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Old 12-17-2008, 04:17 PM   #21
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I hate to break up this circle...

The "too big to fail" philosophy is a realization that a failure of a large and important company - like, say, Lehman Brothers (or LTCM or AIG or MBIA) - would cause further pain in the economy. If propping up a company slows down or prevents a spiral, then it might benefit the economy even though "free market" ideologies are bruised.
Sure. But that begs a couple of questions in and of itself:

1. If becoming "too big to fail" means the taxpayers have to subsidize your failure, maybe we need to consider whether it's wise to allow a business to become so large?

2. Propping up a failing "too big to fail" business or industry takes multiple forms. When the reason for the failure is largely because of the business model and cost structure, propping them up with taxpayer money with little or no demands toward fixing said business model and cost structure is just throwing good money after bad.
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Old 12-17-2008, 04:22 PM   #22
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Originally Posted by ziggy29 View Post
2. Propping up a failing "too big to fail" business or industry takes multiple forms. When the reason for the failure is largely because of the business model and cost structure, propping them up with taxpayer money with little or no demands toward fixing said business model and cost structure is just throwing good money after bad.
This is true. More transparency would work, at least in the financial world.

Saying "See ya" might leave us feeling all warm and fuzzy as we curl up with Adam Smith but it may not be the wisest choice. It's hard to get an economy moving again if credit is constipated or even non-existent.
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Old 12-17-2008, 05:20 PM   #23
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I think most people agree that markets work fabulously well when risks and rewards are transparent, and when those who stand to gain from taking risk will also lose if things go poorly. That was apparently not the case here. Saying "the free market didn't work" is like saying "automobiles don't work" after you get a flat tire. The market works fine if we just have regulations in place that set the conditions for transparency and assuring that the results (good or bad) from taking risks accrue to the proper parties.

I do wonder exactly how the current bailout orgy is helping us re-align risk and reward in our financial system. It does precisely the opposite.
Very well said. And I am of the opinion that we will not secure our future until 90% of the High School graduating class understands that simple bit of information. It is hazardous when an electorate is free to wail to their representatives that we need this, or need that, w/o understanding the implications.


RE: "too big to fail"
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Originally Posted by eridanus View Post
Saying "See ya" might leave us feeling all warm and fuzzy as we curl up with Adam Smith but it may not be the wisest choice. It's hard to get an economy moving again if credit is constipated or even non-existent.
In the short term maybe. But you are ignoring the long-term consequences of breaking the risk/reward link. The next "too big to fail" company takes on too much risk (maybe wiping out smaller companies that cannot be so aggressive), and maybe has to get bailed out ( after destroying truly competitive companies), and on, and on, and on.

However, I do wonder if there may be a point in regulating companies so that they cannot get so large as to cause a meltdown if they make an error. But, if you broke them up, would the industry just still be as large, and still be as dangerous? I dunno.

-ERD50
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Old 12-17-2008, 06:58 PM   #24
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Right on.

I will add another point that anti-free marketers tend to get wrong. They often assert that the free market fails when a poorly run company fails. NO! The free market succeeds when a poorly run company fails, and the value of the company is wiped out. Freedom to succeed (and be rewarded for success) and freedom to fail (and be punished for failure). Without the latter, you don't really have the former.
I'm not sure who the "anti-free marketers" are. Are some of them posting here?

The problem is that this:
Quote:
Originally Posted by samclem
I think most people agree that markets work fabulously well when risks and rewards are transparent, and when those who stand to gain from taking risk will also lose if things go poorly.
doesn't always happen automatically. Suppose I put up a building on my farm, cut corners on the electrical work, and the building burns down. I'm the sole loser when my gamble doesn't work out well.

If I do the same thing while remodling my downtown store, and the entire block burns down, then I've generated a much bigger loss. If I don't have enough assets to reimburse my neighbors for my failed gamble, or if my assets are protected because I made sure that the building was owned by a limited liability corporation, then neither my neighbors nor I have recieved the rewards and losses arising from our own actions.

In the case of certain financial institutions, the claim is that their risky behavior would have led to a depression - which would involve trillions of real losses (not just market values or loan guarantees). This is a case where the people generating the loss won't and can't pick up the tab for the losses they created. So it seems to me that Sam's necessary condition for successful markets isn't satisfied.
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Old 12-17-2008, 09:50 PM   #25
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Originally Posted by Independent View Post
...
Suppose I put up a building on my farm, cut corners on the electrical work, and the building burns down. I'm the sole loser when my gamble doesn't work out well.

If I do the same thing while remodling my downtown store, and the entire block burns down, then I've generated a much bigger loss. If I don't have enough assets to reimburse my neighbors for my failed gamble, or if my assets are protected because I made sure that the building was owned by a limited liability corporation, then neither my neighbors nor I have recieved the rewards and losses arising from our own actions.
....
To take your analogy a little further:

That's why to do work on your commercial building downtown you have to be a licensed electrician & your work subject to inspection by the government building inspector to make sure it's up to code - while just anybody is allowed to wire their own barn out in the country without oversight.

So - who was licensing the "electricians" and writing the the "code", & who/where were the "inspectors"?

And when the buildings burned down - was it the fault of the electricians, the code, or the inspectors?
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Old 12-18-2008, 09:28 AM   #26
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To take your analogy a little further:

That's why to do work on your commercial building downtown you have to be a licensed electrician & your work subject to inspection by the government building inspector to make sure it's up to code - while just anybody is allowed to wire their own barn out in the country without oversight.
Exactly. It doesn't make sense to regulate everything that moves. But it does make sense for those things that can do a lot of damage to bystanders.

