an unanticipated consequence of
Jack M. Balkin
Jack Balkin: jackbalkin at yahoo.com
Bruce Ackerman bruce.ackerman at yale.edu
Ian Ayres ian.ayres at yale.edu
Mary Dudziak mary.l.dudziak at emory.edu
Joey Fishkin joey.fishkin at gmail.com
Heather Gerken heather.gerken at yale.edu
Mark Graber mgraber at law.umaryland.edu
Stephen Griffin sgriffin at tulane.edu
Bernard Harcourt harcourt at uchicago.edu
Scott Horton shorto at law.columbia.edu
Andrew Koppelman akoppelman at law.northwestern.edu
Marty Lederman marty.lederman at comcast.net
Sanford Levinson slevinson at law.utexas.edu
David Luban david.luban at gmail.com
Gerard Magliocca gmaglioc at iupui.edu
Jason Mazzone mazzonej at illinois.edu
Linda McClain lmcclain at bu.edu
John Mikhail mikhail at law.georgetown.edu
Frank Pasquale pasquale.frank at gmail.com
Nate Persily npersily at gmail.com
Michael Stokes Paulsen michaelstokespaulsen at gmail.com
Deborah Pearlstein dpearlst at princeton.edu
Rick Pildes rick.pildes at nyu.edu
Alice Ristroph alice.ristroph at shu.edu
Brian Tamanaha btamanaha at wulaw.wustl.edu
Mark Tushnet mtushnet at law.harvard.edu
Adam Winkler winkler at ucla.edu
David A. Moss's When All Else Fails: Government as the Ultimate Risk Manager should be a vital guide to our future. Moss describes programs ranging from social security to bankruptcy as backstops of support for all classes. As volatility in prices, employment levels, and wages climbs, we should be exploring new "automatic stabilizers" to guarantee every family a "social minimum." Instead, we appear to be privatizing and financializing risk via opaque institutions whose only mandate is to increase their own profits.
Consider, for instance, this vignette from Louise Story's excellent reporting on derivatives trading:
[B]anks in an elite group, which is affiliated with a new derivatives clearinghouse, have fought to block other banks from entering the market. . . Banks’ influence over this market, and over clearinghouses like the one this select group advises, has costly implications for businesses large and small, like Dan Singer’s home heating-oil company in Westchester County, north of New York City.
This fall, many of Mr. Singer’s customers purchased fixed-rate plans to lock in winter heating oil at around $3 a gallon. While that price was above the prevailing $2.80 a gallon then, the contracts will protect homeowners if bitterly cold weather pushes the price higher.
But Mr. Singer wonders if his company, Robison Oil, should be getting a better deal. He uses derivatives like swaps and options to create his fixed plans. But he has no idea how much lower his prices — and his customers’ prices — could be, he says, because banks don’t disclose fees associated with the derivatives. “At the end of the day, I don’t know if I got a fair price, or what they’re charging me,” Mr. Singer said.
As Story explains, if this arrangement prevailed in the housing market, "It would be like a real estate agent selling a house, but the buyer knowing only what he paid and the seller knowing only what he received. The agent would pocket the difference as his fee, rather than disclose it." Whatever Wall Street's apologists say, the secrecy is indefensible. But perhaps the reliance of people like Mr. Singer on derivatives themselves is more troubling still.
Let's step back a bit and think about what a derivative is. There is a dazzling world of financial transactions that come under that heading, but when we think of deals like Robson Oil's, the following reflections from Brian Holmes are clarifying:
[A derivative] is a fungible contract, created by applying a mathematical formula to an underlying asset or commodity whose price is susceptible to fluctuation . . . . By assembling constellations of values that statistically tend to fluctuate in opposite directions, derivatives were supposed to mitigate the risks of globalization with the highest degree of efficiency. The idea was that that all risks, including collective ones, should be made into salable products, formatted for the market by private actors in search of a profit. . . .
Derivatives . . . have nothing directly to do with production; instead they are conceived to manage the environmental risks that weigh on the future of speculative activity. In this sense they are meta-commodities that govern the unfolding of the contemporary economic model. Their fascinating appearance acts to conceal the private deliberations that effectively shape the environment in which any productive or consumptive activity can take place.
