"Misapplying the theory I mislearned in college."
By Simon Johnson
Global megabanks and their friends are pushing back hard against the idea that additional reforms are needed – beyond what is supposed to be implemented as part of the Dodd-Frank 2010 financial legislation. The latest salvo comes from Goldman Sachs which, in a recent report, “Measuring the TBTF effect on bond pricing,” denied there is any such thing as downside protection provided by the official sector to creditors of “too big to fail” financial conglomerates.
The Goldman document appears hot on the heels of similar arguments in papers by such organizations as Davis Polk (a leading law firm for big banks), the Bipartisan Policy Center (where the writing is done by a committee comprised mostly of people who work closely with big banks), and JP Morgan Chase (a big bank). This is not any kind of conspiracy but rather parallel messages expressed by people with convergent interests, perhaps with the thought that a steady drumbeat will help sway the consensus back towards the banks’ point of view. But the Goldman Sachs team actually concedes, point blank, that too big to fail does exist — punching a big hole in the case painstakingly built by its allies.
Of course, the report puts a different spin on matters. But if you add in a little bit of recent Goldman history – not mentioned in the report – the dangers of relying on their read of the data become readily apparent.
The Goldman analysts make clear that, even under the most favorable interpretation (i.e., theirs), very large financial institutions were able to borrow more cheaply than other financial firms at the height of the crisis in 2008-09. The funding advantage they measure in the crisis looks (from their charts) to be in the range of 400-800 basis points.
In fact, there was further advantage to being one the very largest firms – remember that when hedge funds “ran” from Morgan Stanley, their destination was JP Morgan Chase (this point is not in the Goldman report, which conflates these two firms with other very large financial institutions).
The Goldman team shows there was an even larger advantage for huge non-bank financial companies than there was for banks, but they neglect to mention that their company was one of our large non-banks as the crisis intensified. Goldman was allowed to convert to become a bank holding company in September 2008, so that it could access the Fed’s discount window (i.e., increase its ability to borrow from the central bank.) This conversion was allowed – or perhaps even urged by officials – precisely because they feared the consequences of Goldman failing.
Goldman executives argued long and hard in September 2008 that they were too big – and complex and generally important – to be allowed to fail. Hank Paulson, then Secretary of the Treasury and former head of Goldman, felt strongly that the continued existence of his firm was essential to the well-functioning of the world economy.
The measured difference in spreads is obviously huge but even greater is the real funding advantage between not being able to borrow from the Fed (think CIT group, $80 billion total assets, which foundered and begged for assistance in fall 2009) and being able to borrow from the Fed (Goldman Sachs, $1.1 trillion total assets when it hit the rocks in mid-September 2008).
CIT, of course, was not a bank – hence the argument that it should not be allowed to borrow from the Fed. But Goldman was not a bank either at the relevant point in time.
The issue of TBTF is not about the rules or the cost of credit relative to small banks in a period of calm. It is about the availability of government support, broadly defined, when bad things happens – enabling the megabanks to borrow more cheaply than would otherwise be the case.
Goldman Sachs has downside protection available to it which a small or even medium-sized regional bank cannot hope to access. This helps increase liquidity in their bonds and generally makes it easier to borrow in good times as well as bad.
The Goldman team argues that big banks show lower losses than smaller banks both in the recent credit cycle and during the S&L crisis. But this uses F.D.I.C data and it necessarily masks all the other support provided by Fed support and various kinds of debt guarantees. And Goldman does not cover the emerging market debt crisis of the early 1980s, which was all about big bank losses (with Citi at the center, as it was in 2007-08).
Goldman also argues that the funding advantage for megabanks today is smaller than it was in the crisis, indicating that there is no longer a TBTF issue in the minds of creditors.
But this rather indicates two points. First, we are not in a crisis – so the immediate cash value of government support is lower, at least for short-term debt. But the availability of that support in the future or in various unspecified difficult scenarios is hugely valuable, and a compelling reason to buy megabank debt. Second, megabanks pay a complexity or opaqueness premium on their debt. Creditors charge more than they would otherwise because they cannot see inside the largest of these groups to understand the risks they are taking and the shocks to which they are vulnerable.
The probability that the government (including the Fed) will protect all creditors fully has never been one and will never be zero. Even at the height of the financial crisis, the credit default swap spread for some large financial institutions was high (e.g., for Morgan Stanley, so insuring its debt against default was expensive).
Creditors weigh the odds. The spread on megabank debt over benchmarks is the combination of downside guarantees (which tend to lower spreads) and the complexity premium (which tends to increase spreads).
The real issue for too big to fail is: by how much does the prospect of government support lower spreads compared to what they would otherwise be. The Goldman report acknowledges that too big to fail exists and distorts the market, but conveniently ignores the question of how big this distortion is really – and how it threatens to again bring down the economy.
By James Kwak
Update: See bottom of post.
For years now, Anat Admati has been leading the charge for higher capital requirements for banks, especially large banks that benefit from government subsidies, first in a widely cited paper and more recently in her book with Martin Hellwig, The Banker’s New Clothes. Admati’s great service has been clearing the underbrush of misunderstandings and half-truths so that it is possible to have a debate about the benefits of higher capital requirements. Yet even after all this work, the media (and, of course, the banking lobby) continue to repeat claims that are simply false or highly misleading.
In another effort to beat back the tides of ignorance, Admati and Hellwig have put out a new document, “The Parade of the Bankers’ New Clothes Continues,” which catalogs and addresses these claims. In the simply false category, the most common is probably that capital is “set aside”; in fact, banking capital is assets minus liabilities, and the capital requirement places no restrictions on what a bank can do with those assets.
In the highly misleading category is the claim that higher capital requirements would force banks to reduce their lending. Banks can respond to higher capital requirements by raising more equity capital or by reducing their balance sheets. As Admati and Hellwig write, “If increased equity requirements cause banks to reduce their lending, the reason is that they do not want to increase their equity.” (If they can’t sell new shares, then they have more fundamental problems and probably shouldn’t be in business.) And why don’t they want to increase their equity? Because executives have one-way compensation packages based on return on equity, which is not adjusted for risk, so they don’t want to increase the denominator.
As Admati and Hellwig no doubt realize, this is not a battle that is going to be won solely with truth, light, and logic. The banking lobby has a vested interest in sowing confusion, with masterpieces like the IIF’s “report” claiming that higher capital requirements would shrink the global economy by 3.2 percent. And as long as bankers say that such-and-such a regulation will hurt growth and kill jobs, they will get a hearing. Ultimately, it’s all about politics, which was roughly the message of 13 Bankers. (Which is another reason why, in the long run, the only things that matter are campaign finance reform and early childhood education.)
Update: Banks’ unwillingness to increase equity by selling shares (or by not doing buybacks and dividends) is not simply due to one-sided bonus packages tied to ROE. A perhaps more serious problem is that of debt overhang. In short, if a company already has a lot of debt and its solvency is in question, shareholders will be reluctant to put more equity into the firm. That new money would mainly provide greater security to creditors, increasing the value of the firm’s debt, without providing much benefit to equity holders. So in this case, it’s not just the bank’s managers who resist selling new shares; they are actually doing so in the interests of shareholders (but not society). (For much more, see this paper by Admati et al.).
