Sunday, December 21, 2008

Economics and biology

A Victoria's Secret catalog gets me thinking about economic stimulation, credit, and regulation.

At this time of hair-raising de-leveraging, the going joke is that "We found the WMD's!". This came up in an excellent piece by Henry Blodget in the Atlantic. But I'd like to suggest a different metaphor- that of cancer, another syndrome of defective regulation/intelligence. Blodget takes the position that the system (and human nature) is built to forget the past, so whatever we learn now will inevitably go up in smoke, in the excitement of the next bull/bubble market. Just as competition is the life blood of economic activity and its associated ills, so selection is the lifeblood of biology, and its associated ills such as cancer.

Over evolutionary time, our cells have acquired ornate mechanisms of growth regulation, so that they divide like hell's bells early on, producing a baby from one cell in nine months, but then slow to a crawl, or in the case of many cells like neurons, enter complete stasis, not dividing at all while doing the work of adulthood. There are many controls over cellular decisions like responding to local damage, living amicably with one's neighbors, and whether to divide, culminating in the most extreme solution to all three- cell suicide, called apoptosis.

The most well-known example of such a regulator is p53, a protein which is positioned at a central nexus, receiving signals about damage to DNA, chemical stresses, and other problems that might warrent holding up cell division or even committing hari kari. When signalled, it binds to various genes on the DNA and turns them on to execute the program of either shutting down cell division (p21/CDK complex), or shutting down the cell completely (Bax/caspases).

Through the inexorable process of natural selection, some cells will find a way around the commands to stop growing or to destroy themselves. They may have DNA damage to the very genes, like p53, that provide that regulation, or their defect may generate vast over-expression of pro-growth signals that become immune to countervailing influences. This is cancer, and it takes several defects in the regulatory system to allow such over-growth to develop.

Is that starting to sound familiar? The financial system is set up with its own selective imperatives, foremost of which is to make money. Once a bull market gets going, as Blodget relates, the naysayers tend to be wrong year after year after year, lose money, and get sidelined. Cheerleaders such as Blodget himself during the internet stock boom, and real estate agents parrotting the mantras of "real estate never goes down" hold the floor while the music is playing and the disease is getting worse. And worst of all, regulators like the Fed are also overtaken with deregulatory zeal, even in cases like Ben Bernanke, who despite being a student of the great depression promoted the idea that regulators had no role in preventing bubbles, but can only hope to clean up after them. The regulatory systems become compromised, and the disease spreads until the music finally stops, and everyone scurries for cover. Thankfully, this disease is not terminal, but it is still extremely painful, and worth trying to prevent.

I think that throwing up our hands in the face of this process (as Blodget fatalistically does) is not acceptable. Biology labors against a far more difficult problem, there being billions years of evolution that went into the cellular control mechanisms that keep us (mostly) alive through reproductive age. We ask medical research to win the "war on cancer", but are we to ask no more of economists than to accede to human psychology, and let wealth and productivity wither periodically for the freedom of the financial markets to engage in speculative excess?

One template to look at is bank regulation. Banks in their regulated aspects did quite well during this crisis- it was the unregulated derivatives, hedge funds, and wildly overleveraged "investment" banking that collapsed, with the remaining investment houses ironically seeking protection by taking the form of regulated banks. Banking regulation restricts leverage to about 1:10, as well as restricting the targets of that leverage- collateralized loans in such things as real estate or businesses with whose operations the bank has some, if not thorough, familiarity. In combination with modest deposit insurance and other guarantees from the government, this makes for a quite stable system.

The amazing thing was that the Fed, other regulators, and congress decided that other actors in the system that made far riskier loans (to speculators in financial markets) could be far more highly leveraged, (1:50 or above), since the government was not directly on the hook through deposit insurance or other guarantees. Even the LTCM collapse did not warn Greenspan and others that this leverage is a disease that could bring down the entire system, while not offering much public good in return. It is, simply, a genteel form of gambling with very, very large amounts of borrowed money.

