Monday, May 31, 2010

Robert Reich: Stop Subsidizing Wall Street

Robert was on a roll this last few days. He has published articles that have popped up on different web scans as significant comments.

Dr. Reich is an academic that loves to serve his fellow man. He has been a member of three Democratic administrations and believes that he is an expert on “public policy”. Surveying his “policy” recommendations, I conclude that he feels that he was born too late. He would have been very happy to be a leading Marxist economist. At every turn he has recommended turning away from capitalism toward state control of all aspects of the economy. He regards actions taken by the government as wiser and morally superior to individual action. The use of force is okay with Dr. Reich.

What brings him to mind is that I came across his blog. This particular entry is entitled: “Financial reform bill unlikely to end taxpayer subsidy of derivative trading on Wall Street

This may not sound particularly controversial because the federal government subsidizes many industries and companies. Handing out federal money is a major activity of both political parties and nothing at all new.

You might ask, which specific taxpayer subsidy is he talking about? How are the taxpayers subsidizing derivative trading. One answer could be that our government has decided that financial companies who traded derivatives were bailed out because of the “too-big-to-fail” irrationality. That is, some financial companies got carried away trading derivatives, lost gobs of money, and the government bailed them out by giving them money. That would be a subsidy, you say. Sorry, no. That is not what our Dr. Reich has in mind.

Just like any other sector of the economy, existing banks do receive a portion of the public dole. Considering how convoluted and contrived federal spending and the means of providing subsidies and support has become in the U.S., there are possibly many different actual subsidies that the banks receive. I have not researched it. But, upon reflection, I can think of two. One is that a considerable proportion of the money that the bank lends comes with no expense. It comes from the expansion of the money supply by way of the Fed. When the Fed. expands bank credit the bank receives new money in its reserve/deposit account at the Fed. The bank can then take that money into it’s own coffers and loan it out. The bank’s only expense or risk is that the Fed. may decide that the amount of money it has put into the economy should be reduced and begin a process of restriction and shrink the reserve accounts, which would require the bank to call in loans. The risk of restriction is small. It rarely happens.

Another benefit that existing banks receive from the current situation is a considerable reduction in competition. The regulatory burden on banks (and the rest of the financial sector as well as the economy as a whole) is extremely large. Even someone who has some understanding of banking would be staggered by the amount of paperwork, filing, extraneous record keeping, staff, and expense of the regulations. Just keeping track of all of them, and learning about and implementing new ones takes a considerable staff and administrative expense. The cost of regulation is one of the factors leading to bank consolidation. The economies of scale of a larger bank make it easier to cover the cost of regulation. Competition is reduced by the consolidation and by the tremendous expense and risk involved in starting a new bank of any size.

But none of these means of supporting the current banking establishmen is what Dr. Reich means is that banks are protected against their folly by government guarantees of customer deposits. What he is referring to is the Federal Deposit Insurance Corporation, which isn’t a corporation at all but a government entity. You see its initials all the time. Somewhere on its promotional and contractual material, every bank has placed “Member FDIC”. I’m not sure that “membership” is optional, but the marketplace, supposedly, would punish any bank that wasn’t a member. I mean, who wouldn’t want their deposits insured?

The FDIC collects funds from the banks, just like insurance, and guarantees that if the bank defaults, the FDIC will cover the difference between the bank’s assets and the deposits, up to $250,000 per customer (not per account). The FDIC was created during the depression to try to give people some confidence in their banks. Banks had been failing at a rapid pace for want of capital. People were afraid that they wouldn’t be able to get their money. Deposit insurance seemed the ticket.

But it is a fraud. It isn’t insurance. The fees collected by the FDIC could not cover much, and are certainly not sufficient for the size of the major banks today. Even when it was created it was recognized that the FDIC could not stand on its own, so it was backed with federal government guarantees. When the FDIC runs out of money, the federal purse bails it out. It did, too, during the 70’s when Thrifts began failing in large quantities (more government malfeasance). So, today, everyone who has paid attention knows that if banks begin failing the feds will have to pony up more money to cover the FDIC’s obligations.

Now along comes Dr. Reich, who wishes to expound on the virtues of government and, since it is popular to bash banks these days, bash the “rich” bankers. He capitalizes on the ignorance and poor education of most Americans, and forthrightly declares that the banks are being subsidized.

He has to ignore that the precarious situation of the banks over the last five years is directly related to the cheap money policies of the Fed., the efforts of the federal government to eliminate sound credit practices in the mortgage industry, and the forced semi-nationalization of the largest banks. Ignoring facts and reality is a way of life for Dr. Reich.

