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Wednesday, September 23, 2009

Is "Time" Really "The Enemy of Reform"?

What if someone offered you the following bet: heads you win, tails they lose? Would you take it? Say, that the counter party offering the bet asked you only to pay a portion of your "earnings" into a pool to cover potential losses. Would you still take the bet? Now, let's say that the counter party allowed you to create money out of thin air (say up to 10 times whatever capital you actually possess) to risk on the bet? Wouldn't virtually everyone who breathes want to take part in this "gamble" - a gamble that is essentially a no-lose proposition that can be made on "capital" that you literally can create out of thin air?

Extending this analogy further, say at some point, you flipped tails 10 times in a row thus causing sizable losses to the counter party under the terms of the bet. Mathematically, given that the bettors created capital out of nothing and continually made this bet, wouldn't the counter party now potentially face losses orders of magnitude greater than his ability to pay? But, would you really care? Of course not. You would simply hope that at some point they make the game available to you again.

Now, if you were the counter party who offered this bet and the one who faced untold losses, what might you conclude from this series of events, i.e., how would you go about "reforming" this bet? Would it dawn on you, that this is a bad bet to make in the first place? Would it dawn on you that the nature of this bet systematically provides incentives for anyone to take the other side and mathematically insures that you will face significant losses at some point? Really, wouldn't you just stop?

Or, would you take a different approach?

Would you continue to offer the bet but attempt to "oversee" or "regulate" the coin flip in such a way as to prevent it from landing on tails too many times? Would you continue to offer the bet but just "cap" how many times bettors could flip? Would you continue to offer the bet but turn around and castigate the bettors as greedy profiteers and threaten them with retribution if and when you face the inevitable carnage? Would you just raise the amount they pay from their earnings into the loss pool?

Does this sound like an insanely idiotic example that would never take place in real life? Well, in fact, this bet is the essence of the United States banking system, because it is the essence of the FDIC. The Federal Deposit Insurance Corporation is a government program which insures bank deposits. In other words, if a bank takes a risk and makes a lot of money - they win, but if they don't, the FDIC loses. And, unlike private insurance, which would discriminate against poorly run banks by not agreeing to insure their depositors - the FDIC must insure every bank that meets its regulatory criteria. Not surprisingly, the
FDIC is broke:
The FDIC estimates bank failures will cost the fund around $70 billion through 2013. Ninety-two banks have failed so far this year. Hundreds more are expected to fall in coming years largely because of souring loans for commercial real estate.

The FDIC's fund has slipped to 0.22 percent of insured deposits, below a congressionally mandated minimum of 1.15 percent. The $10.4 billion in the fund at the end of June is down from $13 billion at the end of March, and $45.2 billion in the second quarter of 2008.

The FDIC board will meet at the end of the month and will likely put out several options, Bair said Friday, including tapping a Treasury credit line, assessing fees on banks in advance and again increasing the fees that banks must pay.
Did you catch that? The FDIC is now considering borrowing from the taxpayers!
The chairman of the Federal Deposit Insurance Corp. says she is "considering all options, including borrowing from Treasury," to replenish the dwindling fund that insures bank deposits.

"I never say never," FDIC Chairman Sheila Bair told an audience at Georgetown University Friday.
Please, please say "never"!

moral hazard created by the FDIC is compounded by the government run banking system's ability to literally create money . First, the Federal Reserve creates money out of thin air whenever it purchases government securities on the open market. Second, banks, which receive these reserves, pyramid them by lending multiples of the reserves in their possession to businesses and the public. This creates massive amounts of leverage in the banking system all backed by the FDIC's explicit guarantee. This inflation, which causes malinvestment predicated on continually increasing nominal prices, coupled with regulations and other government policies that explicitly encourage bad loans (see The Community Reinvestment Act) render this system a house of cards waiting to collapse.

In fact, such a system necessitates a recurring cycle of booms and busts. No amount of central planning, oversight, or threats can stop the laws of reality from operating. With that in mind, consider Treasury Secretary Timothy Geithner's recent
testimony to the House Financial Services Committee on Financial Regulatory Reform. Rarely do we see such a blatant demonstration of utter intellectual bankruptcy. Consider the following:

But make no mistake: The flaws in our financial system and regulatory framework that allowed this crisis to occur, and in many ways helped cause it, are still in place.