So, in a rational world, we would have a regulator with general responsibilities to limit leverage, allowing the most leverage in closely regulated and beneficial institutions (banks), while allowing less (instead of more) in speculative and more lightly regulated institutions. Indeed, it has always mystified me why margin accounts at brokerages are allowed at all- borrowing to buy stocks is the surest way to increase market volatility. There is nothing wrong with speculation, which plays an important role in market efficiency, but lending someone money to speculate is like playing Russian roulette, not just for the speculator and the lender, but for the markets and the economy as a whole.

A general leverage regulator is needed because, like the cancer process, financial markets are endlessly inventive (aka "innovative") at devising new ways to gamble. Mutations and lapses in attention will always occur, so that formal rules will always be out of date. No regulatory system is perfect, just as nobody is completely immune to cancer, but we can learn from history and do better, on a speedier time frame than that of evolution. The Fed is ideally positioned to be this regulator, and should have the function of restricting all kinds of leverage added to its portfolio of regulating banks, keeping the currency stable, and promoting sustainable economic growth.

While I am at it, let me throw out several more pieces of an economic reform program, though this is mostly oriented to the car bailout and general economic mess, not the financial industry specifically.
  • Health care: Relieve businesses of the administrative burden of health care by nationalizing it, as per the pending Obama plans, or something more adventurous like single-payer. Businesses should not shop around for younger employees because they are cheaper to insure. Employees should not depend on employers to provide health care. Incidentally, one step towards cost control could be to revise the FDA approval process to have two levels of approval- one basic level for safety and efficacy, as is done now, and a second level for demonstrated cost/benefit advantage over the current standard of care. One cause of rising health care costs (aside from the absurd duplication and expense of private care insurers/deniers) is that new treatments are not put through a rigorous benefit analysis. Drug and device companies relentlessly push marginal products through the approval process, then devote vast sums to advertise them for benefits that are often absent or minimal.
  • Pensions: Businesses should likewise be relieved of the administrative burden and cost inequality of pensions, switching to a nationalized program combining a beefed-up social security with government-run 401K funds. Nowhere is the burden of retirement provisioning more apparent than in the domestic car industry. With roughly 2 or 3 retirees for every worker, they are groaning under this burden, and every sensible program to downsize them in accordance with their self-managed decline in market share makes this ratio even worse. Pensions for all companies (and government entities, which are likewise facing financial chaos from their pension obligations) should be immediately nationalized, so that each employer pays a set tax rate per current employee (like the social security system, only not capped by maximum income). This could be a mix of defined benefits as a safety net and an optional 401K-like account with the government, offering a few selections of risk. Then all retirees, including those not employed (such as housewives, for instance) would get a mix of defined benefits and invested returns that are partially tied to their contributions and former income, and partially set as a safety net not dependent on prior work at all. This would allow older companies with many retirees to compete on a level playing field with new startups, give all citizens the assurance of retirement income whether or not they worked or were married to a worker, and allow workers to switch jobs without fear of losing their pension.
  • Unions: I support greater unionization, but unions impose costs as well, especially when they are too successful in gaining income and working (or non-working) condition benefits. Unions should organize downtrodden farmworkers and janitors, not dictate no-work jobs, antiquated labor-intensive technologies, and 100K/year longshoreman salaries. My proposal would be that unions be prohibited from representing anyone over the national median income. This would put higher-salaried workers into the regular job market, instead of an artifically negotiated system. What would this do to NBA players? I am not sure- Insofar as management has monopoly power, in this case congressionally sanctioned, workers should likewise be able to organize. However the government's role should generally be to break monopolies, not sanction them.
  • Executive pay: The salaries of many corporate and investment managers have been clearly excessive and economically detrimental, motivating them to find beneficial option sale and exit strategies rather than building better companies. Salaries should be capped at 25X the median salary of the managed corporation including subsidiaries. Extra income should be restricted to a new kind of stock option granted on a five year plan, where the grant price is the mean price for the current year, and the options can be redeemed only after five years, at the mean stock price of the trailing year. This would go a long way to re-aligning the interests of management with those of employees and stockholders. There would be no private pensions, parachutes, etc. One interesting side-effect of this proposal would be to motivate management teams to separate themselves from the underlying base companies so that they could be paid more. But since they would have separated rather than subsidiary relationships, this might open a new market for management services, which might enable corporate boards to bid more effectively for these services, enhancing competition and keeping prices down.

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