So the subsidy that Dr. Reich is referring to is actually no subsidy at all but a insane obligation left over from the 30’s that could put the federal government on the hook for trillions. Now, does Dr. Reich want to end the subsidy? No. He thinks that the FDIC is a fine organization. Instead, he is focusing on the derivative trading.

Not just any derivative trading, but the defensive or hedge trading. There are really two different approaches to derivative trading. One approach is intent on making money, just like most investment. This derivative trading is generally short term and is a form of speculating, i.e., expectations of advantageous price changes. This kind of trading can often result in significant losses, just like speculating on the price of a stock. You expect the price of the stock or derivative to go up, but it often goes down, and until you sell it, you lose money on the market price. Not all derivatives function that way.

A defensive or hedge approach to derivative trading is exemplified by the corn farmer, perhaps the source of one of the first derivative markets. When the corn farmer plants his crop he founds his expectations on the current price of corn, or perhaps on what his experience suggests the price will be when he harvests and delivers his crop to market. But of course, the future is not known. The price could be very different in a few months. It the market price for corn is lower, the farmer is sure to lose money. So the farmer buys a derivative. He buys a financial product that will pay him money if the price falls. He buys what is called a put option. If the price of corn on his delivery date is the same as the put or higher, the farmer reaps his expected profits and is happy. The money he paid for the put is lost. If the price of corn has dropped, the farmer makes up for his losses from his crop by the return on the put. The farmer has maintained his position.

The put option is purchased from another party who holds the same view of the future as the farmer, that the corn prices in future will be the same or better than today. He knows that he has a risk of lower prices, but he has factored that into his business, and has either reserves or a hedge of his own to cover potential losses. The farmer regards the cost of the put as a business expense and the seller of the put regards the potential loss as a factor in his business. The transaction and the decisions are done in a very businesslike manner.

So the bank has certain exposures to interest rates. If the interest rates change in a manner that is unprofitable, the bank will lose money. To offset potential losses, the bank buys derivatives just as the farmer did. For these derivatives to make sense, they must offer significant return with little cost, just like the corn farmer’s put option. The bank regards this as a business expense. It is a good banking practice.

What Dr. Reich does is confound the two different types of derivative activities. It may be true that some, most, or even all banks engage in both types of derivative trading. But it is clear that Dr. Reich is trying to have it both ways in that he yells “derivatives” in such way to capitalize on the danger of volatile aggressive trading, while also mentioning in an aside that banks are using hedge derivatives.

Reich says, “If derivative trading is so useful to them in order to “mitigate the risks” of other banking activities, the banks should be willing to foot the bill.”

Dr. Reich wants it to seem that the taxpayers are getting ripped off by overly aggressive banks who are risking huge taxpayer funds by aggressive, semi-rational derivative trading. He says that taxpayers are footing the bill. This is the same thinking that considers tax breaks or reductions to be a government expense. No money is going to the banks (in fact it costs the banks money to “belong” to the FDIC). As noted above, the reason the taxpayer may pay any money is if the Fed. policies drive many banks to the brink of default. If one or two banks fail because of poor business practices or banking decisions, for example, the FDIC will generally be able to meet its obligations. The problem is when there is a systemic or broad problem. But, according to Reich’s thinking, the bankers have a sweet deal: if the bankers have “bet” right, they pocket lots and lots of money; if they “bet” wrong, the taxpayers will have to pay. He says, “Derivatives can generate huge risks for the economy unless carefully regulated. Neither logic nor experience suggests that you and I and every other taxpayer should be subsidizing this gambling.” But none of his argument is related to reality from start to finish.

Let me make one observation about derivatives and the banks. The derivative tools banks and other intelligent large volume traders use are the result of brilliant inductions from highly complex, high-speed, high volume, international trading. They are intellectual marvels. But, at root, the banks and other financial traders are being taken for a ride. The tools work very well when the basic data they depend upon are real, but the data isn’t. Instead, the data, which is interest rates and money flows, is contrived and manipulated by governments around the world, mainly the U.S. In the long run, and when they need it most, the banks will be let down by their tools precisely because the tools depend upon being connected to reality, and the governments interfere. This situation is an excellent example of von Mises observation that prices are cognitive tools.

At the beginning of this entry I mentioned that Dr. Reich had two articles of interest recently. I will discuss the second in my next blog, hopefully in a day or two.

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