There are two solutions to this problem. First, if the bank really is insolvent, it should be shut down. Second, if it isn’t, regulators could force the bank to retain its earnings rather than paying them out in dividends and buybacks; over time, that would increase the amount of equity in the firm. Creditors could also refuse to lend to a bank that is too highly leveraged—but in the case of systemically important banks, creditors don’t really care, because they know they will be bailed out in a crisis. (That is undeniable, even for people who think that managers and shareholders might not be bailed out.)
By James Kwak
I feel like I should have something deep and original to say about Corey Robin’s fascinating article on nineteenth-century European culture, Nietzsche, and the economic philosophy of Friedrich Hayek. In addition to the things I’m better known for, I studied European intellectual history at Berkeley, with Martin Jay no less, and I’m pretty sure Nietzsche figured somewhat prominently in my orals. But Robin has far surpassed my understanding of Nietzsche, which is almost twenty years old, anyway.
The story, in very simplified form, goes like this. For Nietzsche, and for other cultural elitists of late-nineteenth-century Europe, both the rise of the bourgeoisie and the specter of the working class were bad things—the former for its mindless materialism, the latter for its egalitarian ideals, which threatened to drown the exceptional man among the masses. One set of Nietzsche’s descendants was the political theorists like Carl Schmitt, who “imagined political artists of great novelty and originality forcing their way through or past the filtering constraints of everyday life.” Another, which Robin focuses on in this article, is the “Austrian” school of economics led by Friedrich Hayek.
People often like to think of the Austrians as advocates of liberty, both for its Economics 101 properties (free choice in free markets, under certain assumptions, maximizes societal welfare) and its moral properties. Robin ties Hayek’s conception of liberty, however, back to Nietzche’s. Hayek cared about liberty for ultimately elitist reasons: liberty is not an end in itself, but a condition that enables the select few to make the world a better place. In his words, “The freedom that will be used by only one man in a million may be more important to society and more beneficial to the majority than any freedom that we all use.” And those select few are likely to be the rich, for only they have the requisite time and freedom from material concerns: “However important the independent owner of property may be for the economic order of a free society, his importance is perhaps even greater in the fields of thought and opinion, of tastes and beliefs.”
This idea is obviously echoed in Ayn Rand’s novels, which celebrate the individual genius standing out against the backdrop of collectivist mediocrity. It has also trickled into the contemporary conservative worship of the ultra-rich. The phrase today is “job creators” (whatever that means), but it has the same moralistic overtones as in Nietzsche and Hayek—a class of people who are better than the rest of us, on whom we depend for our salvation and prosperity, and whom we should not presume to question or constrain through, say, safety regulation or higher taxes (“penalizing success,” in the jargon).
I used to say that most Americans voted against their class interests because they thought they would one day be in the upper class: there’s some poll statistic floating around according to which X percent of Americans think they will one day be in the top 1 percent by income, where X is some high number like 40 or 45. But today, five years after the financial crisis, with median income below where it was fifteen years ago and social mobility at developing-world levels, I can’t imagine many people really believe that vast riches are in their future. An alternative explanation is that many Americans just think the rich are better than they are and that it’s wrong to question your betters. (This is not inconsistent with George Lakoff’s model of the Strict Father and a hierarchical universe as the governing principle of modern conservative ideology.) Nietzsche would no doubt be horrified by most aspects of contemporary American society, but that might give him some comfort.
By James Kwak
The Federal Reserve is serious—about something.
On May 2, The Wall Street Journal reported that regulators were pushing to require “very large banks to hold higher levels of capital,” including minimum levels of unsecured long-term debt, as part of an effort “to force banks to shrink voluntarily by making it expensive and onerous to be big and complex.” The article quoted Fed Governor Jeremy Stein, who said, “If after some time it has not delivered much of a change in the size and complexity of the largest of banks, one might conclude that the implicit tax was too small, and should be ratcheted up” (emphasis added).
A few days later, Fed Governor Daniel Tarullo said roughly the same thing (emphasis added):
“‘The important question is not whether capital requirements for large banking firms need to be stronger than those included in Basel III and the agreement on capital surcharges, but how to make them so,’ said Mr. Tarullo, adding later that even with those measures in place it ‘would leave more too-big-to-fail risk than I think is prudent.‘”
Tarullo recommended higher capital requirements and long-term debt requirements for systemically risky financial institutions.
Last week, Governor of Governors Ben Bernanke quoted from the same talking points (emphasis added):
“Mr. Bernanke said the Fed could push banks to maintain a higher leverage ratio, hold certain types of debt favored by regulators, or other steps to give the largest firms a ‘strong incentive to reduce their size, complexity, interconnectedness.’
“The Fed chairman acknowledged growing concerns that some financial companies remain so big and complex the government would have to step in to prevent their collapse and said more needs to be done to eliminate that risk.”
It’s important to note exactly what Stein, Tarullo, and Bernanke are all saying.
- Here’s what they’re not saying: Too-big-to-fail banks enjoy implicit subsidies and impose externalities on the rest of us; therefore those subsidies and externalities should be priced; and then those banks can decide whether they want to absorb those costs or make themselves smaller.
- Here’s what they are saying: Too-big-to-fail banks are too big and complex and pose a systemic risk to all of us; therefore they need to become smaller and less complex; and the Fed will tweak the regulations until they become smaller and less complex.
What’s remarkable about this? These three men—probably the three most important on the Board of Governors when it comes to systemic risk regulation (as opposed to monetary policy, for example)—all say that they know that the megabanks are too big and complex. They all say that accurate pricing of subsidies and externalities is not an end in itself.* They all say that the goal is smaller, less complex banks.
But here’s what baffles me: If the goal is smaller, less complex banks, why not just mandate smaller, less complex banks? Why beat around the bush with capital requirements and minimum long-term debt levels? Those tools might be appropriate if you think huge, complex banks should exist but you want to make them safer. But if you’ve already concluded that banks need to be smaller and less complex, then they’re just a waste of time.
They also betray a frightening naivete regarding corporate governance. The theory is that higher capital requirements, for example, will lower banks’ profits, which will upset shareholders, who will eventually force the board of directors to eventually convince the CEO to break up his empire. This scenario, unfortunately, depends on the premise that American corporations are run for the benefit of their shareholders, which is only roughly true, and even that often requires long, expensive, and messy shareholder activist campaigns.
Instead, there’s an obvious solution: rules that limit the size and scope of financial institutions. But Bernanke has ruled out “arbitrary” size caps in favor of his cute regulatory dial-tweaking.
