The Paulson Dilemma - Part 2

In my piece entitled “The Paulson Dilemma”, posted, I am ashamed to say, on June 8, I promised a follow-up “in my next posting”. Since then, what I intended to say has become more obvious as the anti-Wall Street populist demagoguery has ratcheted up, and the banks who received (or were forced to take) TARP money and other Government help have been trying to move heaven and earth to pay back the TARP money and get out of the Government bear-hug.

In “The Paulson Dilemma” I suggested (and tried to show) that 1) free-market financial systems naturally create increasing “systemic risk” during long periods of “good times” and 2) politically, no government which has the executive authority to intervene in the financial markets, regardless of its political philosophy concerning economics (i.e.” laissez faire” or statist or anywhere in between), will stand by and do nothing in the face a financial crisis which seems to pose a “system risk”.

From these two propositions, (and the unstated but known tendency of all government bureaucracies, once in control of anything, to tend to continue in that control) I erected the straw-man question: are all free-market financial systems destined to be transformed into non-free market extensions of the central government (including, for this purpose, the central bank)? I suggested that I would take the contrary view in my next posting. Here goes.

With any government bail-out comes increased government control over the entity that received the benefit. This is natural and appropriate. A democratically installed government that does not gain or exercise this control will not long be in office when the natural populist storm of indignation (toward Wall Street plutocrats feeding at the public trough) comes whistling down main street toward the beltway. And, of course, democratic government is, and is intended to be, a mechanism for converting political influence into policy.

This control over formerly private enterprises will be wielded in favor of those political factions who form the coalition that elected the government. Again, this is meant to be a statement of the obvious, and not necessarily pejorative. This is true whether the “favor” is direct and remunerative, or is merely the adoption of policy that is consistent with the economic philosophy at the center of gravity of the coalition.

Because government is about politics, and politics can channel absolutely any initiative (for example wealth redistribution or the modern economic equivalent of a Bill of Attainder for specific companies or even whole industries), the control gained over financial institutions, inevitably, will be exercised in a manner which is partly or completely at odds with the interests of the non-governmental owners of those companies. For example, (i) limiting executive pay when the national and global marketplace for executive talent is not subject to uniform rules consistent with those limitations, or (ii) insisting, on the one hand, that banks shore up their balance sheets (which means building reserve capital at the expense of deploying that capital in loans) and, on the other hand, threatening political vengeance if banks don’t lend more and, on the third hand, implying that bankers will be severely punished for taking risks that turn out badly. These are not coherent guidelines under which a business can be run rationally, and certainly not in the best interest of the shareholders (in their capacity as profit-seeking owners). Instead, the business becomes a vehicle for achieving political objectives without regard to the impact on the commercial health of the business or the effect on its long-term viability. Businesses that are subject to this control are at a competitive disadvantage. The longer and more intrusively this control is exercised, the more significant will be the impact. Its competitors will “eat its lunch”.

In other words, absent going all the way to a state owned and controlled economy with rigid barriers to the flow of human and monetary capital out of the country (i.e. a state enforced monopoly in favor of the government controlled businesses), the application of government control to businesses will cause those businesses, over time, to become a smaller and smaller percentage of their particular market.

This phenomenon was demonstrated in reverse, so to speak, with the liberalizations in China starting with Deng. At Mao’s death, virtually every enterprise of every industry was a state owned and controlled entity. The liberalizations were implemented by allowing private enterprises to start up and operate in certain economic sectors. Gradually, the permitted range of activities of private enterprise was widened. With certain exceptions (usually involving favored officials or favored government sectors, such as the People’s Liberation Army), the state-owned enterprises were not converted to private businesses. However, in industries where private enterprise was permitted, the percentage of the market represented by the state enterprises declined from 100% to, often, very low percentages, by virtue of the explosive growth of the private businesses and the relatively static activity of the state businesses. The state businesses were at a competitive disadvantage because they continued to be required to satisfy all the non-business (i.e. political) objectives mandated to them under the strict communist period. These objectives included everything from revenue generation for the state (hampering the ability to retain and reinvest profits), employment without regard to business need or productivity, production quotas without regard to whether the enterprise was creating wealth (profitable) or destroying wealth (operating at a loss) and the requirement to use specified sources of material without regard to quality or suitability (in order to create a market for upstream enterprises), to provision of all manner of social services such as housing, food, schools and clinics. Against such competition, any private enterprise with even a little room (freedom) to be nimble and creative will prosper.

As applied to the big US banks, this means that the longer and more intrusive is the Government control, the less competitive the controlled businesses will become. Their relatively less fettered competition will prosper at their expense. This competition could be from the banking sector inside this country, unless the controls are made uniform (i.e. without regard to whether the financial institution was a recipient of bail-out help or not) through national regulation, or from other less regulated forms of financial activity "disintermediating" the banking business (as the securities business did in the last 30 years) or from outside the country.

Over time, banks that were “too big to fail” in the last crisis will become smaller and smaller percentages of the market. Capital will flow to less regulated institutions and, over time, the massive government presence in the industry will diminish as a result of the persistent differential growth rates of the less regulated versus the more regulated.

What I have written above is well understood by the banks themselves, which is why, as of this writing, the last of the TARP banks are struggling to get free of the Government and repay their TARP money and give up their Government loss protection, even though their existing non-governmental shareholders will be massively diluted by the capital-raising required.

The fact that there may be processes at work which may cause it all to come out all right in the end is, however, no reason to be passive in the political debate concerning the role of government and the private sector. Massive wealth destruction, with concomitant lowering of living standards, can result from wrong-head government intervention in the private sector, even if there is a feedback mechanism which mitigates the effect over time. Hundreds of millions of Chinese lived hard, short and unhappy lives between 1949 and the unset of Deng’s reforms who would have lived longer and happier lives had those reformed been introduced earlier.