By Arnold Kling
I am reading Edward Conard’s Unintended Consequences, because Tyler Cowen wrote,
I find parts of this book brilliant and other parts dead wrong. In any case it is full of substance, it is one of the must-read books of the year
Tyler wrote a second post about the book here. Conard has views that run counter to The Great Stagnation, which perhaps explains why Tyler considers him “dead wrong.”
Conard takes the view that the 1990s boom was real, with genuine gains in productivity. For every fact that a Michael Mandel might supply to claim that the boom was phony (as far as I know, Mandel is not mentioned by name by Conard), Conard supplies an equal and opposite fact. Conard claims that if you include intangible investment (think of Garett Jones workers), capital formation in the United States was enormous in the two decades preceding the crisis.
For me, the most interesting thing about the book probably was Conard’s take on the Recourse Rule, issued early in 2001. That rule gave favorable capital treatment to AAA-rated securities, and some of us see that as the catalyst for subsequent innovations that manufactured such securities to produce regulatory arbitrage.
Conard argues that the Recourse Rule was a good move, because it steered banks away from holding the high-risk tranches of mortgage securities and steered them toward holding the low-risk tranches instead. Indeed, that may have been the thinking of the regulators, and in a static world it may be right. Other things equal, if banks hold more AAA tranches and fewer junior tranches, that reduces the risk to taxpayers. But other things were not equal. I still believe that the amount of securitization unleashed by the Recourse Rule meant that banks wound up taking on more mortgage risk, rather than less.
In many ways, Conard gives us the economic version of Steven Johnson’s Everything Bad is Good for You. The trade deficit is good for us, because we used it for capital formation. Inequality is good for us, because the middle class is risk averse and wants fixed-income assets, and we need rich people to hold the residual claims (equity) in risky investments. Financialization is good for us, because it allows risk-takers to lever up and generate more capital formation. Government guarantees of banks are good for us, and even should be made more explicit, because bank runs are the really big problem, and moral hazard is manageable.
Of course, channeling lots of capital into low-quality mortgages is nor good for us, and Conard understands that. But overall, he is in favor of banks and the risks that they take.
Leaving short-term capital sitting idle causes unemployment…Keynes describes this as the the “paradox of thrift”…Lending and borrowing…increases the size of the economy, its growth rate, and employment.
I wince at the phrase “causes unemployment.” You could have an economy with very little risk-taking and full employment. It could be a long-run equilibrium, relatively stagnant. I would be more comfortable saying that a sharp transition away from risk taking would lead to a period of high unemployment.
He also writes,
Some critics blame banks for borrowing short and lending long, but that’s the purpose of banking. Long-term investors willing to put their capital at risk don’t need banks.
That is a quote worth framing, I think. As you know, I think that people want to hold short-term riskless assets and issue long-term risky liabilities, and that financial intermediaries accommodate this by doing the opposite. However, I believe that there is such a thing as too much financial intermediation. Conard seems to write as if the limit, if any, has not been reached.
Reducing the size and interconnectedness of banks will do little, if anything, to reduce the threat of panicked withdrawals. In a crisis, bank failures do not occur in isolation.
I am not sure that the evidence supports this view. There are economists who argue that customers do fairly well at distinguishing strong banks from weak banks. In other words, the “domino theory” or “contagion theory” of bank runs is not necessarily supported empirically.
I don’t know about Tyler, but I think Conard is pretty close to “dead wrong” in his defense of the scale of the largest banks and the financial sector as a whole. I think he is dead wrong in supposing that regulators can use risk-based pricing to solve the problem of moral hazard in deposit insurance. As I have been saying in my discussion of principles-based regulation, I think that the banks can run circles around the regulators when it comes to playing any sort of principal-agent game.
I may have more to say when I’ve finished the book. I have been emphasizing areas where I disagree with Conard, but in fact I agree with much of what he writes. Meanwhile, Nick Schulz interviews Conard. The diversity of his influences (see the end of the interview) does not surprise me, given his Austro-Keynesian macro views.