Again, Bernanke’s position might be defensible if he wasn’t already sure that today’s banks are too big and complex. Then it might make sense to tweak the incentives and see how the market reacts. But if he knows they are too big and complex, he should eliminate that risk in the simplest, most direct way possible. If he’s not sure how much smaller and simpler banks need to be, he can do it in steps: set one set of size and scope limits, see what he thinks about the outcome, and then set another set of limits if he’s still unhappy.
To use a crude analogy, let’s say we’re concerned about guns on airplanes. Ben Bernanke thinks, like I do, that guns on planes present an unacceptable risk to the safety of air travel. But his approach is to charge a $100 fee for anyone who wants to bring a gun onto a plane. If people keep bringing guns on board, he’ll raise the fee to $200, then $300, and so on until people stop. The sensible, obvious solution is to just ban guns on planes. But that would be “arbitrary.”
* It is theoretically plausible that one should simply price the subsidies and externalities and then let the market determine whether big banks provide enough societal benefit to offset the costs they impose on the rest of us. But that is not what Stein, Tarullo, and Bernanke are saying.
By James Kwak
For years, the world’s largest banks have been up in arms over threats by regulators to increase their (equity) capital requirements. Making banks hold more capital, they argue, will force them to reduce lending and will increase their cost of funding, making credit more expensive throughout the economy. One of the chief defenders of the megabanks has been Josef Ackermann, CEO of Deutsche Bank until last year and also chair of the Institute of International Finance, which claimed that higher capital requirements would reduce economic output by a whopping 3.2 percent.
Anat Admati and Martin Hellwig have been tirelessly debunking the myth that higher capital levels will force banks to curtail lending and torpedo the global economy, most recently in their excellent new book, The Banker’s New Clothes. Some of the arguments against higher capital requirements are simply incoherent, like the idea that banks would be forced to set aside capital instead of lending it. (Capital is the difference between assets and liabilities, not cash that you put somewhere for safekeeping; were it not for reserve requirements, which are something else, a bank could lend out 100 percent of the money it can raise.)
Some contradict basic principles of corporate finance, like the idea that adding more equity capital increases banks’ cost of funding.* Yes, equity is usually more expensive than debt (meaning that investors demand a higher expected rate of return) because it is riskier (the range of possible outcomes is greater). But as you add equity, both the debt and the equity become less risky (since the firm is less leveraged), which reduces the cost of debt and the cost of equity. According to Modigliani-Miller, the two effects balance out perfectly, given a few assumptions.
In the real world, debt has a tax advantage (interest on debt is tax-deductible, while cash that is paid to shareholders or reinvested in operations is not), so increasing debt can reduce the overall cost of financing. But that’s a government subsidy. Lower leverage might increase banks’ funding costs, but would reduce taxpayer subsidies; to a first approximation, this would make society better off, not worse off (since subsidies are distorting).
Ackermann’s old bank was one of the most insistent that higher capital requirements were bad and that having to issue new stock was bad. Last summer, one of his successors said, “The bank aims to apply all capital levers at its disposal before considering raising equity from investors.”
Well, until last week. That’s when Deutsche Bank raised almost €3 billion by selling new stock. And what happened? Its stock closed up 3.7 percent.** (The S&P 500 was up 0.7 percent.)
What does that mean? Well, the big banks would have you believe that equity is “expensive,” so forcing banks to to issue more equity is bad for them and will increase their funding costs (which they will pass on to the rest of us). In this case, however, Deutsche Bank’s shareholders clearly thought that selling new stock was a good thing, since it made the bank more valuable. And it couldn’t possibly have raised the banks overall cost of capital (including both debt and equity): if you change your capital structure, your operations don’t change, and the value of your company goes up, that means that your cost of capital must have gone down. In other words, Deutsche Bank was leveraged past its optimal debt-to-equity ratio, even leaving aside societal considerations, so issuing new equity (raising capital, in banking parlance) was a good thing. It made both their debt and their equity less risky, reducing their cost of capital.
Of course, the big banks aren’t going to stop whining about capital requirements anytime soon. This is just further evidence that the global economy—and the banks themselves—would be just fine with more capital.
So who would be worse off? Well, anyone whose bonus is tied (asymmetrically) to return on equity, for starters.
* Unfortunately, “capital” means something different in the banking world than in the corporate finance world. In the former, capital is the difference between assets and liabilities, and is a rough synonym for equity—rough because, by regulation, some types of liabilities are counted as some types of capital. In corporate finance, capital refers to financing in general; the weighted average cost of capital, for example, includes the cost of both debt and equity.
** That was the 4 pm NYSE close, which came after the announcement of the stock sale, but before the bank reported earnings.
By James Kwak
A friend brought to my attention another example of how Excel may actually be a precursor of Skynet, after the London Whale trade and the Reinhart-Rogoff controversy. This comes to us in a research note from several years ago by several bioinformatics researchers titled “Mistaken Identifiers: Gene name errors can be introduced inadvertently when using Excel in bioinformatics.” The problem is that various genes have names like “DEC1″ or identifiers like “2310009E13.” When you important those text strings into Excel, by default, the former is converted into a date and the later is converted into scientific notation (2.310009 x 10^13). Since dates in Excel are really numbers behind the scenes (beginning with January 1, 1900), those text identifiers have been irretrievably converted into numbers.
This problem is related to what makes Excel so popular: it’s powerful, intuitive, and easy to use. In this case, it is guessing at what you really mean when you give it data in a certain format, and most of the time it’s right—which saves you the trouble of manually parsing text strings and converting them into dates (which you can do using various Excel functions, if you know how). But the price of that convenience is that it also makes it very easy to make mistakes, if you don’t know what you’re doing or you’re not extremely careful.
There are workarounds to this problem, but as of 2004, it had infected several public databases. As the authors write, “There is no way to know how many times and in how many laboratories the default date and floating point conversions to non-gene names have adversely affected an experiment or caused genes to ‘disappear’ from view.”
By James Kwak
Yesterday’s Wall Street Journal had an article titled “Foosball over Finance” about how people in finance have been switching to technology startups, for all the predictable reasons: The long hours in finance. “Technology is collaborative. In finance, it’s the opposite.” “The prospect of ‘building something new.’” Jeans. Foosball tables. Or, in the most un-self-conscious, over-engineered, revealing turn of phrase: “The opportunity of my generation did not seem to be in finance.”
We have seen this before. Remember Startup.com? That film documented the travails of a banker who left Goldman to start an online company that would revolutionize the delivery of local government services. It failed, but not before burning through tens of millions of dollars of funding. There was a time, right around 1999, when every second-year associate wanted to bail out of Wall Street and work for an Internet company.
The things that differentiate technology from banking are always the same: the hours (they’re not quite as bad), the work environment, “building something new,” the dress code, and so on. They haven’t changed in the last few years. The only thing that changes are the relative prospects of working in the two industries—or, more importantly, perceptions of those relative prospects.
Wall Street has always attracted a particular kind of person: ambitious but unfocused, interested in success more than any achievements in particular, convinced (not entirely without reason) that they can do anything, and motivated by money largely as a signifier of personal distinction. If those people want to work for technology startups, that means two things. First, they think they can amass more of the tokens of success in technology than in finance.
