on too much risk. A more honest answer to Congress would have been is that this risk was inherent in light regulatory regimes. It is a trade-off that allows a big upside. If you benefit from the upside, you need to be prepared to suffer when things go awry.
Firm Interest versus Individual Interest
There are many reasons to contest Greenspan’s free market ideology but the nexus between economic growth and the systematic lightening of the financial regulatory load is hard to refute. For our purposes here, there is a technical objection to what Greenspan has said that is illuminating. In his explanation to Congress of where he want wrong, Greenspan appears to place the self-interest of firms at the foundation of his free market ideology. This is problematic for a couple of reasons that may shed some light on why the roof has come crashing in. First, it seems to equate the interests of firms with the interests of the individuals conducting business on their behalf. Second, it suggests that firms and individuals make decisions for the same set of reasons that individuals do.
The first error seems to reflect a detachment from the realities of the compensation of your average investment banker and the nature of their relationship to their employer.
In Greenspan’s day, loyalty to the firm was far more important than it is now. But, to use Lehman’s as an example, for every Dick Fuld, who started as an intern in 1969 and never left and identified himself as a lifer, there are literally hundreds if not thousands of Lehamn employees and partners who came to work their mid-career because they perceived it to be in their economic advantage. Many of these would have been actively recruited by Lehmans on such mercenary terms. Corporate performance would have driven some part of their compensation, but outstanding individual performance would have not only increased their compensation but it would have opened up doors to advancement withing the firm or to the highest bidder on the street.
The rates of compensation for top performers are truly staggering. Fuld himself made between a third and a half a billion dollars from 2000 to 2007. The high salaries were defended as being dictated by the market and necessary to both attract talent and to keep talent from leaving. Employment contracts commonly featured large payouts for termination of employment. In this environment, the assumption of risk on behalf of the corporation is of indirect importance to the self-interest of the individual. For the high-performers, the directing minds of the firm, they will be fabulously wealthy and have employment opportunities available to them elsewhere regardless of whether the firm exists or not. What the compensations structure and leadership style has set up is, in effect, a tragedy of the commons that sees risk pile up onto the firm by people indifferent to its long-term effect.
The second error is the assumption that individuals and firms make decisions for the same set of reasons and in the same way.
People are creative, individualistic, irrational, unpredictable, variable, inscrutable and motivated by a range of obscure inputs into their notion of self-interest. Firms are corporate constructs with process driven decision making structures that are framed by strategic priorities shaped in varying degrees by executive management, a board of directors and shareholders. These are two fundamentally different decision making constructs. Equating the two makes it difficult to understand either. That, in turn, makes it hard to accept a regulatory regime that is based on this confusion.
And the Environmental Issue?
So what does the collapse of the credit-swap market have to do with the environment? The answer is simple: perhaps everything.
Framing the solution to the climate change problem and the host of other environmental issues will require, one way or another, a direct engagement with the market capitalist system. There are three big picture scenarios in which this is going to happen: the total destruction of the capitalist market system; the effective containment of the capitalist market system; or the harnessing of the capitalist market system for address environmental issues.
The last choice is the one that we should be intensely focused on now. It has the greatest potential to be effective; it can serve to create wealth and develop a foundation for continued economic growth; it is best able to support a technological basis for addressing the climate change problem; and, it is the least destructive to the exisiting social order. There is a limited window of opportunity to move in this direction before social and environmental pressures make it untenable.
The conversation around regulation and deregulation of financial institutions provides an opportunity to approach the issue differently. If we agreed that a healthy economy was desirable, and we assumed it was necessary to creating a healthy environment, and we approached the regulation of the economy as not a clash of ideology but rather a results oriented design problem, we might be able to learn from what happened leading up to the credit crisis and design an effective regulatory scheme that supported environmental aims.
It is too much to come up with the framework of that scheme here, but we can say something about the relevant inputs.
1. The economic self-interest of individuals is an powerful, in unfocused, driver of behaviour;
2. Individuals are more likely to be able to appreciate the effect of environmental degradation on their economic interest (and that of their children) than firms will;
3. Demand is a powerful, and focused, motivator;
4. More capital and more risk must be taken on in relation to the funding of technological innovations
5. Risk is part of the foundation of market captalism.
6. In order to ensure the flow of capital, creditors need to be able to transfer some risk to more sophisticated parties;
7. Left to their own devices in the current regulatory regime, there is a potential conflict between the interest of the firm and the interest of individual actors;
So, we can imagine a system that had been better but lightly regulated and that still allowed for a market in mortgage backed commercial paper. Had there been an effective attempt to ensure that there were limits or safeguards to the amount of risk any individual firm could have taken on. The result would have been economic growth and increased access to housing.
Now take it one step forward. What if instead of supporting investments in housing, creditors had lent money to support investments into technology that either reduced our reliance on fossil fuels or helped remove greenhouse gases from the atmosphere. The result could have been – and still could be – economic growth and real progress on addressing the envrionmental crisis confronting our planet. But this can only happen if the creditors are able to sell an interest in the risk they have assumed with their lending.
So, ideology aside, from a design perspective, there is a lot that government can do to provide effective regulation of financial institutions to both provide the mechanisms and the focus necessary to ensure success. It would be a mistake if in response to the current economic crisis, we took this as a message to overly restrict the flow of credit and to limit sophisticated parties’ ability to assume risk for investment purposes. Some regulation is required but governmental action in this area should be thoughtful and progressive, it should reflect some learnings from what has happened and, above all, it should do no harm to our ability to combat climate change.
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