Deconstructing the Put-Option State
Larry and David Zaring have a thoughtful piece making the case against an overly exhuberent regulatory response to the financial crisis. There is a lot of wisdom to what they say. At its bottom, however, it seems to me that the keygovernment failure lay not in our regulations but in our political culture. As Simon Johnson (of the must-read Baseline Scenario blog) observes in the most recent issue of The Atlantic, our current debacle looks less like Wall Street circa 1930 than Indonesia circa 1997. The problem is not that we are reaping the whirl-wind of unregulated markets run amok, but rather that we are reaping the whirl-wind of a system where politically powerful business actors get the up-side of huge risks, while they can push the downside on to the public. We are living in the put-option state.
The put-option state is not the same thing as the deregulated state. Of course, by definition it is always possible to say ex post that any particular crisis could have been solved by better regulation ex ante. After all, if set of actions X had horrible consequences, it is tautalogical to claim that we could have avoided those consequences had we forbidden set of actions X at the outset. Hence, every problem can be seen as a failure to regulate ex ante. What the failure of regulation story doesn’t tell us, however, is why institutions engaged in self-destructive behavior in the first place. Yes, they did so because they were allowed to do so, but why did they want to?
The answer, of course, is that they didn’t think that they would have to pay if the whole thing blew up. They had the “Greenspan Put.” They could force the government to buy their bad investments at a mark-up and save themselves from bad decisions. This is not really what happened in 1929, but it is what happened all over the emerging market world in the late 1990s. Bankers in Thailand, Korea, and Indonesia with powerful political connections made out like bandits on risky or self-dealing transactions with the knowledge that they could bend the state (and through it the tax payers) to their benefit if things went bad.
The put-option state, however, is not a regulatory creation. There was no explicit government guarantee of the GSEs. There was no explicit government guarantee of money market funds. There was no explicit government guarantee of the commercial paper market. There was no explicit government guartantee of AIG, CitiGroup, Bank of America, Bear Sterns, or the rest. The put options on which these institutions built themselves don’t exist in our laws. They still don’t exist in our laws, as each of these bailouts has been conducted on an ad hoc, transaction by transaction basis. The put-option exists at the level of political practice rather than at the level of enacted law.
What this means, however, is that fixing the real problem — the put option state — is not a matter of simply changing our regulations. It is a matter of changing our political culture. It was the political culture, not the laws, that gave the put to the barons of Wall Street. What is needed to fix this is not a new relationship between the SEC and the CFTC. What is needed is political leadership that can shift the political culture itself. It is here, I believe, that the Obama Administration has made its gravest errors. It looks as though the stress tests are going to result in a further rescue of “solvent”-but-still-mysteriously-in-need-of-capital banks by converting billions of dollars in government preferred shares into common equity. In short, the tax payer goes from creditor to investor in order to save institutions that cannot save themselves by raising capital in the real market. We simply continue the put-option state.
The truth is that our current regulatory system actually has in place a set of procedures for dealing with insolvent banks, albeit procedures that would need to be beefed up to deal with current volume. When a bank is insolvent we put them in recievership, wipe out the equity and perhaps the junior debt and then sell off the profitable bits that are left. New managment is installed. The bank never shuts its doors. Money continues to flow in and out. Depositors and other senior creditors are protected. For any other kind of institution we would call this process bankruptcy, and it is blessedly where Chrystler has finally ended up (although it should have been there months ago). In the patois of the put-option state, however, this orderly process of liquidation and reorganization of the insolvent (the process that actually exists within our legal structure) has been tarred as “nationalization,” in order for the government to take even larger equity positions in banks. This is Orwellian rhetoric of the first order.
To paraphrase Cassius, the fault is not in our laws but in ourselves that we are underlings. As much as we may need regulatory reform, we need a new political culture more.