Second—since these are the some of the most conservative, trend-following people that exist—it means they’re buying at the top.
By James Kwak
In chapter 7 of White House Burning, we proposed to eliminate or scale back a number of tax breaks that I benefit from directly, including the employer health care exclusion, the deduction for charitable contributions, and, most importantly, tax preferences for investment income. We did not, however, go after tax breaks for retirement savings, on the grounds that Americans already don’t save enough for retirement.
Well, in my latest Atlantic column, I’m going after that one, too. I changed my mind in part for the usual reason—the dollar value of tax expenditures is heavily skewed toward the rich. But the other reason is that the evidence indicates that this particular subsidy doesn’t even do what it’s supposed to do: increase retirement savings. Instead, we should take at least some of the money we currently waste on tax preferences for 401(k)s and IRAs and use to shore up Social Security, the one part of the retirement “system” that actually works for ordinary Americans.
Of course, this isn’t going to happen anytime soon. President Obama proposed capping tax-advantaged retirement accounts at $3.4 million, which is a step in the right direction. ($150,000 would be a better limit, since most people reach retirement with far less in their 401(k) accounts.)* But even that was attacked by the asset management industry as theft from the elderly.
* Yes, I know about the issue of small business owners who only set up accounts for their employees because they want to benefit from them themselves. It’s a red herring. First, if an employer doesn’t have a 401(k), employees can contribute $5,000 to an IRA—and $5,000 is a lot more than most middle-income, small business employees are currently contributing. Second, the right solution would be to default everyone into a retirement savings account instead of relying on employers to decide whether or not to set up 401(k) plans.
By James Kwak
Matt Bai’s recent article on how Curt Shilling’s gaming company, 38 Studios, managed to secure a $75 million loan from the State of Rhode Island and then flame out into bankruptcy is a reasonably fun read. Bai’s main emphasis, which I don’t disagree with, is on Rhode Island’s Economic Development Corporation, which managed to invest all of its capital in a single company in a risky industry that, apparently, had failed to secure funding from any of the VC firms in the Boston area. Overall, this seems like another example of why government agencies shouldn’t be trying to act like lead investors.
But the story has another moral, which struck closer to home for me. Shilling apparently founded the company because he liked MMORPGs and because he wanted to become “Bill Gates-rich.” When the going got tough, in Bai’s words, Shilling “seemed to think that he could will Amalur into being, in the same way he had always been able to pitch his way out of a bases-loaded jam, even with a throbbing arm. His certainty reassured employees on Empire Street, who had no idea that he was running out of money.”
Software is hard. Really hard. And it’s even harder when you’re up against good competition. It has to be done right, and you cannot get it done twice as fast by working “twice” as hard. Too many software companies have been run into the ground by people who wanted to make a fortune but had no understanding of how software is built. Most of them are back-slapping frat boys who climbed the corporate hierarchy in sales, not world-famous athletes. But Curt Shilling, apparently, was just like them.
By James Kwak
I teach corporate law, and one of the topics in a typical introductory corporate law course is hostile takeovers. The central legal question is: to what extent is a board of directors allowed to undertake defenses against a takeover bid, even if (as is always the case) the potential acquirer is offering a premium over the current market price?
Whenever I teach one of these cases, I always bring up the nagging economic question: if the share price is $20, and Big Bad Raider is offering $30 in cash to each and every shareholder, where does the board get the chutzpah to claim that, under its leadership, the true value of the company is more than $30? (I understand the argument that Bigger Badder Raider might be convinced to pay more than $30, but the law, at least in Delaware, allows boards to use some takeover defenses to fend off any acquirer.) This always baffles me, but the law is premised on the idea that there is some fundamental value that is hidden deep inside the current board’s “strategic plans,” and that Big Bad Raider may rob shareholders of this fundamental value.
One of the intellectual rationales for takeover defenses, as for several other devices that insulate current boards from the outside world (such as staggered boards) is the idea that too much shareholder pressure can cause corporations to make decisions that are good in the short term but bad in the long term. Again, this raises the question of why board members (or the lawyers and academics who support them) should be trusted when they say that policy X, even though it increases the stock price in the short term, is really bad in the long term. The short-term price increase can only occur if the market, in aggregate, believes that policy X is good for the company in the long term. So, in essence, board members are claiming that they are smarter than the market. Yes, the market makes mistakes (I’m no believer in perfect efficiency), but you should rarely trust someone who claims to know when those mistakes occur.
In a new paper, Lucian Bebchuk attempts to dismantle “The Myth That Insulating Boards Serves Long-Term Value.” His argument come in at least three forms. The first is that even if it were true that shareholder pressure (whether actual shareholder activism, or board decisions taken because of the threat of shareholder activism) could produce decisions that are good in the short term and bad in the long term, this must be balanced against the other benefits of shareholder pressure. Activists will also favor decisions that are good in the short term and in the long term. Furthermore, shareholder pressure is what constrains managers who might otherwise use the corporation’s resources for their own ends—whether empire building, preparing campaigns for political office, or lavishly redecorating their executive suites.
The second is a review of empirical studies showing:
- Shareholder activist campaigns produce increases in short-term stock prices
- Those short-term increases are not reversed in the following five years
- Those increases are not reversed even after the initial activist fund sells its holdings (meaning that the people it sells to are not harmed)
- Activist campaigns result in improvements in operating performance over the next several years (often reversing previous declines)
- Various measures of board insulation, including staggered boards, are associated with lower stock returns and operational performance
The third is Bebchuk’s observation that, in a world of investment vehicles seemingly catering to every taste, there are no funds that attempt to make money by systematically betting against shareholder activists and holding their positions for the long term. If activism were bad, you would think someone wuld be betting real money on that principle. Not only that, but the investment funds that do have a long-term horizon, such as CALPERS, have voted consistently against board insulation, and continue to do so.
None of this should be surprising. Even if it were possible for some clever hedge fund manager to pressure a company into doing things that are good in the short term but bad in the short term, what is the alternative? Without accountability to shareholders, why would we expect board members to serve any interests other than their own? The typical independent board member is the CEO or former CEO of some other company. His reputation depends on that company and a large chunk of his net worth is tied up in that company’s stock—not the company on whose board he sits. What penalty is there for being a director of a failing company? None. (See Rubin, Robert.) If we insulate boards from shareholder pressure, we are essentially counting on directors’ altruistic feelings toward shareholders. Hope is not a strategy.
But this myth will no doubt persist. Why? One reason is that, in academia (legal academia, at least), there is a market for entirely theoretical models that are devoid of any empirical support. More important, the myth of board insulation benefits corporations’ current directors and executives by freeing them to pursue their own interests.
Among the major supporters of board insulation are the U.S. Chamber of Commerce and the Business Roundtable. These organizations often hold themselves out as defenders of capitalism and free markets. But on this issue, it’s clear that they are not taking the side of corporations themselves or their shareholders. Instead, they are on the side of the select few who run those corporations. The ability of that privileged elite to mobilize corporate resources to protect themselves from their own shareholders is what ensures that the myth will persist.