Derivatives thus offer a tempting alternative to the messiness of politics. Rather than investing in sustainable energy, the US can allow everyone to hedge their own bets. Worry about peak oil? Buy some derivative that pays off big when it hits $200 a barrel. Think it's all a big hoax? Then you can short the same instrument, or come up with some exotic variation on the short. Everyone gets to vote with dollars on some future. Worried about your home price? Robert Shiller seems to think that a "thick housing futures market" would help you diversify away that risk.
There are a few problems with such a future. Let's forget, for now, the unfortunate fact that so many Americans are broke. Let's not trouble with the divide between the median household (which has has net worth of under $100,000) and the top 1 percent of households’ mean wealth of over $15 million.* Let's heroically assume that individuals can make all kinds of bets, er, investments, based on what they think the future holds. Could derivatives still serve as our ultimate risk manager?
Not really. Consider Mike Konczal's fanciful take on the problem:
[W]hat do we call a product that pays out in times of high volatility, in times when an event out of the ordinary happens? One thing to call it is “insurance.” . . . There’s good reason we regulate insurance – it needs to pay out exactly at the moment when it is the least likely to get paid.
[There are limits to what insurers can promise. What] would you price a contract that paid $100 if the world turned into The Walking Dead, where cities were overrun with armies of zombies? The short answer is that you wouldn’t pay anything, since when you need to collect it the person on the other end is probably a zombie. This “who can credibly commit to backstopping bad events” goes towards a notion of the role the government can play in financial markets.
Of course, we did see a version of that disaster in 2008. Zombie banks walk among us to this day, propped up by lenient regulators,low interest rates, and dead ideas. Their employees will get about $143 billion in bonuses this year--more than the "$130 billion total budget gap for all 50 states," according to SEIU. Perhaps in gratitude for the state's generous subvention, Josef Ackermann (head of Deutsche Bank) said "I no longer believe in the market’s self-healing power" in 2008, admitting a role for government.
Yet this is the same Josef Ackermann who "pledged to seek 25 percent returns on capital before tax" after the crisis. As Simon Johnson argues, "In a world where safe assets barely earn a few percent, he can only achieve such returns through significant risk-taking." Competitors will do the same, dancing while the music is playing. It's hard to credibly promise protection to all the Robson Oils of the world, and to support seven to nine figure incomes. Risks have to be taken.
So we are in a curious situation: the very instruments designed to diversify away risk in one field end up exacerbating it in others. Back in November, 2007, one of the world's best economic sociologists (Donald Mackenzie) was thinking about what he called the "end-of-the-world trade:"
The trade is the purchase of insurance against what would in effect be the failure of the modern capitalist system. It would take a cataclysm – around a third of the leading investment-grade corporations in Europe or half those in North America going bankrupt and defaulting on their debt – for the insurance to be paid out.
I asked one investment banker what might cause half of North America’s top corporations to default. No ordinary economic recession or natural disaster short of an asteroid strike could do it: no hurricane, for example, and not even "the big one," a catastrophic earthquake devastating California. All he could think of was "a revolutionary Marxist government in Washington."
The exchange both reveals a mindset common in New York and London, and confirms Mackenzie's larger thesis about "performative theories" in finance. MacKenzie's book An Engine, Not A Camera: How Financial Models Shape Markets describes how both finance theorists and traders' views on "how the world works" end up promoting the very conditions they claim to merely reflect. The trader here locates the source of risk in the only institution that could credibly get the economy out of a severe rut, or (more importantly) avoid the rut in the first place.
MacKenzie's trader's nightmare scenario of a Marxist government is not nearly as plausible as the doomsday on the horizon of leading novelists, historians, environmentalists, and geologists. To take but the latest example of a flourishing genre, consider these ideas from Alfred McCoy:
Other developed nations are meeting [the threat of declining oil supply] aggressively by plunging into experimental programs to develop alternative energy sources. The United States has taken a different path, doing far too little to develop alternative sources while, in the last three decades, doubling its dependence on foreign oil imports. Between 1973 and 2007, oil imports have risen from 36 percent of energy consumed in the U.S. to 66 percent. . . .
[Given current trends in the dollar's value, one can imagine] OPEC oil ministers, meeting in Riyadh, demand[ing] future energy payments in a "basket" of Yen, Yuan, and Euros. That only hikes the cost of U.S. oil imports further. At the same moment, while signing a new series of long-term delivery contracts with China, the Saudis stabilize their own foreign exchange reserves by switching to the Yuan. . . .
The oil shock that follows hits the country like a hurricane, sending prices to startling heights, making travel a staggeringly expensive proposition, putting real wages (which had long been declining) into freefall, and rendering non-competitive whatever American exports remained.
Rather than engineering alternative sources of energy, we have focused on "financial engineering" of distributed risk management. But who really thinks we can arrange an "end of the oil era" trade to hedge against the situation McCoy is describing?
The ultimate irony is that ostensibly distributed risk management really isn't that diversified at all. As Amar Bhide has demonstrated, the modern financial system is Hayek's nightmare:
The financial system has been giving up . . . on the decentralization of judgment and responsibility. Case-by-case judgments by many, widely dispersed financiers with the necessary 'local knowledge' have been banished to the edges. . . . The core is now dominated by a small number of very large firms that have little direct contact with the ultimate real users or providers of finance. . . . [E]mployees of the organizations that produce research and ratings--and the traders whose aggregated opinions constitute the wisdom of crowds--usually don't have much case-by-case local knowledge. They, too, often rely on [standard] statistical models, or just take cues from each other. (A Call for Judgment, 12)
Conservative thinkers like Russ Roberts and Nicole Gelinas have also observed just how far modern finance is from anything resembling a decentralized, "free market." Louise Story's "secetive banking elite" is not merely affecting derivatives trading, but core operations across the sector.
The finance industry's long term efforts to take over government's role in major risk management fail even on their own, free market terms. It's time for radical rethink of the role of finance in the economy. The right is already well on its way toward "tight money" or even a gold standard as an answer to our current economic crisis. Progressives must realize how much is at stake if they fail to deliver an alternative narrative. Matt Stoller gets this, and offers the following insights:
Liberals should stop their love affair with conservative technocratic myths of monetary independence[,] move beyond [a] consumer-driven approach[,] and think about reform of the credit system, of the monetary order, as Elizabeth Warren [and Jane D'Arista have]. The link between the Federal Reserve and the ‘real economy’ is broken. When banks were the main conduit between the financial world and economic activity, translating savings into investment, the Fed could manipulate the economy by manipulating the banking sector. But now that shadow banks dominate our credit markets, and the Fed has allowed hot money to take over monetary policy, the Fed’s tools just don’t work. That’s why quantitative easing is foolish. We must dispatch with the ridiculous notion that pushing hundreds of billions of dollars into a broken banking system will have useful consequences.
Instead, let’s recognize that the Fed doesn’t fulfill either part of its mandate, and work towards a better and more plausible system of monetary stability. That’s not a longterm process, it’s a constant process. D’Arista argues that the Fed must connect itself to the shadow banking system and force credit to flow. This necessarily implies important changes in how the Fed interacts with financial services firms and entities. To give some idea of what this might look like, at least conceptually, Timothy Canova paints the portrait of a more democratic Federal Reserve financing the government debt during World War II. Cooperating with a phalanx of institutions, such as the Reconstruction Finance Corporation, and government boards that directed wartime rationing, the Fed was able to . . . dramatically equalize economic opportunity and wealth-building for the middle class.
Whatever one thinks of Stoller's, Canova's, and D'Arista's views, we should be able to agree that high finance's theories of risk management have led it to usurp roles that only government can play. We continue to bet on the privatization of risk at our peril.
*I derive that figure from Wolff's update on trends in household wealth and Domhoff's observation that "there has been an 'astounding' 36.1% drop in the wealth (marketable assets) of the median household since the peak of the housing bubble in 2007. By contrast, the wealth of the top 1% of households dropped by far less: just 11.1%."