TOPICS IN POLITICAL ECONOMY

CHINA, CONVERGENCE, AND MARKET CAPITALISM

Most of the noise coming out of this week’s meeting of the  G-20  heads of state in London will be about regulation,  “stimulation” and new barriers to international trade.   But there Is very likely to be one truly significant long-run political outcome: the functional acceptance of China by “the West” as a major financial and economic power.

This acceptance will take the form of communiqué  language that makes it clearer than ever that China’s share of voting power in the International Monetary Fund (and, perhaps, in the World Bank) will be increased substantially within the next two years.  This shift in voting power will be facilitated by a large increase in IMF resources contributed by member governments, most prominently the Chinese.  

The Death of Market Capitalism?  At the same time, noisemakers at the G-20 meetings will add decibels to the continuing funereal chorus from the chattering classes about “the death of market capitalism.” This, despite the fact that China owes its rise to global power thanks to its embrace of the key elements of market capitalism:  market prices to provide incentives to producers and letting individuals own the means of production and grow rich.

Market capitalism is not going to wither away just because financial regulators around the world decide to insist on less risk-taking by (government-supported) financial institutions, such as FDIC-insured banks, “too big to fail” investment banks, and government real estate lending agencies (FNMA and Freddie Mac). 

It was a form of market capitalism that lifted 400 million Chinese out of dire poverty in the fifteen years between 1990 and 2005, and which now makes some pundits muse about turning global leadership over to the “G-2” – the United States and China. 

Why Losing Market Share May Be Progress.  If market capitalism is not dying, then perhaps the U.S. is threatened by China because of a shrinking share of global economic output?  This notion surfaces in numerous discussions about China’s extraordinary economic achievements as well as international comparisons  of spending on research and development,  patents issued, educational achievements and a myriad of other measures.

But the emphasis on “market share” is simple-minded and incorrect, if the absolute level of economic well-being continues to improve.  In this situation, which certainly describes the past 15 years or so, a smaller market share for #1 simply reflects more rapid growth by lower-ranked countries. 

Furthermore, as Nobel prize winning economist Edward Prescott and Stephen Parente have suggested, if all countries would dismantle “barriers to experimentation”  (ranging from civil strife to monopolies to trade protectionism), “there is no reason why the whole world should not be as rich as the leading industrial country.”  In short, China’s progress over the past two decades is a strong argument in favor of what is known as the “convergence” hypothesis among economic growth theorists – as well as market capitalism.

Cut the Bad-Mouthing.  So, when China sits down in a much bigger chair at IMF board meetings in 2011, there is no reason to bad-mouth either the U.S. or market capitalism.  Instead, congratulate the Chinese and remind yourself that it was a form of market capitalism that got them there.

THE SIREN CALL OF FINANCIAL MARKET REGULATION

At the recent meeting of G-20 finance ministers in London it seems "more regulation" was on everyone's lips as the way to avoid a repeat of the current financial mess.  The only difference between the U.S. and most of the other countries was "how much?" 

The Europeans are hung up on bringing hedge funds under much tighter regulation.  Why is this so?  At first glance, it is hard to understand: no huge "too big to fail" fund had to be bailed out by any government - although a lot have simply folded up and returned a few cents on the dollar to their original investors.  It is true that hedge fund managers became very nervous when their "prime brokers" such as Bear Stearns and Lehman Brothers started looking sickly.  These funds started pulling out their money and securities - or buying credit default swaps to protect themselves if their broker went bust. Were they wrong to behave in this manner?

The standard European politician's complaint is that hedge funds are secretive and disruptive, especially for the managements of old-line, sleepy corporations. That would help explain the push for regulation - along with the fact that they pose a long-run competitive threat to already over-regulated traditional financial institutions. 

Who's the Biggest  Problem?  The fact is that it was the most regulated institutions in the U.S. that have caused us the most problems: investment banks and money market funds overseen by the SEC plus commercial banks and bank-holding companies overseen by the FDIC, the Comptroller of the Currency and the Federal Reserve. 

With respect to the rating agencies (who made a major contribution to the 'perfect storm' of the current financial mess), the SEC has plenty to answer for. They required money market funds to structure their portfolios around S&P and Moody's credit ratings as a substitute for the funds' own due diligence. And anyone who studied the models used by  credit agency analysts to rate complex mortgage securities had to take a dim view of their robustness (i.e. using less than 10 years loss experience). All this, plus the well-known weakness in the agencies' current business model, where issuers, not investors, pay for the rating.

