The Continuing Scourge of Too Big To Fail

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I had the distinct pleasure of hearing Simon Johnson, an economist and professor of entrepreneurship at MIT's Sloan School of Business (and former Chief Economist for the International Monetary Fund) speak last night at a wonderful event produced by Zocalo Public Square, a local LA non-profit public affairs forum.  Johnson also is the author (with James Kwak) of the recently published 13 Bankers, about the financial crisis and how to stop another crisis from occurring again, and blogs at the Baseline Scenario, a blog I've been following for months and have linked to several times previously.

Johnson spoke quite emphatically about the need for fundamental financial reform, not as a partisan of any stripe (indeed, he claims to be a free-marketer more than anything else) but because the current financial system we have is not actually "capitalism" per se.  Why is that?  Well the phrase "too big to fail" (TBTF) signifies the problem at the center of our financial crisis, and within TBTF lies the potentiality for a future crisis even larger than the current one.  

First of all, what is "too big to fail"?  While we've certainly all heard the term bandied about since September 2008, I imagine there is some confusion out there.  The concept is that the financial institutions that were bailed out through the Troubled Assets Relief Program (TARP) instituted by former Treasury Secretary Hank Paulson, Federal Reserve Chair Ben Bernanke, and President Bush, among others, simply held too many assets in our economy, and were too interconnected, to be allowed to declare bankruptcy.  If the financial institutions (banks, such as Bank of America, and investment houses, such as Goldman Sachs) were allowed to fail, as Lehman Brothers was, then those failures would lead to an unprecedented breakdown of the global financial markets.  Furthermore, due to the interconnectedness of the various players in the markets, the thinking goes, the failure of one of the financial institutions could lead to the failure of others.  Why the institutions were all so interconnected is perhaps beyond the scope of what I'd like to say here today (in interests of length), but suffice it to say that AIG is one of the primary sources of the interconnectedness, and Goldman Sachs is another.

How did we get to this point where the banks were so big and interconnected that they could not fail without bringing down the global economy?  Well, I could try to explain, but I think I'll let Prof. Johnson explain, with the help of Steven Colbert:

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Simon Johnson
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Prof. Johnson raises a few points that are worth elucidating in that segment; first of all, the idea that the TBTF banks have an incentive to act recklessly and to take foolish risks with their investors' money.  This concept is known in economics terms as "moral hazard," and is essentially the idea that if you have a guarantee that the risks you face have been either eliminated or severely reduced by another party, then you will be inclined to take larger risks than you would without that guarantee.  Take, for instance, driving a car without auto insurance versus driving with auto insurance; you're likely to drive far more slowly and carefully without insurance than you would with insurance, because with your insurer's guarantee that they'll pick up any financial losses you incur through poor driving, you are not "on the hook" for your mistakes in the same way you would be without insurance.

The implicit backing of the government that came with the TARP bailouts of the largest financial sector players creates a moral hazard scenario in just the same way.  If a TBTF investment firm received a government bailout, then the individual managers and employees at that firm will be liable to take risks that they would not otherwise, as whatever they do, the government will ensure that their poor decisions don't cause the firm to go bust.  So, far from reducing the incentives of financial firms to reduce their exposure to risky investments, the bailouts in fact increased the incentives of firms to take massive risks, and to leave taxpayers to foot the bill.

A second point to discuss that is a corollary to the first (and which Johnson spoke at length about last night) is that the TBTF firms, with their implicit government backing, are receiving preferential treatment in the financial markets that are creating advantages for the banks to become even larger.  Essentially, because the government will not allow the TBTF firms to fail, they receive reduced interest rates when borrowing from private lenders.  Because the lenders perceive the TBTF firms as "safer" investments than firms that don't have government backing, they are willing to reduce the interest rates they charge the TBTF firms compared to other firms.  Naturally, this situation distorts the market's functioning, and gives the TBTF firms an advantage over their competitors that allows them to gain even larger market shares.  Hence, the failure of capitalism due to government intervention in the marketplace.  Johnson estimated the interest rates of the TBTF firms were reduced by approximately .7-.9% compared to their non-TBTF competitors, which may not sound like much, but when applied to loans and trades of billions of dollars at a time, those fractions of percents add up to large sums of money.  

