Saturday, June 20, 2009

A Regulatory System as a Competitive Advantage

One of the most central themes in how I think about the interaction between economics and politics is the importance of the rules governing capitalism, in order for capitalism to reach its full potential and serve society in the best way it can.

The case for a well regulated economy is quite simple when you look at the alternatives:

Socialism does not work because no one can ever know enough about human economic behavior in order to plan everything in advance, and an unregulated economy does not work because that leads to monopolies, oligarchies and crime, and makes a democratic process impossible.

The economic crisis has now reached a stage where the role of regulation is becoming apparent for the U.S. financial system. More specifically, I argue that U.S. financial companies are now doomed to failure in competition with foreign financial companies because they have not, and will not, be adequately regulated.

A recent article in the New York Times highlights this problem. The article explains that, as a result of the crisis, the influence of British, German, Swiss and Japanese banks is growing on Wall Street and in the U.S. in general. As Eugene A. Ludwig explains, this could have something to do with regulation:

“What worries me is the competitive edge that non-U.S. banks have vis à vis U.S. banks,” said Eugene A. Ludwig, the comptroller of the currency under President Bill Clinton, who now runs the Promontory Financial Group, a Washington bank consultant group. “Non-U.S. banks generally operate under more coherent regulatory structures than U.S. banks do, which creates imbalances that non-U.S. banks can exploit, especially at a time when their U.S. counterparts are operating under extraordinary constraints.”

In short, the U.S. economy has again reached a stage where it is a wild west-style economic system that is essentially unregulated. The little regulation that exists is highly fragmented, where different financial regulators oppose each other and where financial companies can choose their own regulator, invariably picking the one that enforces the least amount of regulation.

By contrast, financial institutions in the EU operate in a much more comprehensive economic framework in general. A lot of this has to do with the work that was done in anticipation of the introduction of the Euro as the common currency. More specifically, Germany refused to go along with the project unless the German brand of stable capitalism became central to the operation of the Euro zone.

Some of the best examples of this are:

- The European Central Bank has a single mandate: to fight inflation ONLY, and not concern itself with economic growth, and to be wholly independent from politicians. A very helpful international comparison of central banks can be accessed here:

- Antitrust laws and fierce enforcements of those laws are meant to ensure that the “too-big-to-fail” problem does not occur.

- Bank capital requirements are higher, and additional credit rating standards are imposed on complex financial products such as mortgage-backed securities.

In addition to these rules, several countries in the EU have other regulatory advantages over those that U.S. companies have, such as:

- A single financial regulator with clear, often internationally harmonized rules (such as Basel I and II, and multiple EU agreements)

- Unlimited liability instead of limited liability. In many countries in the EU, financial executives are personally liable for what happens in their companies. This obviously creates a different risk-taking climate.

- The right of the government to take over non-banking institutions such as mutual fund companies and hedge funds in order to protect investors, much like the FDIC takeover authority in the U.S..

What I have listed above under the heading of “regulatory advantages” may seem like a not so coherent list of issues, but what these things lead to in terms of the role of financial institutions in the economy is one central thing:

A focus on long-term profits instead of short-term profits

It would be very hard to argue that a focus on short-term profits is a good thing from a societal economic perspective, or indeed from any perspective other than that of the individual financiers.

A focus on short-term profits, I argue, leads to large-scale “looting”, which I explained in
this blog post on circular looting.

Needless to say, the focus that American financial institutions have on short-term profits, as a result of the inadequate regulatory framework, is the explanation as to why U.S. companies are being challenged by foreign ones now. U.S. companies are simply not equipped to compete in the long term. When the looting is done, the companies have nothing to show for.

What we are seeing right now is a failure of the central functions of capitalism. Because the system has been under-regulated, if not unregulated, the good dynamics of capitalism where efficiency, choice, competition and innovation are central components have been shoved aside, in favor of outright looting.

Presently, U.S. financial companies appear to be doing better, but make no mistake, this is only an illusion. The suspension of the mark-to-market rule has enabled them to grab numbers out of thin air and make it look like they’re profitable again. Also, because the federal government is lending money to them extremely cheaply, on a highly unsustainable level I might add, these companies are currently experiencing some short-term gains.

As soon as the government realizes that the enormous subsidies cannot go on anymore, U.S. financial companies will start to tumble once again. My guess is that that will happen within 1-2 years.

The New York Times article gives the example of the U.S. auto industry not being able to compete with the Japanese auto industry, which I think is an excellent example. Because the U.S. government failed to implement proper standards for automobiles there was seemingly no need to change anything, you just keep churning out new cars for quick profits.

One day, though, the confidence of the public was used up, and the U.S. auto industry as we knew it died. In a not so distant future, Bank of America will be the new GM, and Deutsche Bank will be the new Volkswagen.

Moreover, I advise that the winner-takes-all voting system should be destroyed.


Anonymous said...

I'm confused. I thought the government was being accused of over regulation in order to control the excesses of the banks?

Now you are saying that they are still being unregulated?

Anonymous said...

If we move to a system of regulation like the europeans, wouldn't that mean that americans will have less access to loans and things like credit cards because banks will have to be more cautious about who they lend money to?

If that happens, america's economy will be completely transformed because 70% of it is based on consumer spending. what will replace this consumer spending? manufacturing jobs? but american workers can't compete with lower wage workerss from other countries! so, no manufacturing jobs will return. then what?

At least the europeans have a social welfare system, with 3 week vacation packages, maternity leave, free healthcare,etc, etc....they can "survive" without jobs. Americans can't.

Jacob said...

The commonly mentioned stat that "70% of the economy is made up by personal comsumption" is not well understood. It does not mean that 70% of the money is coming from consumers, simply that this is the way the cake is sliced. In many countries in Europe government spending is about 40% of the total spending, whereas business and personal spending makes up the rest. The only real difference between the two is that the U.S. government spends less than half of what most other governments spend, and that is why the U.S. has no safety net.

So, your scenario is not directly relevant, although more regulation would still lead to less credit and less consumption.

And yes, what I advocate is an economy where you "spend what you have" instead of taking loans. I believe that loans should be for businesses and for buying homes, but not for buying TVs or food.

I strongly believe that the U.S. must create a social safety net, for humane reasons and for business reasons.

Anonymous said...

In terms of this 70%, are you saying that the government accounts for 20% of the spending (whereas in europe it's 40%) and that the other 50% is then spread between what businesses are spending and what consumers are buying?

So, 20% government, 30% business and 20% consumers spending or some such scenario?

Jacob said...

yes, that's right

Anonymous said...

Can someone please explain to me how Goldman Sachs and JPMorgan were able to report profits in such a short period of time?

Anonymous said...

Here's a really good article on Goldman Sachs and their most recent adventures: