externalities

I can hear you all saying: ‘Huh?’

Well there’s no economic news today so I thought I would attempt to tie together a few of the broader themes that seem, to me at least, to be crucial as we get the economy going again.

That’s where what I call social value comes in.

The purpose of regulation should be to preserve or establish social value in the face of potentially anti-social private behavior. And that’s it.

The surge of deregulatory legislation – is that an oxymoron? – dating back to the Reagan years was built upon a false premise: that private interests will always be pressed by market forces to correct any anti-social behavior and, eventually, eliminate harmful activity. Alternatively in cases where that mechanism failed, the pro-market advocates argued that the mythical market would engender new forms of activity sufficient to mitigate the pre-existing bad activity.

Let me explain further by looking at the case of pollution.

First we must recognize that private entities – you, me, and businesses the world over – find it highly profitable to pollute. Yes, pollution is profitable. The cost of eliminating a pollutant from an economic process is usually quite high, and to the extent that that cost can be made external to the entity involved there is an incentive to do so. In other words it is cheaper for someone to pollute and have society at large bear the cost, than it is for that same person, or business, to bear the full cost themselves. Economists have long been aware of this phenomenon and call it the problem of ‘externalities’.

Externalities are everywhere: an obvious example being carbon dioxide pollution created by our modern way of life. None of us, individually, bears the cost of the damage being done by CO2 being dumped in vast quantities into the atmosphere, and the power companies who are the most egregious polluters certainly don’t. Yet the damage has the potential to play havoc with our standard of living at some point in the future.

So with an externality there is a social sharing of the cost coupled with an individual avoidance of that same cost.

The existence of externalities distorts the economy. Current wealth and profits are illusory because they do not include the cost of countering the anti-social behavior. Case in point: the shareholders of GE earned profits on their ownership of a business that spewed toxic waste into the river Hudson for decades. Those profits were illusory when the cost of cleaning up the toxins is taken into account. So inflated was the difference between the announced profit and the fully costed profit that GE fought for three decades to avoid having to pay for its own mess: it even went so far as to deny it was accountable.

So profitable is polluting that GE’s anti-social activity is more the norm than the exception. It is only in recent years that pressure from social activists has resulted in admission that market forces, when left to themselves, are incapable of protecting society against such anti-social activities.

And remember: it is entirely sensible and rational for businesses [and individuals] to pollute. If we accept that businesses exist to make profits, which is the bedrock assumption of capitalism, then we must also accept that those businesses will seek to offload cost onto society – ‘externalize’ them – rather than have their shareholders absorb the full cost of whatever processes they are engaged in.

Which brings me to financial reform.

Banks, by which I mean the financial industry at large, are essential to our economy. They create credit. They do this by borrowing short term money – from things like your checking account, and lending it longer term – in things like your mortgage. Simple. This is an inherently risky undertaking. Banks call checking accounts ‘demand deposits’ exactly because a customer can demand his of her money at any time. We do this all the time whenever we draw cash from an ATM: we don’t have to warn the bank, we just walk in and ‘demand’ it by extracting it from the machine. Banks try to offset this risk by gathering deposits in more predictable forms like CD’s that have certain maturity dates.

But there’s more to it: because banks have experience in predicting how much their customers will want to draw out cash they don’t just lend the exact amount they have in deposits they lend many times that. In effect banks gamble that they will have enough cash on hand to pay out to depositors on any given day. It is this gamble that allows the banks to create credit and thus help the economy grow.

Why do they do this?

It’s profitable.

But, as must be obvious, it is also risky.

There is always the remote possibility that enough customers ask for their cash back that the bank finds itself unable to meet all its commitments. It must then sell off assets to raise the needed cash or go out of business. This is why banks always keep a supply of easily sold assets like government bonds: they can be liquidated and turned into cash at short notice.

The ultimate buttress a bank has to avoid going out of business is its own capital. Capital is simply an irredeemable deposit given to the bank by its original shareholders. It is irredeemable because the shareholders cannot simply ask for it back – if they want to get their cash they have to sell their shares, which has no effect on the bank itself.

The banks can also add to its own capital by making profits and then retaining them rather than paying out dividends.

The easiest way for a bank to generate big profits is to adjust the relationship between its capital and its assets. Since a balance sheet must always balance, the only area where a bank can stretch the rules is to bulk up its assets versus its capital. This relationship is expressed as a ratio: e.g. ’10:1′ or ’30:1′. Obviously if a bank has $30 of assets for each $1 of capital, it will earn more than it would at $10 to $1. But it also entertaining much more risk because each dollar of capital has to cover the potential loss of far more assets. Conversely: when the ratio is higher and the capital is spread thinner across all the bank’s assets, the chances of the bank losing all its capital and going out of business is mush higher.

Now we can get back to social value.

Since we recognize that banking is a vital part of a modern economy we, that is to say society at large, has underwritten chunks of a bank’s balance sheet. We have, for instance, created FDIC insurance that eliminates depositor risk on certain deposits. More recently, and this is the bigger problem, we have all but announced that none of the big banks will be allowed to fail. That is an awesome cost we have lifted from their shoulders.

Notice what we have done here: we have externalized the cost of the risk. The shareholders do not have to worry about managing those deposits or capital ratios as carefully as they might were they not insured or guaranteed. So they can entertain more risk and thus make more profit for themselves. Also notice: society does not get paid for providing this insurance. The shareholders get all the benefit.

Why?

Because we need banks and the collapse of a bank is so damaging to the economy that is worth providing the insurance. Besides we can justify it by claiming that we are protecting depositors – people like you and me – who otherwise might lose our savings.

Knowing that the taxpayer is covering their backs a bank’s shareholders then act just like GE’s in the example I mentioned above: they act anti-socially in order to exact extra profits. In effect they pollute. They create toxic products and externalize the cost of any problems associated with those assets. Meanwhile the shareholders and the management benefit from the free insurance that enables the polluting behavior.

Worse: when confronted with their anti-social activity, and when the threat of regulation raises the possibility of that behavior being limited, the banks act exactly like GE did: they deny responsibility, they obfuscate, they deploy armies of lobbyists and lawyers to help prolong the period of pollution, and, when ultimately forced to conceded, they do so begrudgingly and never fully absorb the cost of the externality they foisted on society. They do all of this, naturally, while proclaiming in their media activities to be exemplary citizens.

So what to do?

It should be a simple task: force internal what is now being made external. Make the shareholders and management pay the full cost of the polluting behavior. In the case of banks this would include charging for the implicit guarantee that they would be bailed out. This is over and above the FDIC insurance which the banks fund already. We can enforce huge capital ratios that make pollution unprofitable. We can place a heavy regulatory burden on product development to drive up the cost of new products and thus raise the threshold of their profitability – hopefully this would reduce the flood of socially useless but toxic assets being created on the bank’s trading desks. We can also simply refuse to provide a guarantee for certain activities – frivolous interbank trading for instance that does nothing but inflate trading desk bonus pools. I am sure you can all add to this list.

My point in raising all this is that we are currently discussing two reforms: that of the finance industry, which has been a very depressing activity of late given the weakness of the administration’s proposals; and that of our environmental legislation. I think we can borrow from the latter to energize the former. If we can introduce ‘cap and trade’ legislation for CO2 and other pollutants, maybe we can do it for mortgage backed securities and other forms of toxic banking.

It could prove to be a lot more effective than the miserable half measures the administration is currently arguing for.