So what is Prof. Johnson's solution?  To break up the TBTF firms into smaller, more manageable (and less economically dangerous) firms.  Johnson and a number of other significant economists estimate that a $100 billion limit on total assets under a firm's control is an ideal target to aim for.  What does that figure mean?  Well the current combined holdings of Bank of America, JP Morgan Chase, Citigroup, and Wells Fargo are approximately $7.4 trillion, and there are 23 institutions in the US that have assets over $100 billion.  Therefore, there will have to be a lot of division of these large institutions into smaller ones (simple arithmetic reveals that the $7.4 trillion of the four megabanks noted above, if divided into $100 billion sub-banks, would create 74 new institutions) and it is in the process of "breaking up" the banks that a lot of complication will occur, as in any complex transaction.  Furthermore, these firms are all multi-national, meaning that the US acting alone will not achieve any significant regulatory reforms unless those reforms are accompanied by international agreements.  It will be difficult enough for Congress to pass any semblance of meaningful financial reform (as evidenced by the Republicans' continued obstinacy) without having to deal with cross-border issues as well.  

I think I'll stop there for now.  There is still lots more to discuss about the financial crisis, as my understanding of the causes and the (proposed) solutions has been growing and evolving rapidly in recent months, and I'm eager to share what I've gained with you, my readers.  Despite not being a "finance guy" in the least, I believe that the simple fact that our financial sector has become such an integral part of the world economy requires that I attempt to understand what happened and how to prevent a recession of similar scale from ever happening again.  Any understanding I gain I'll attempt to pass on, since it's such a complex topic, but worthy of understanding by many.

In this posting I've focused only on the TBTF firms and the threats they pose to the financial markets and the world economy.  In future postings, I'll look at the political implications of such concentrations of wealth and power, as well as how it is that the financial sector got to have such power and influence as it does today.  If you have any further questions or a need for clarifications (or if I've totally bungled some facts in this posting) please comment on this piece below, or email me at generationalnavelgazing -at- gmail dot com (trying to protect my account from spammers, you know).

Additional programming note: I plan on returning to the subject of the Tea Party movement soon in an additional posting following up on my post from two weeks ago, so stay tuned for that.

Brokering dialogue with the Tea Party

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Last week was my spring break from UCLA, and instead of going to a tropical locale with umbrella drinks, I decided to get a jump on earning course credits and learn new skills through taking a class on public mediation.  For those of you not familiar with mediation as a form of dispute resolution, the basic concept is that two parties (referred to as "disputants" in our training course) will agree to meet with a neutral mediator, and the mediator will work to facilitate a dialogue between the disputants to foster an understanding of each other's interests between them.  The mediator will attempt to structure the dialogue so that the disputants can come to a resolution between each other that is mutually agreeable, not a resolution that is imposed by a judge  or arbitrator, as in other dispute resolution approaches.

The key aspects of the mediation strategy are in active listening, where the mediator seeks to give full attention to each disputant to hear their side of the story, and then, through active listening, to discover what each disputant's interests are.  "Interests" in a dispute can range from the purely economic, as in unpaid wages owed a worker, to the purely emotional, as when a person feels disrespected by his/her spouse.  Mediation is an attempt to deal with not only surface-level concerns, such as money issues, but the deeper feelings that may lie underneath those issues that conspire to prevent the disputants from reaching a mutually satisfactory resolution.  In mediation lies the idea that conflicts can be an opportunity for greater understanding and better relationships between individuals, not just power struggles where the winner takes all.

When I entered the class, I figured that I would simply learn some new skills for conflict resolution, skills that would be especially handy for me since I am a person who fears conflict with others.  What I discovered, however, was a new approach towards dialogue and communication, and a new framework through which to view political and policy debates.  By attempting to "hear" the other's concerns - to not judge the other immediately, but to give them an opportunity to feel heard and respected - I found that the disputants would be able to give voice to the feelings underlying their side of the dispute.  Once the two parties' emotions were acknowledged, resolution became more possible.

Since President Obama's inauguration, and especially with the raucous health care reform town hall meetings last August, I have been troubled by the rise of the Tea Party movement in American politics.  Beyond the basic inconsistencies of the Tea Partiers' main messages (if they're so concerned with government spending, where were they during the 8 years of the Bush Administration's unprecedented deficit-spending?  If they're so concerned with increasing taxes, why are they protesting when the Obama Administration just gave tax cuts to 95% of Americans (okay, maybe 92%)?  If they're worried about Big Government, why didn't we hear a peep out of them when President Bush presided over the largest expansion of government since the days of FDR?) I have puzzled over what is uniting all of these generally white, older, lower- to middle-class conservatives in such strident opposition to a government that is seeking to make their lives better.  Are they just mad that "their guy" lost the election?  It's doubtful that such resentment would still sustain such a large movement a year and a half after the election ended.  Are they all just racist?  I have to admit that I've certainly thought and expressed that belief in recent months, but again, it's hard to believe that such a large swath of the population would be motivated solely by racial issues.  No, I believe that race plays a significant role, but it's something more subtle than that.

Yesterday, a classmate forwarded me a link to a post by Steve Benen of Washington Monthly magazine that helped to clear up my thinking on the Tea Partiers and their sympathizers across the country.  Benen discusses a fascinating Dallas Morning News article profiling a family that is suffering under the strain of breast cancer, unemployment, and high out-of-pocket health care expenses; in other words, exactly the kind of family that the health insurance reform bill is intended to help.  But the family opposes the health reform bill, fearing government inefficiency and death panels, which Benen states

...makes the response all the more fascinating. Amy Townsend appears to have heard the right-wing propaganda, and seems inclined to believe it. "Every government program," she told the paper, "none of them work very well." 

The Townsend family is, however, currently getting by on unemployment benefits (a government program), and is holding onto some coverage through COBRA (another government program), which they can afford thanks to federal subsidies (through another government program). 

The point isn't to mock the Townsends or to question their judgment. The point is to appreciate the power of conservative political rhetoric in 2010. Many of those who stand to benefit from a stronger safety net have been led to believe they want a weaker one. Many of those who'll finally be able to get better care under a health care system that's been screwing them over have been convinced that they won't, or can't, benefit from reform.

There's a lot to unpack here.  I have thought a lot about an idea that many Democrats subscribe to (and that Benen represents well here), which is that the GOP convinces people through "rhetoric" or "propaganda" to vote against their own "interests," as if their interests are strictly economic in nature.  It's an essentialist argument on its face, that people can be defined solely by their economic concerns, and it gives credence to the widespread conservative critique of liberal conceit; that liberals believe they "know" another person's interests better than the people themselves do.

My contention is that the Tea Partiers are protesting mainly against the "face" of the government that is supposed to represent them, and the changing of American culture that has been going on for decades, but the evidence of which had been remarkably suppressed by the Bush Administration and its overwhelmingly white male leadership (with the notable exceptions of Condoleeza Rice and Colin Powell, of course).  Now we have not only a black President, but a female Speaker of the House, female Secretary of State, black Attorney General, Asian-American Secretary of Energy, etc.  This is not the government that many Americans are used to, and I think that, while one can call the Tea Partiers' reactions "racism" (and I certainly have!) I have come to believe, as noted above, that it's more subtle than that.  People feel that their government no longer represents them - they can no longer "see themselves" in the government, and they can't trust those "other people" to handle their tax money, help them afford health care, protect them from terrorism, etc.  As noted above, the vast majority of Tea Partiers are conservative and white, and would likely not vote Democratic anyways.  But then watching Fox News increases peoples' levels of fear and distrust by Fox speaking directly to their feelings of being unsettled with the "new order" running the government, and telling them that those feelings are widespread and that people should act on those feelings rather than hearing what the other side actually has to say.

So all this to say that I think that people also have an "interest" in feeling that their government represents them and their interests, and that speaking to their intellects, rather than their gut feelings of disorientation, will not ultimately be very productive for Democrats.  While this family in the article quoted may be going directly against their own economic interests, they are choosing instead to act on their interest in being represented by a government they "recognize," I suppose.  I'm not at all trying to justify the Tea Partiers, and I certainly do believe there is a strong racist element in the Tea Party movement, I've just been trying to imagine what it is that people react to so viscerally, and these last few paragraphs are what I've come up with thus far.

So how does one have a productive dialogue with the other side?  I'm not really sure yet, but through my basic studies of mediation I came to this point in my understanding of the Tea Party movement, and I believe that mediation represents a potentially useful tool for engaging in that dialogue.  How one engages a national dialogue is far beyond me, but I believe that initially at least it comes down to showing respect on an individual level, and an understanding that another's experience of the world is not your own.  So if you encounter a person who holds diametrically opposite views to your own, and there is not a fear of physical violence ensuing between you, I'd say take a moment to really listen to their concerns, you might be surprised what they tell you.

I plan to revisit this topic in future posts, and I'm in the process of formulating a major research project for next year that just might involve mediation...stay tuned.  In the meantime, if you're interested in learning more about the power of engaged dialogue, take a look here.

One more thing about the energy proposal...

President Obama made the announcement that I discussed in my previous post in front of an F/A-18 "Green Hornet", a combat jet that runs on a 50/50 blend of conventional jet fuel and biofuel.  The biofuel that the Hornet runs on is derived from camelina sativa, an oilseed that has been grown primarily in Montana after being brought over from Europe in the 1980s.  Camelina shows great promise as a biodiesel and biojet fuel feedstock, due to the fact that, in contrast to other biofuels such as corn ethanol and soybean biodiesel, camelina does not compete with food crops in its growth, harvesting, and production processes.  For every acre of corn grown to be used as ethanol fuel, that is an acre that is not being devoted to food production.  Multiply that scenario by the thousands of acres currently devoted to corn ethanol production and you have a scenario where the drive for energy is driving up the price of food, which I discussed in a post a bit over a year ago.

Camelina can be grown on "marginal" land, which refers essentially to non-farm-quality land, with minimum fertilizer and irrigation needs, so that the resource intensity of camelina development is far lower than resource-heavy corn production.  Thus, camelina and other second-generation biofuels show the way forward for biofuel development globally, a future where biofuel development is a sustainable enterprise that can coexist easily with food production processes.

I'm personally very excited about sustainable, domestically-produced camelina, due to the great national security risks that importing foreign energy presents to our country, and the fact that first-generation corn ethanol is simply not sustainable over the longer term from either an environmental or economic standpoint.  I produced a Powerpoint presentation and a research paper last fall about camelina that I have now posted on the right-hand column of the blog under "Recent Works," so if you have further interest in learning more about camelina and about biofuels more generally, I encourage you to take a look.

To drill or not to drill, that is the question, baby

President Obama announced a new energy policy proposal yesterday, which appears to have surprised both environmentalists and fossil fuel interests in that the proposal seeks to open vast new areas of US coastline for offshore oil drilling.  The new drilling is combined with new regulations and policies to invest significantly in green energy resources, including new auto regulations mandating higher fuel economy standards of 35.5 miles per gallon across a company's entire fleet of cars and trucks by 2016.

But ultimately, nobody's really paying attention to the higher fuel economy standards, despite the very positive climate benefits those standards will have, when the topic du jour is offshore drilling.  Did the President really just give in to the "drill baby drill" crowd?

Well, I would argue that the answer is yes and no.  The President has just deftly given the Republican party, and its oil and gas interest supporters, enough rope with which to hang themselves, policy-wise.  Take a look at the chart below, helpfully supplied by the NY Times:

Copyright 2009 New York Times

All of the state coastlines that are now opened to new offshore drilling have Republican governors, except for Maryland, Delaware, and North Carolina.  Meanwhile, the areas north of Delaware on the Atlantic side, and all of the Pacific coast will remain off-limits to drilling, with the environmentally sensitive Bristol Bay in Alaska that was opened for exploration by President Bush now closed off for at least seven years.

The way I read it is, if Republicans want to drill so badly then let them, for as others have noted, allowing them to do what they have claimed offshore drilling would do - completely solve America's oil needs indefinitely - will be shown to be false.  Offshore drilling, because it has been anathema to environmentalists, has been built up to mythical status among Republicans, when any responsible politician would admit that there likely won't be enough oil to supply the US for long, and even then, the new oil will not affect gas prices at the pump.  The government lease and exploration process will take years, and then the companies that purchase the leases will need to actually extract and refine the oil, so don't expect any new "homegrown" oil for at least 10 years.

But that scenario only plays out if everything goes smoothly on the political end of things, and when does that ever happen?

Access to oil and gas in South Atlantic waters also would probably meet stiff resistance from the coastal states unless Congress first enacts a plan to share the billions of dollars in potential revenue from lease sales and oil and gas development. And that's not easy.

Lawmakers from coastal states that would benefit have been pushing for that, but some other senators argue that proceeds from oil and gas resources in federal waters should go to the U.S. Treasury.

Here's the thing, the governors will likely take a lot of flak from environmental and concerned citizens' groups from within their states if they agree to allow the offshore drilling, no matter where on the political spectrum they are.  What would help the governors neutralize that criticism is the prospect of increased state revenues from oil and gas development to help their states, but Congress would have to approve those deals.  Politicians never like to give up "free" money coming to their states at the expense of other states, so it would be quite a battle between the interior-state politicians and the coastal-state ones over who receives the proceeds from oil and gas development.  Hmm, divide and conquer, Mr. President?

Then there's the idea that Americans appear to have that any oil that is drilled from US territory by a multinational corporation like Exxon Mobil will automatically be sold in the US.  This is just wrong.  Oil drilled in the US will be shipped to wherever the demand is greatest in the world, just as oil is now.  While the US is currently a major consumer of oil in the world, who is to say that the oil drilled here won't be shipped to China instead?  In a few years the Chinese economy will only have grown further, so it isn't beyond the realm of possibility.

So all in all, what should we take away from these developments?  I believe this report from Kate Sheppard at Mother Jones provides a clue:

Environmentalists are not just angry that Obama is giving away the store on oil and gas drilling, they also feel that he's basing his decision on a dubious premise—that more drilling will enhance the nation's energy security. The US currently imports 57 percent of its oil, according to the Energy Information Administration. The nation accounts for 23 percent of total world oil consumption, but has only 3 percent the world’s oil reserves within its borders. Drilling off every coast in the US won’t resolve that issue. Even the most productive portion of the area opened to drilling, the eastern Gulf, is expected to yield only 3.5 billion barrels of oil. The US consumes 19.5 million barrels of oil per day, which means that these wells would only produce about 180 days worth of oil. And at current global oil prices, recoverable American-produced petroleum isn't likely to be cost-competive. (emphasis added)

Did you catch that?  For any offshore drilling to occur in this country, the oil companies have to actually believe that there is enough oil for them to recover before they make any capital investments.  It's dubious whether a sufficient amount of oil exists in these newly-opened areas to make it worth the oil companies' while to drill.  And therein lies the rub - President Obama just gave the Republicans and oil companies the access to offshore oil wells that they've been clamoring for for years, and now they're going to have to work to roll back Americans' expectations of just how much oil there is within our borders.  Republicans will have to explain to Americans that just because oil companies now can drill offshore, gas prices will not drop back to $1.50/gallon, indeed:

"Where are the Republicans out there talking about how crude is going to go down" when drilling is allowed, "because oil certainly isn't reacting to it today," said Michael Masters, a hedge fund manager who's testified repeatedly before Congress that big inflows of investment dollars are driving up oil prices, not supply shortages. "It's not a supply and demand issue. ... Crude is detached from the fundamentals."

Masters is referring to oil futures markets, where speculators have notoriously been driving up the price of oil for years now, apart from any increase or decrease in production.

So Obama has managed (it appears thus far, anyways) to divide Republicans on oil drilling, while simultaneously putting them on the defensive regarding their previous claims of the amount of oil the US truly has within its borders.  With the Trojan Horse of offshore drilling, Obama managed to slip by the first increase in vehicle mileage standards in nearly 30 years, a move that on any other day would have provoked howls of protest from the Republican side of the aisle.  On balance, it appears that the positive environmental effects of the new vehicle mileage standards regulations may well outweigh the negatives of offshore oil drilling, but Obama was able to distract the other side (and much of the media) from noticing with the shiny, glossy offshore drilling announcement.

And as for the environmentalists, well I noticed a curious coincidence regarding two of the largest environmental organizations, the Sierra Club and Greenpeace, see if you notice a certain similarity:

"Is this President Obama's clean energy plan or Palin's drill baby drill campaign?" quipped Greenpeace Executive Director Phil Radford in a statement on Wednesday.

“Drilling our coasts will do nothing to lower gas prices or create energy independence,” Michael Brune, executive director of the Sierra Club, said in a statement. It will only jeopardize beaches, marine life, and coastal tourist economies, all so the oil industry can make a short-term profit.” (emphases added)

So both Greenpeace and the Sierra Club released statements, indicating that they were notified ahead of time about the drilling plans, and taking a look at their websites (Greenpeace, Sierra Club) there was either no mention of Obama's announcement on the Sierra Club website, or just a rather rote statement from Greenpeace's Executive Director.  If this plan were so terrible, wouldn't the greens be shouting into any TV camera they could find about how terrible it is?  Could it be that they're in cahoots with the President on a strategy to mollify the "drill baby drillers" while the actually environmentally progressive legislation gets passed in the background?  I think that the President and the enviros are betting that in the time it takes for any sort of viable oil drilling operations to get set up offshore, the US would have already begun the transition towards alternative fuels, obviating the need for major drilling operations at massive costs.  Also, the Bristol Bay area that has now reverted back to protected status in the Obama plan was a key sticking point with environmentalists, so it's not as though they lost out entirely.  But then again, I could be totally wrong.  I just find the curiosities of this particular announcement and the context surrounding it too intriguing not to try to suss it out.  Time will tell.