"Bankruptcy for profit" (10 March 2009)

Economist Simon Johnson, of the excellent Baseline Scenario blog, wrote a post that effectively sums up what is so frightening about the predicament the big banks' negligence has put the U.S. in. Obviously, it's not that the U.S. is in danger of becoming a social democracy or a socialist state or whatever making Limbaugh's legions whine -- I would welcome that sort of development anyway. And banks have never been a purely private industry anyway; they have always relied on certain dispensations and implicit guarantees from the state to operate. The real danger is that the current chaos and uncertainty in banking will worsen the principal-agent problem and lead to the sort of corruption we associate with organized crime becoming entrenched in the official economy.

Maybe I'm naive, but part of American "exceptionalism," it seems to me, is its complacency about corruption, as though its highly ambitious and self-interested capitalists instinctively shy away from compromising the system by cheating it, by abusing the commercial codes of trust that allow the economy to function and thrive where graft-laden bureaucracies falter. But downturns challenge that faith, and well-placed people begin to see more advantage in rewarding themselves financially than in the glory of power in a proud and growing economy. Johnson's post explains how that may be playing out now.

Boris Fyodorov, the late Russian Minister of Finance who struggled for many years against corruption and the abuse of authority, could be blunt. Confusion helps the powerful, he argued. When there are complicated government bailout schemes, multiple exchange rates, or high inflation, it is very hard to keep track of market prices and to protect the value of firms. The result, if taken to an extreme, is looting: the collapse of banks, industrial firms, and other entities because the insiders take the money (or other valuables) and run.
This is the prospect now faced by the United States.

This analysis suggests some of the powerful incentives various financial players have to create more confusion than what the volatility in the markets have already generated. They can profit personally, or at least protect themselves, and the expense of the system generally. The scheme of bailouts as they are being conducted currently by the state, play right into these players' hands.

The course of policy is set. For at least the next 18 months, we know what to expect on the banking front. Now Treasury is committed, the leadership in this area will not deviate from a pro-insider policy for large banks; they are not interested in alternative approaches (I’ve asked). The result will be further destruction of the private credit system and more recourse to relatively nontransparent actions by the Federal Reserve, with all the risks that entails.

Responding to Johnson's post, Yves Smith points to a 1994 paper by economists George Akerlof and Paul Romer that makes a similar point. Their argument is a kind of moral-hazard variant that sees an incentive for corruption in the wake of bailout plans.

Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society's expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations....Unfortunately, firms covered by government guarantees are not the only ones that face severely distorted incentives. Looting can spread symbiotically to other markets, bringing to life a whole economic underworld with perverse incentives. The looters in the sector covered by the government guarantees will make trades with unaffiliated firms outside this sector, causing them to produce in a way that helps maximize the looters' current extractions with no regard for future losses.

Then we have an economy that lacks even the pretense of competitive meritocracy, an inherently unsustainable one in which connections to favored firms is all that matters. Those firms profit without sustainable business models, at the expense of firms that might have such models, until the economy grinds to a halt. That may actually be what has already happened.