By James Kwak
While the spreadsheet problems in Reinhart and Rogoff’s analysis are the most most obvious mistake, they are not as economically significant as the two other issues identified by Herndon, Ash, and Pollin: country weighting (weighting average GDP for each country equally, rather than weighting country-year observations equally) and data exclusion (the exclusion of certain years of data for Australia, Canada, and New Zealand). According to Table 3 in Herndon et al., those two factors alone reduced average GDP in the high-debt category from 2.2% (as Herndon et al. measure it) to 0.3%.*
In their response, Reinhart and Rogoff say that some data was “excluded” because it wasn’t in their data set at the time they wrote the 2010 paper, and I see no reason not to believe them. But this just points out the fragility of their methodology. If digging four or five years further back in time for just three countries can have a major impact on their results, then how robust were their results to begin with? If the point is to find the true, underlying relationship between national debt and GDP growth, and a little more data can cause the numbers to jump around (mainly by switching New Zealand from a huge outlier to an ordinary country), then the point I take away is that we’re not even close to that true relationship.
In their response, Reinhart and Rogoff also argue that it is correct to weight by country rather than by country-year. Their argument is basically that weighting by country-year would overweight Greece and Japan, which had many years with debt above 90% of GDP. Herndon et al. recognize this point:
“RR does not indicate or discuss the decision to weight equally by country rather than by country-year. In fact, possible within-country serially correlated relationships could support an argument that not every additional country-year contributes proportionally additional information. . . . But equal weighting by country gives a one-year episode as much weight as nearly two decades in the above 90 percent public debt/GDP range.”
Both weighting methods are flawed. (Country-year weighting is only flawed if there is serial correlation, which there probably is; if the U.K.’s nineteen years with debt greater than 90% of GDP were independent draws, then it should be weighted 19 times as much as a country with only one such year.) But this brings me to the same point as above: if your results depend heavily on the choice of one defensible variable definition rather than another, at least equally defensible definition, then they aren’t worth very much to begin with.
Here’s another way to put it. Let’s concede the weighting point for the sake of argument. If Reinhart and Rogoff had not made any spreadsheet errors in their original paper—that is, if the only factors at issue were country weighting and data exclusion—they would have calculated average GDP growth in the high-debt category of 0.3%. If they then added the additional country-years as they expanded their data set, while sticking with their preferred weighting methodology, that figure would have jumped to 1.9%—and the 90% “cliff” would have completely vanished. (See Herndon et al., Table 3.) What happened is that Reinhart and Rogoff’s choice to weight by country rather than country-year makes their method extremely sensitive to the addition of new data.
The question to ask is this: If a method produces results that can drastically change by the addition of a few more data points, are those results worth anything? The answer is no.
Update: Or, as Mark Thoma said (not necessarily about Reinhart and Rogoff directly):
“It’s even more disappointing to see researchers overlooking these well-known, obvious problems – for example the lack of precision and sensitivity to data errors that come with the reliance on just a few observations – to oversell their results.”
By James Kwak
One more thought: In their response, Reinhart and Rogoff make much of the fact that Herndon et al. end up with apparently similar results, at least to the medians reported in the original paper:
So the relationship between debt and GDP growth seems to be somewhat downward-sloping. But look at this, from Herndon et al.:
Yes, we still have that downward slope. But two things:
1. There’s no cliff at 90 percent, which was the central finding of the original paper. This is the second sentence of that paper:
“Our main result is that whereas the link between growth and debt seems relatively weak at ‘normal’ debt levels, median growth rates for countries with public debt over roughly 90 percent of GDP are about one percent lower than otherwise; average (mean) growth rates are several percent lower.”
2. Aren’t we only supposed to be interested in empirical results that are significant? What the figure from Herndon et al. says, in their words, is this:
“Between public debt/GDP ratios of 38 percent and 117 percent, we cannot reject a null hypothesis that average real GDP growth is 3 percent.”
I find it hard to agree with Reinhart and Rogoff when they say, “We do not, however, believe this regrettable slip affects in any significant way the central message of the paper.”
By James Kwak
In 1975, Isaac Ehrlich published an empirical study purporting to show that the death penalty saved lives, since each execution deterred eight murders. The next year, Solicitor General Robert Bork cited this study to the Supreme Court, which upheld the new versions of the death penalty that several states had written following the Court’s 1973 decision nullifying all existing death penalty statutes. Ehrlich’s results, it turned out, depended entirely on a seven-year period in the 1960s. More recently, a number of studies have attempted to show that the death penalty deters murder, leading such notables as Cass Sunstein and Richard Posner to argue for the maintenance of the death penalty.
In 2006, John Donohue and Justin Wolfers wrote a paper essentially demolishing the empirical studies that claimed to justify the death penalty on deterrence grounds. Donohue and Wolfers attempted to replicate the results of those studies and found that they were all fatally infected by some combination of incorrect controls, poorly specified variables, fragile specifications (i.e., if you change the model in minor ways that should make little difference, the results disappear), and dubious instrumental variables. In the end, they found little evidence either that the death penalty reduces or increases murders.
Now the macroeconomic world has its version of the death penalty debate, in the famous paper by Carmen Reinhart and Ken Rogoff, “Growth in a Time of Debt.” Thomas Herndon, Michael Ash, and Robert Pollin released a paper earlier this week in which they tried to replicate Reinhart and Rogoff. They found two spreadsheet errors, a questionable choice about excluding data, and a dubious weighting methodology, which together undermine Reinhart and Rogoff’s most widely-cited claim: that national debt levels above 90 percent of GDP tend to reduce economic growth.
I’ve never been a big fan of Reinhart-Rogoff. In White House Burning, we cited their main result but added (p. 151),
“It is hard to know what it means for the United States because even their findings for advanced economies are the averages over sixty years of twenty different countries—nineteen of which did not enjoy the particular benefits of issuing the world’s reserve currency.”
Now it turns out that the averages were wrong. To see how, you can read Herndon et al. (it’s very short and readable) or the excellent post by Mike Konczal. If you don’t want to do that, there are four basic issues:
- The 2010 Reinhart and Rogoff paper excluded data for certain countries and years that, when included, increase mean growth for debt levels greater than 90 percent. (In their response, Reinhart and Rogoff say that those country-years were not available when they did the original paper.)
- The results were averaged by country and then the country averages were themselves averaged. The problem here is that, for example, New Zealand only had debt above 90 percent in one year, and in that year its growth was –7.6 percent—but since only ten countries ever had debt over 90 percent, that outlier constituted one-tenth of the average.
- Their spreadsheet formula accidentally omitted several countries; including those countries increases the average growth level for debt levels over 90 percent.
- One figure—New Zealand’s—was mistranscribed from one spreadsheet to another; correcting that mistake slightly raises the average growth level.