Uh, ok, I actually agree with that. What else?:
We may disagree over details of how to best fix those flaws, but that cannot mean we do not act.
Well, at least we had a sentence together. Consider the literal meaning of that last sentence. How can we disagree "over the details of how to best fix those flaws"? They are logically obvious. In any case, if we do disagree, how could we act? What exactly would we do? Let's say that I hold that logic dictates that the system be dismantled and replaced with a completely private banking system based on a 100% reserve hard money standard under a system that respects private property and upholds contracts. On the other hand, let's say that Geithner thinks we must leave the system completely intact but increase the budget of the regulators by $500 billion so that there are 185 regulators for every employee of every bank on the planet that watch and monitor them even when they go to the bathroom. What would we do?

Of course, as a
pragmatist, Geithner does not literally think we could disagree over essentials. He takes for granted that businessmen who seek profit are evil and must be throttled by the state. How exactly you do that in terms of fines, jail sentences, and how many regulators to send to the bathroom with the bankers is a "detail" that he is open to discussing, but "action" is what is truly important - as long as it is action in the direction of statism and more government control.

Naturally, Geithner goes on to detail his plans for more regulation, more oversight, etc., i.e., more "action", without ever questioning the essence of the nationalized banking system or evaluating the causes of the collapse. In fact, he regards the collapse as "sudden" as if on the basis of hundreds of years of economic history and theory, no one could possibly have foresaw such an outcome. Then, in a final demonstration of the essence of all that is destroying this country, Geithner makes the following statement:
But as we do this, we must remember the President's admonition on Wall Street last week. Time is the enemy of reform.
Is there any better expression of the philosophy of pragmatism than that last line? To the pragmatist mind, "time", meaning some form of reasoned deliberation over the causes and therefore fundamental solutions to the crisis, is regarded as the "enemy". To him, facts, reason, principles, i.e., thought is the enemy. "Action" is paramount and, implicitly, "reform" is statism not "efforts to make something better."

Geithner is literally saying that "reason is the enemy of statism". For the second time, we agree.


HaynesBE said...

Clever allegory. When I was reading it though, I thought you were going to write on "healthcare reform" and was startled to see you connect it to banking.
What struck me next was that your allegory fits any attempt to personalize benefits while socializing the costs, i.e. socialism. Throw in fiat money and the printing press...and you have a great picture of why socialism MUST self-destruct.

Thanks so much (as always) for your analysis!

The Rat Cap said...


YES!! Great observation. I re-read the post again thinking it was related to health care or virtually any government program (especially "insurance" mandated for people with pre-existing conditions...) and as you say, it is an indictment of socialism as such not just the narrow application pertaining to the banking system.

Of course, that assumes you can think in principle. A modern intellectual might even accept this explanation and then reject it as it pertains to health care or government subsidized insurance for people that build houses in hurricane zones, etc. arguing that it is somehow different...

I will say that the particular issue of "moral hazard" is so accute when applied to the banking system since it is at the base of virtually every thing we do as human beings and since it is so obvious in the context of the most recent crisis. I find it amazing that the principle of the FDIC is not challenged at all - it is not even on the radar screen. It shows you the extent to which modern intellectuals are so far gone.

Thanks as always for your great comment.

HaynesBE said...

Moral hazard also plays a big role in health insurance, especially when it includes 1st dollar coverage. If the treatment for your illnesses are paid for by a third party, there is not the financial consequence of unhealthy lifestyles---from as simple as hand-washing to avoid the flu to smoking, exercise, good nutrition, etc.
It will be interesting to look for more parallels in other areas of government intervention.

The Rat Cap said...


And, just as the government, rather than dismantling the banking regulations that lead to moral hazard, increases regulations and oversight to prevent people from acting on the very incentives they create - the same is true or will be true in health.

Since people's bad health is regarded as a "cost to society" the government will step in and begin to regulate people's lifestyles: no smoking, drinking, fast food, exercise daily, etc. - you are already seeing these kinds of efforts and they will increase as government becomes the underwriter of health care costs.

So, rather than leaving individuals alone to face the consequences of their actions (in banking or health), these policies necessitate more control and oversight. The state must insure that bankers do not take too much risk (since they are on the hook) and the state will need to insure that individuals do not take the "wrong" kind of risks since they are on the hook...

garret seinen said...

Doug did you notice the IBD editorial, http://www.investors.com/NewsAndAnalysis/Article.aspx?id=507128
endorsing your viewpoint?
cheers, gs

The Rat Cap said...


Thanks for that link. I will probably do a follow up post on how hedge funds (the supposedly unregulated evil guys) came out of crisis ok.

Interestingly, because investors know that hedge funds are not insured, they diversify their risk so that if one blows up, they are safe. FDIC encourages people to put their eggs in one basket under the belief that they will be bailed out which contributes to the moral hazard - it's great that we have a close to free market example right in front of us with the hedge funds yet, the new regulations are calling for what...regulations of the hedge funds.