Quote:
So - who was licensing the "electricians" and writing the the "code", & who/where were the "inspectors"?

And when the buildings burned down - was it the fault of the electricians, the code, or the inspectors?
Because you put words in quotes, I'm assuming that you are looking for the financial system analogy. The way it's supposed to work is that "banking examiners" and "insurance examiners" look at companies' books to make sure that their capital is adequate for the risks they are assuming.

"Who's at fault when something goes wrong?". Any or all, depending on the facts. The system is supposed to be somewhat redundant. The electrician who did the work is supposed to do good work, and the inspector is supposed to catch the rare case when he doesn't. So if the reason the building burned down is poor electrical work, then both the worker and the inspector failed.

(I'm not sure if you are looking at "the code" as a separate issue. If so, then regulation can fail because the code the inspector is supposed to be following is bad, or because the inspector didn't follow it, or both. Stiglitz referred to this example The New York Times > Log In
It seems like the people enforcing the rules had the power to write the rules, so it's kind of hard to distinguish between "inspectors" and "code" in this case.)

Note: The link above has an odd name. When I click on it, I get a 10-2-08 NYT story with a headline "Agency’s ’04 Rule Let Banks Pile Up New Debt".
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Old 12-18-2008, 09:58 AM   #27
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Great analogy, and great way to look at the issue.

I'll add that with the building code analogy, there are a few more things at work:

Quote:
The system is supposed to be somewhat redundant. The electrician who did the work is supposed to do good work, and the inspector is supposed to catch the rare case when he doesn't.
1) Also, the materials used are standardized, and have 'evolved' to be more mistake proof in all steps of the process.

2) There is at least some transparency to the owner (who may not be too concerned about his neighbors, but does not want his own building to burn down) - I look over the work that is done in my home to make sure it was done properly. Even if you are not an expert, you get a sense of things, even if just the general 'did they act professional'.

3) Your insurance company wants to know the work was done right. They have a direct or indirect hand in this (I'm pretty sure the ins co had input on building codes, and are pretty much the reason URL was formed).

4) Feedback. There are millions of buildings, and many fires each year. When a fire breaks out, there is a postmortem. Ins cos collect data, and will ask for changes if something stands out.

5) Time. Buildings and ins have been around a long time. Things move slow enough, that bad practices can be corrected. Maybe aluminum wire was eliminated just due to cost, but IIRC there were safety issues (it contracts/expands more than Cu, I think - causes more mechanical stress on connections).

So look at that, and see how many things are missing in the financial side. New products, things hidden from view, failures far-and-few between so not much corrective feedback, who holds the risk, etc....

So yes, regulation is needed, but it needs to focus on transparency, or who the heck knows what is really going on until it is too late?

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Old 12-18-2008, 08:37 PM   #28
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Great analogy, and great way to look at the issue.

I'll add that with the building code analogy, there are a few more things at work:

1) Also, the materials used are standardized, and have 'evolved' to be more mistake proof in all steps of the process.

2) There is at least some transparency to the owner (who may not be too concerned about his neighbors, but does not want his own building to burn down) - I look over the work that is done in my home to make sure it was done properly. Even if you are not an expert, you get a sense of things, even if just the general 'did they act professional'.

3) Your insurance company wants to know the work was done right. They have a direct or indirect hand in this (I'm pretty sure the ins co had input on building codes, and are pretty much the reason URL was formed).

4) Feedback. There are millions of buildings, and many fires each year. When a fire breaks out, there is a postmortem. Ins cos collect data, and will ask for changes if something stands out.

5) Time. Buildings and ins have been around a long time. Things move slow enough, that bad practices can be corrected. Maybe aluminum wire was eliminated just due to cost, but IIRC there were safety issues (it contracts/expands more than Cu, I think - causes more mechanical stress on connections).

So look at that, and see how many things are missing in the financial side. New products, things hidden from view, failures far-and-few between so not much corrective feedback, who holds the risk, etc....

So yes, regulation is needed, but it needs to focus on transparency, or who the heck knows what is really going on until it is too late?

-ERD50
Okay, I'll try to push the analogy a little further (maybe too far). I'll emphasize your 1 and 5.

In the electrical world, suppose a manufacturer comes out with a new, lower-risistence alloy that allows for thinner wire and lower costs. There is some concern that this alloy reacts with traditional insulation materials and degrades them. The manufacturer says to not worry -- their engineers have a computer model that says this can't happen. But, the model is proprietary and so complex that nobody from the gov't could possibly understand it. My guess is that the code doesn't get updated. Nobody thinks that the potential benefits of switching to the new wire outweigh the potential costs. Building codes are conservative.

But, in the last __ years, the word in the financial sector has been that we can't do anything to slow down innovation. Only the latest and greatest ideas will support our economy. The regulators can't keep up so they should get out of the way. I think that's the attitude that needs to change.

Fortunately, financial regulators have an intermediate option. Instead of banning a product, they can require a higher level of capital to support it. We'll lose some potential efficiencies, but that seems better than periodic meltdowns.

There may be better ways to provide information to owners (your #2) and creditors than we have today. Your #4 gets to the "too big to fail" issue. simply limiting the total dollars that any one firm can put in an unusual product could result in smaller failures where we learn instead of getting buried. Some people have suggested limiting the size of financial companies. That seems like a huge change from current practice, but it certainly seems to deal directly with the TBTF concern.

Except for the last option (putting a cap on total firm size), all of these possibilities are things that I thought regulators were routinely doing years ago. I don't think we need a whole new structure, we simply need to dust off the old ideas and use them.
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