Leaving aside the Excel problem for now, I think this points to a weakness of the original methodology. The paper was, technically speaking, extremely simple: take all the country-years, divide them into four groups by debt level, and average within each group. I thought at the time that if an economics graduate student tried to submit this as part of a dissertation, it would never be accepted. I remember looking at this chart and thinking: So what? Does that prove anything? How do I know that this is significant—especially since the mean and the median are so different? (Usually if the mean is very different from the median, it is being dragged up or down by some huge outlier.)
Like most people, I think, I thought they were averaging by country-year, not country. Averaging by country obviously makes the results even more sensitive to outliers. Reinhart and Rogoff claim in their response that this is a standard approach; maybe it is. But this is what the paper says (emphasis added):
“The annual observations are grouped into four categories, according to the ratio of debt to GDP during that particular year as follows: years when debt to GDP levels were below 30 percent (low debt); years where debt/GDP was 30 to 60 percent (medium debt); 60 to 90 percent (high); and above 90 percent (very high). The bars in Figure 2 show average and median GDP growth for each of the four debt categories. Note that of the 1,186 annual observations, there are a significant number in each category, including 96 above 90 percent.”
I think the most natural reading of this passage is that they were averaging individual country-year observations, not countries.
The other surprising thing, of course, is that they were using Excel (or some other spreadsheet program)—something that I wrote about recently. The attraction of Excel is that it’s visually intuitive, it’s powerful, and it’s fast. The problem is that it’s very easy to make mistakes, it doesn’t have any usable kind of versioning, and there’s no good way to proofread or test it. As Herndon et al. write with considerable understatement, “For econometricians a lesson from the problems in RR is the advantages of reproducible code relative to working spreadsheets.” And if you’re going to use Excel for anything important (like counseling economic policymakers), you’d better be damn good at it. For example, you shouldn’t be manually copying numbers from one tab to another (an error shared by Reinhart and Rogoff with the risk management department of JPMorgan’s Chief Investment Office).
This raises another issue. Programming is getting easier and easier, but it’s hard to do well. Economics these days depends heavily on programming. It seems to problematic to me that we rely on economists to also be programmers; surely there are people who are good economists but mediocre programmers (especially since the best programmers don’t become economists). If you crawl through a random sample of econometric papers and try to reproduce their results, I’m sure you will find bucketloads of errors, whether the analysis was done in R, Stata, SAS, or Excel. But people only find them when the stakes are high, as with the Reinhart and Rogoff paper, which has been cited all around the globe (not necessarily with their approval) as an argument for austerity.
By James Kwak
I’m no fan of the genre of CEO interviews published in the Sunday Times. But this past Sunday’s CEO-of-the-week column featured Marcus Ryu, a good friend and someone I’ve worked with at three different companies.
Marcus is not only very smart and someone who really knows what it’s like to build a company from the ground up, but he’s also someone who has thought very hard about what it takes to succeed as a company and what a company needs in its CEO. Unlike many CEOs, he doesn’t believe in gut instinct or the magical ability to judge character. He believes that success in business is hard and, as I’ve heard him say many times, there never is a day when suddenly everything becomes easy. If you are or want to be a CEO someday, I recommend it.
By James Kwak
Now that I’m a law professor, people expect me to write law review articles. There are some problems with the genre—not least its absurd citation formatting system and all the fetishism surrounding it—but it’s not a bad way to make arguments about how and why the law should change in ways that might actually help people.
That was my goal in my first law review article, “Improving Retirement Options for Employees, which recently came out in the University of Pennsylvania Journal of Business Law. The general problem is one I’ve touched on several times: many Americans are woefully underprepared for retirement, in part because of a deeply flawed “system” of employment-based retirement plans that shifts risk onto individuals and brings out the worse of everyone’s behavioral irrationalities. The specific problem I address in the article is the fact that most defined-contribution retirement plans (of which the 401(k) is the most prominent example) are stocked with expensive, actively managed mutual funds that, depending on your viewpoint, either (a) logically cannot beat the market on an expected, risk-adjusted basis or (b) overwhelmingly fail to beat the market on a risk-adjusted basis.
People in all fields often say that some outcome is bad—here, plan participants pay a weighted average of 74 basis points in expenses for their domestic stock funds, not counting the extra transaction costs incurred by actively managed funds—and say that someone should change the law. While law professors sometimes say that the solution is for Congress to pass a new statute, there are other ways of accomplishing an objective. In the paper I use a common device in the profession: I argue that including actively managed funds, in asset classes where everyone knows that index funds are cheaper and likely to do better than most active funds, may already be against the law (depending on how carefully those funds are selected). In particular, it violates the existing fiduciary duty of employers and plan trustees to invest participants’ money prudently.
The argument is moderately involved, and involves statutory and regulatory detours into such things as section 404(c) of ERISA and the corresponding safe harbor implemented by Department of Labor regulations. But the ultimate point is that plan participants should be able to sue their plan fiduciaries for breaching their duties, and courts could already rule in their favor. Since the law is admittedly not entirely clear-cut, I recommend that the Department of Labor should clarify its guidelines under ERISA (which could be done without Congressional action) to make it clear that actively managed funds create potential liability for plan fiduciaries. The likely result is that most plans would shift to index funds in order to avoid liability, investor costs would fall by about 80 percent, and, in aggregate, investors would do slightly better than before even on a gross (before fees) basis.
This change would also solve the problem of plan trustees who also happen to be mutual fund companies stuffing retirement plan investment menus with their own funds—particularly their most poor-performing funds—which is the problem I wrote about in my Atlantic column last week.
I should add that I do understand that there probably are some fund managers who can beat the market on an expected, risk-adjusted basis. I’ve seen the papers, and I’m convinced that there are more people who beat the market than can be explained by dumb luck.* (There are also far more people who trail the market than can be explained by dumb luck.) But the fact is that, in aggregate, the pursuit of “alpha” is value-destroying, whether the search is conducted by individual investors or by trustees of employer-sponsored retirement plans. The government should not be subsidizing a vast operation that wastes ordinary people’s money. Index funds would give Americans retirees more money and asset management companies less money. From a public policy perspective, that’s a good thing.
* I took empirical law and economics with Ian Ayres and John Donohue. In one class, Ian asked if any of us could think of a policy issue on which we had changed our position because of an empirical paper. Most people had trouble thinking of one. That is, if you think that the minimum wage increases unemployment, you will not be convinced otherwise by any number of papers, and vice versa. Whether there are people who can beat the market is one big issue on which I have changed my mind. I used to believe that no one could beat the market, essentially for the reasons outlined by Burton Malkiel in A Random Walk Down Wall Street. Now I think there are people who can beat the market, but they are hard to find and for most people it’s not worth trying.
By Simon Johnson, April 1, 2013
In both 13 Bankers (2010) and White House Burning (published 2012, paperback just came out) James Kwak and I weighed the merits of going back on a global gold standard. In those books, we ended up siding with the prevailing fiat currency system – in which money is backed by nothing more than your confidence in central banks.