While the new SEC Chairwoman has talked obliquely about moving the agencies towards an "investor pays" model, the major government initiative at the moment seems to be to impose regulation and its attendant costs on the only honest canary in the credit rating coal mine - the unregulated credit default swap market.

And then there's the shadowy links between Bernie Madoff and the SEC staff, and the failures to follow up on credible suspicions of a long-standing Ponzi scheme.

AIG's Regulator: Asleep at the Switch.  Only just coming to light - and lost in the uproar over AIG bonuses -  is the failure of Federal government oversight of AIG's disastrous bets on derivatives.  In an extraordinary "mea culpa" in recent Congressional testimony, the Acting Director of the Office of Thrift Supervision has conceded that his agency (which had authority to examine all parts of AIG due to its ownership of a federal savings bank) fell down on the job despite "continuous, consolidated supervision of the AIG group."

You would think that thoughtful politicians and public officials would understand that it wasn't too little regulation that contributed to the financial mess, but a combination of clueless regulation, perverse incentives (e.g. for rating agencies and financial firms' compensation arrangements) and an inability by the federal government to effectively address the "too big to fail" issue that are the central regulatory issues.  Addressing these subjects effectively is where real leadership in Congress and at the agencies is needed - and sorely lacking.

"MARK TO MARKET" ACCOUNTING: GASOLINE ON THE FIRE?

To understand the importance of the "mark to market" issue that is causing so much anguish in the financial markets  ("gasoline on the fire," in the words of Warren Buffett), here's a homely example.

Personal "Mark to Market" Accounting. Let's say a year ago I drew up a personal financial statement in the form of a balance sheet.  On the asset side, I have a very enjoyable Picasso portrait passed on by a deceased aunt.  Her estate valued the painting at $300,000 and that's what I put in my statement. After making all the other entries, my net worth (assets minus liabilities) came to $200,000.

But I read in the paper today that similar Picasso portraits are now selling for only $100,000. If I updated that financial statement, I would show a net worth of zero.  Should I  (1) declare bankruptcy or (2) ask a still-alive rich uncle for an immediate cash infusion?

Or (3) should I just go on as if nothing much had happened, continuing to admire the painting every time I passed it.  (Although I might advise my future heirs that if the market didn't turn around before I died, the painting wouldn't be as valuable as they had counted on.)

Financial Institutions, Regulators and "Mark to Market."   If you are like most regulated financial institutions these days and it's "subprime" mortgage securities instead of Picassos that we are talking about, your choice is generally limited to (2). Of course, there is no functioning market in such securities, so the valuation numbers are guesses, given an air of authority by complicated formulae. 

The application of "mark to market" accounting to all manner of assets was intended by the regulators to reduce the ability of managements to "cook the books" by demanding an "objective"  and transparent valuation method. But anyone who is familiar with the accounting issues in, say, money market funds, knows how complex and seemingly arbitrary some of these issues can be.  Indeed, in many respects, required accounting approaches are as much philosophical or political as they are technical  (just ask an energy company executive about accounting for oil and gas reserves).

As explained clearly by Holman Jenkins in The Wall Street Journal, because of "mark to market" accounting, the regulatory agencies consider many mortgage-heavy banks as insolvent, or close to it, and demand that they raise new equity capital (or provide it via the U.S. Treasury, with politically generated constraints).  Without this pressure from the authorities, most banks with "toxic assets" could probably earn their way out of the current mess so long as the profit spread between their (government insured) deposits and lending rates remains extremely wide.

It's Called Forbearance.  We've been down this road before - in the early 1980s when every major U.S. international bank had a pot full of developing country debt on their books that was in default. Strict application of regulatory accounting rules at that time would have forced several of the majors out of business. The regulators and the Treasury Department decided to look the other way and concentrate on letting the banks earn their way out of the mess (with a little help in the form of renegotiations with the debtors). All the details are in an excellent FDIC paper of several years ago.

Forbearance increasingly seems to make considerably more sense (and drastically reduce taxpayer investment in the banking system) than the current policy mish-mash - which has every would-be investor in new bank equity issues uncertain about how government action will affect their investment.