In the light of recent events – in the US and in Europe – I feel we should reconsider the arguments. On balance, I am now in favor of going back on gold for ten main reasons.
First, gold worked well for Winston Churchill in 1925.
Second, we have all had about as much as we can take with regard to us – i.e., the taxpayer – bailing out banks. Let’s go back on gold and turn the tables, as Grover Cleveland did in 1895, when JP Morgan (the man) was forced to bailout the US government with the famous “gold loan”.
Of course, the bankers could let us just go bust. But that would hardly be in their best interests. And the beauty of the gold standard is that it ties the hands of the government – forcing big banks to either lend at generous terms or watch their franchise value collapse (with the economy).
Third, eurozone officials have created serious confusion on the order of priority for claims when a European bank gets into trouble. With the gold standard it’s easy in a way that everyone can understand – no one gets anything when a bank collapses (and even less when world trade disintegrates).
Of course, in order to be truly effective as a way to stabilize the world’s economy, the return to gold would have to be combined with making deposit insurance illegal everywhere other than in Germany. The good news is that on the latter point, Jeroen Dijsselbloem and the Eurogroup of finance ministers are already far down the garden path.
Fourth, let’s face it – almost all the growth the world has experienced since 1945 has proved ephemeral. And inflation has increased almost without limit since President Nixon broke the final bonds between dollar and gold in 1971. We have experienced undeniably the worst 60 years in human economy history – all since we turned our backs on gold. The sirens of gold are just as right now as they have always been.
Fifth, of course the nay-sayers always bring up the Great Depression, and argue that the gold standard played an integral role in both the banking collapses and the breakdown of international payments and trade. But seriously – how many of today’s supposedly astute observers were really there, and therefore know anything at all about what happened?
We should all apply the principles recently established by JP Morgan (the company) with regard to studies of “too big to fail” subsidies – if there is any margin of error in the estimates of any kind, we should disregard the evidence fully. This will greatly simplify many things, including science, the pages of our leading newspapers, and refereeing for academic journals.
In any case, reports of the severity of the economic slowdown in the 1930s have been greatly exaggerated. Among other things, that decade provided ample time to rest up before the hard working 1940s.
Sixth, with regard to the conventional concern that “there is not enough gold to accommodate world growth without a falling price level”, we should simply apply some of the more compelling modern financial innovations. We can create synthetic gold – for example using iron pyrite – and have governments trade that, building on the “success” of existing gold exchange-traded products that do not in fact involve any gold.
Seventh, the fact that high profile people such as Glen Beck endorse gold should encourage us in the same direction. After all, Mr. Beck is a busy person with many well remunerated activities. If he chooses to spend time with gold, the market is telling us something.
Eighth, you should read this book by Gillian Tett. The title tells you everything you need to know about many things.
Ninth, while the Financial Services Roundtable has not weighed in yet on this issue, once they figure out the subsidies angle, they will be all over it (hint: those gold loans to the government are highly profitable and debtors more generally get crushed as a matter of routine). Anyone opposing the lobby will be ridiculed, rolled over, or bought out, so why not get on board now?
Tenth, currency convertibility should be suspended every April 1st at least momentarily. That might help remind us of the crazy things we have done in pursuit of a supposedly more stable currency and more prosperous financial system.
Correction: due to an editing error, the original version of this post did not make it sufficiently clear that the end of Bretton Woods broke the gold-dollar link and ushered in the chaos of the modern world. This has now been corrected. (h/t: David Stockman)
By James Kwak
Back in the heady days of the financial crisis, I used to recommend Planet Money as a good way for non-specialists to learn about some of the basic economic and financial issues involved. Over the years, I’ve become less thrilled with the show, for reasons that will become obvious below. In particular, whenever Ira Glass dedicates a full This American Life episode to a Planet Money story, I cringe nervously, but I listen to it anyway, since, well, I’ve listened to just about every TAL episode ever, and I’m not about to stop now.
But I can’t let this weekend’s episode, on Social Security disability benefits, pass without comment. In it, Chana Joffe-Walt “investigates” the Social Security disability program, first by visiting Hale County in Alabama, where 25% of all working age adults are receiving disability benefits, and then by talking to different types of people (lawyers and public sector contractors) who help people apply for benefits.
The worst part of the episode comes at the end, where Joffe-Walt claims that the Supplemental Security Income program, by paying benefits to poor families with disabled children, discourages children from doing well in school and from seeking work as adults, because either would cause them to lose their benefits. (“One mother told me her teenage son wanted to work, but she didn’t want him to get a job because if he did, the family would lose its disability check.”) On that topic, I’ll just outsource the rebuttal to Media Matters, citing the National Academy for Social Insurance and the Center for Budget and Policy Priorities, among others.
But the story as a whole suffers from the same kind of facile extrapolation from the individual story to national policy. The first half (on Hale County) winds up to the following punch line: There are lots and lots of people receiving disability benefits, and they receive lots and lots of money in aggregate, because there aren’t enough jobs where you can sit down. Or, rather, that’s Joffe-Walt’s conclusion from talking to people in Alabama: the reason they can’t even imagine working with back pain, and she can, is that they don’t see any jobs around where you can sit down.
Only then, as she pulls back the camera, the problem becomes the decline of American manufacturing, lost jobs, and newly unemployed factory workers without the skills they need to find new jobs. But which one is it? Is it too many jobs where people stand up (the problem in Hale County) or not enough (the decline of manufacturing)? Probably the latter: the story makes more sense as one where one set of jobs goes away, leaving people unable to get the jobs that are now available, and they turn to disability insurance instead. But that doesn’t explain Hale County, where there are no sit-down jobs.
Then there’s the weird way the whole episode treats welfare reform. “Ending welfare as we know it” comes up in a couple of places: first as a positive example of what we should be doing (moving people from passively receiving benefits to working), and later as a cause of the rise in disability claimants. On the latter point, Joffe-Walt cites the fact that federal welfare funding declined, shifting the burden to the states, which gave the states the incentive to push people off welfare and onto disability. True enough. But she overlooks the big story. Federal welfare reform set lifetime benefit limits, meaning that, after a few years, you get completely cut off. After some welfare recipients got jobs, this was the factor that ensured that welfare rolls would go down. Many people who couldn’t work and got welfare now can’t work and get disability. That’s a good thing—especially if the alternative is pushing them onto the streets.
Leaving all that aside, though, the story boils down to the idea that disability benefits are valuable, so people are trying to get them, framed as some sort of epiphany. “Holy cow, Batman, incentives matter!” But this is just social insurance 101. When designing programs that help poor and disadvantaged people, we already try not to reduce their incentives to work too much. That’s why programs phase out over income ranges, that’s why we have the Earned Income Tax Credit, that’s why we have a debate every time long-term unemployment benefits have to be reauthorized, and so on. Is this some sort of national scandal? No. There are people who are disabled and can’t work, they are entitled to a decent existence, the rest of us who can work should pay for it, and there is going to be a gray area where some people will be motivated to try to get into the program. That’s life.
And is the existence of disabled people some sort of huge new insight into the evolution of the American economy? Again, no. Joffe-Walt claims that the 14 million people receiving benefits outnumber the people who are unemployed and are completely invisible to economists. It’s true the newspapers don’t publish monthly disability figures like they do unemployment statistics. But look at this:
That’s the employment-to-population ratio, from the incredibly useful Calculated Risk. Since the denominator is all working-age people, this chart reflects any growth of disability recipients. And do you see some huge invisible force that is pushing down the employment ratio? I don’t think so. This chart tells the usual story we all know. The economy was very strong in the late 1990s, probably unsustainably so (with unemployment below the long-term sustainable rate, according to the macro guys). We had a recession, and then employment recovered to roughly the sustainable rate. Then we had the financial crisis and a huge fall in employment. Sure, a rise in disability rates could mean the employment-to-population ratio is lower than it otherwise would have been. But it’s not a new way of thinking about the economy. And if we’re getting better at diagnosing mental illness and providing benefits to people with mental illness, that’s a good thing.
I was going to end by trying to explain why I love This American Life and used to like Planet Money (see, for example, the episode where they talked to a chemist about why gold ends up becoming the basis for money in many developing societies) but don’t like episodes like this one. But Ira Glass is one of the savviest people in radio or any medium, so he can figure out what’s going on with the show he co-owns.
By James Kwak
From a Wall Street Journal article about The Children’s Investment Fund:
“[The fund] lost 43% in 2008, among the worst losses by a hedge-fund that year.”
“Both investors and employees defected during the crisis, with top talent leaving to start hedge funds of their own.”
“But with a 30% return in 2012 and a 14% gain this year, TCI has crossed its high-water mark.”
Makes you think.
By Simon Johnson
On Thursday, March 21, Sir John Peace conceded that he lied to investors on March 5, 2013 when he said of Standard Chartered Bank,
“We had no willful act to avoid sanctions; you know, mistakes are made – clerical errors – and we talked about last year a number of transactions which clearly were clerical errors or mistakes that were made…”
Specifically, he now says that these remarks were “both legally and factually incorrect” because Standard Chartered had previously conceded that it deliberately laundered money.
In plain English, what Sir John said is called lying. Or, if you prefer the language of securities lawyers, he engaged in deliberate misrepresentation. He also violated Standard Chartered’s deferred prosecution agreement with US authorities.
Here is the full statement today.
Sir John should resign immediately as chairman of Standard Chartered.
Look carefully at the dates. He lied to investors on March 5 but did not issue this correction until March 21 – apparently after US regulators threatened the bank with renewed prosecution.
If the March 5 remarks were a genuine mistake, Sir John could have retracted them the same day. March 6, 7, and 8 were also pretty much wide open for retractions.
Standard Chartered – in the person of Sir John – has deceived prosecutors, regulators, and the investing public. This is outrageous executive behavior and it cannot be tolerated in a company that holds a US banking license.
If Sir John does not resign, he should be removed by the board of Standard Chartered.
If the bank’s board refuses to act, this will signal that it is not competent to oversee the operations of a global bank.
Senator Elizabeth Warren asked recently: before you lose your banking license,
“How many billions of dollars do you have to launder for drug lords?”
Fed Governor Jerome Powell replied (with the wording from the same Politico article),
“I’ll tell you exactly when it’s appropriate” to consider pulling a bank’s license, he said. “It’s appropriate when there’s a criminal conviction.”
Standard Chartered Bank signed a deferred prosecution agreement which, among other things, requires it to take responsibility for its previously illegal sanction-busting actions.
If the chairman publicly and deliberately denies responsibility – in explicit violation of this agreement – he should step down or be forced out. How can the authorities now have any reasonable confidence that Standard Chartered will comply with the rest of its agreement, including,
“Under the cease and desist order, Standard Chartered must improve its program for compliance with U.S. economic sanctions, Bank Secrecy Act, and anti-money-laundering requirements.”
If Sir John does not go, Mr. Powell and his colleagues should pull the bank’s license.
If under such circumstances the Board of Governors of the Federal Reserve finds it cannot take action, then we must consider amending the Federal Reserve Act.
By James Kwak
Ezra Klein yesterday highlighted one of the underlying problems with even apparently informed discussions of deficits and the national debt: the CBO’s “alternative fiscal scenario.” As opposed to the (extended) baseline scenario, which simply projects the future based on existing law, the alternative scenario is supposed to be more realistic. And it is more realistic in some ways: for example, it assumes that spending on Afghanistan will follow current drawdown plans, not a simple extrapolation of the current year’s spending. But the problem is that it has become excessively conservative in recent years—to the point where, as Klein says, “Policy makers, pundits and others almost exclusively use this model to stoke Washington’s deficit anxieties.”
The basic problem is that the alternative fiscal scenario simply assumes, without further support, that laws will mysteriously change in ways that reduce tax revenue and increase spending (relative to current law). As I put it a while ago,
“ The definitive report on our long-term budget gap implicitly assumes that we do nothing about that budget gap — that we keep cutting taxes and blocking spending cuts at every opportunity.”
Or, in other words, it assumes that Republicans win every fight over taxes and Democrats win every fight over spending.
Things weren’t always this way. For example, the immaculate assumption that tax revenues will remain constant as a share of the economy—despite, for example, real bracket creep, which moves people into higher tax brackets as their inflation-adjusted incomes rise—was only introduced in the past few years: as recently as 2009, the alternative scenario did not assume these mysterious tax cuts. (See this earlier blog post for an explanation.)
I didn’t realize until reading Klein’s blog post that the CBO changed its spending assumption just last year. In 2011, this is how it projected spending other than on Social Security and health care: “Beyond 2021, other spending stays at the same share of GDP projected for 2021 . . .” And this is how it changed in 2012: “For projections beyond 2022, CBO assumed that such spending would, during a five-year transition period, gradually return to its average share of GDP during the past 20 years.” The net difference from this one assumption is about 2 percent of GDP. This is a huge amount—equivalent, for example, to all of the growth in Medicaid, the Children’s Health Insurance Program, and health insurance subsidies over the next twenty-five years.
It’s almost as if, as Congress does things that reduce the long-term national debt (like the Budget Control Act of 2011, which may be a stupid bill, but did reduce the debt under current law), the CBO moves the goalposts further away so the problem remains the same size. This is why, in White House Burning, we adjusted the CBO’s projections, and we showed scenarios with and without the Bush tax cuts (rather than simply assuming, as most people did, that the Bush tax cuts would be made permanent for everyone).
As Klein says,
“Because everyone was used to a fake baseline that assumed their full extension, a supposedly deficit-obsessed Congress managed to resolve the so-called ‘fiscal cliff’ in January by passing a huge tax cut that added trillions to deficits while calling it, amazingly, a fiscally responsible tax increase.”
If only more people had pointed that out beforehand, maybe Congress wouldn’t have been able to get away with that one.