Archive for November, 2009
| Peter Klein |
Douglass North welcomes fellow new institutionalists Elinor Ostrom and Oliver Williamson to the Nobel Club (via Jeffrey Huang):
| Dick Langlois |
Now here is an opening line you will be glad you didn’t write. (From our local newspaper, the Willimantic Chronicle, November 25, 2009.)
WINDHAM — After being vacant for six years, former Windham First Selectman Jean de Smet appointed two co-town historians to preserve and share their knowledge about the town.
This is especially funny in light of the controversial character of de Smet’s administration, although vacancy wasn’t among the complaints, and indeed increased vacancy actually might have improved things. (She was elected on the Green Party slate.)
I have added this article to my file of amusing pedagogical examples of faulty agreement and misplaced clauses. Here are two of my favorites from that file, one from the UConn Daily Campus and another from the Chronicle.
| Peter Klein |
Last week was tough for Shakespeare scholars who wear tweed jackets with leather elbow patches and sip sherry in the faculty lounge. You know, the people otherwise known as Saab drivers.
That’s from a Friday WSJ piece on GM’s attempt to dump its Saab subsidiary. Readers outside the US may not get the joke. Trust me, it’s funny.
The article is actually pretty interesting, an illustration of Williamson’s “impossibility-of-selective-intervention” thesis. “The Saab saga also demonstrates how hard it is for a boutique company to retain its special appeal after being bought by a corporate goliath. GM did make some good Saabs over the years (the midsize 9-5 model of a decade ago was one), but they didn’t seem as special as the pre-GM Saabs, even though the key stayed in the floor.” Maybe, but it isn’t obvious why the mismanagement of the Saab brand (in the US) was GM’s fault, rather than that of Saab’s division heads. Saab may have tanked anyway. Anyway, I did learn a good line from Sir John Egan, the last independent CEO of Jaguar before its acquisition by Ford, that I’ll use the next time I’m teaching about selective intervention: “When an elephant gets in bed with a mouse, the mouse gets killed and the elephant doesn’t have much fun.” Oh, and the article ends well too: “As for those sherry-sipping profs, maybe they should consider buying Chevy Silverado pickups with all the trimmings: Mars lights, gun racks and monster-truck tires. Iconoclasm can take different forms, and the talk in the faculty lounge will never be the same.”
Bonus: That same issue of the Journal also contained a strange piece by John Cassidy praising Pigou, on the grounds that Pigou’s analysis of externalities gives us unique insight into the financial crisis. “Thus, for example, a blow-up in a relatively obscure part of the credit markets—the subprime mortgage industry—can undermine the entire banking system, which, in turn, can drag the entire economy into a recession, as banks refuse to lend.” Um, duh. “Externalities” are ubiquitous, and the idea of the general interdependence of markets has been discussed since, well, Bastiat, if not the Scholastics. Certainly Pigou didn’t offer any special insight into the interdependencies across financial markets or between financial markets and product markets. Writes Cassidy: “Economics textbooks have long contained sections on how free markets fail to deal with negative spillovers such as pollution, traffic congestion and the like. Since August 2007, however, we have learned that negative spillovers occur in other sectors of the economy, especially banking.” Since August 2007? Gee, before that, we all thought banking was an isolated sector of the economy with no connection to anything.
| Peter Klein |
It’s the introduction to a special issue of the Review of Financial Studies:
The special issue features seven papers on corporate governance that were presented in a meeting of the NBER’s corporate governance project. Each of the papers represents state-of-the-art research in an important area of corporate governance research. For each of these areas, we discuss the importance of the area and the questions it focuses on, how the paper in the special issue makes a significant contribution to this area, and what we do and do not know about the area. We discuss in turn work on shareholders and shareholder activism, directors, executives and their compensation, controlling shareholders, comparative corporate governance, cross-border investments in global capital markets, and the political economy of corporate governance.
Here it is on the NBER site; I couldn’t find an ungated version.
| Peter Klein |
Found this posted on a classroom wall in our building. Not quite as witty as this one, but then again, we keep them heavily sedated:
On a more serious note, here’s a conference celebrating the 50th anniversary of Coase’s landmark 1959 and 1960 papers, with an all-star lineup.
| Dick Langlois |
My last post implicitly lauds the science reporting of the New York Times. And I think they generally do a good job. But, still basking in the glow of UConn’s remarkable football win over Notre Dame on Saturday, I am reminded of a — presumably unintentionally — funny bit of science reporting recently in the Times. Reporter Alan Schwartz has been waging a (perhaps justified) campaign about the problem of head-injury risk in football. In one article last month, he quotes a neurosurgeon on the physics of football collisions.
“I go back to Einstein and E = mc2,” said Julian Bailes, a former Pittsburgh Steelers neurosurgeon and one of the leading researchers in the neurological effects of football concussions. “The players are definitely much more massive and that’s one factor. But you have 300-pound linemen running 4.3s — and that factor is squared. The impacts that players face today, not just the big ones that everyone sees but the routine ones in the trenches, is what really worries me.”
Converting the mass of a 100Kg football player (light by NFL standards) into energy according to the Einstein formula would yield about 2,000 megatons of energy, probably enough to cause head trauma even in an NFL lineman. (It is the quoted source who makes the mistake, but the reporter and his editors didn’t catch it or at least didn’t remark on it or change it.)
When I was in high school, the assistant football coach was also the physics teacher. He tried to psych us up for one game against (as always) a bigger and more talented opponent by quoting the correct version of the mechanics of collision — energy goes up as the square of your velocity, not the square of the speed of light. How fast you get going, he was telling us, is much more important than the weight of the opponent. I found this a refreshing change from the usual cliché about the manner in which the opposing players were likely to don their athletic supporters. But under the circumstances, and especially as I was one of the few who had any idea what he was talking about, I declined to point out that smacking into another football player is an inelastic collision, so energy isn’t conserved. Momentum is always conserved, but that’s linear in both mass and velocity. I didn’t play football very seriously or for very long, but I am happy to blame the experience for my increasing mental lapses as I grow older.
Extra point. By the way, the inelastic collision pictured above is between Notre Dame running back Armando Allen and UConn middle linebacker Greg Lloyd (son of the former Pittsburgh Steeler of the same name) at the goal line on Saturday. UConn won the game in the second overtime. In college football, each overtime session allows both teams a single possession from the 25-yard line. In the first overtime, both teams scored a touchdown and an extra point. In the second overtime, UConn held ND to a field goal and then scored a touchdown on their turn, thus winning the game. This differs from the professional rule: sudden death. On Sunday, the Patriots beat the Jets in overtime because they won the coin toss and then quickly got close enough to score a field goal. Thus, in the pro game, the coin flip determines the outcome with high probability, a circumstances that rightly causes consternation among fans. Economists have suggested auctioning off possession in overtime, with the currency being the field position from which you are willing to start. At the very least, they ought to use something like the college system.
| Peter Klein |
In an oft-cited passage from The Mechanisms of Governance (1996), Williamson describes the research program of transaction cost economics this way:
Transaction cost economics (1) eschews intuitive notions of complexity and asks what the dimensions are on which transactions differ that present differential hazards. It further (2) asks what the attributes are on which governance structures differ that have hazard mitigation consequences. And it (3) asks what main purposes are served by economic organization. Because, moreover, contracting takes place over time, transaction cost economics (4) inquires into the intertemporal transformations that contracts and organization undergo. Also, in order to establish better why governance structures differ in discrete structural ways, it (5) asks why one form of organization (e.g., hierarchy) is unable to replicate the mechanisms found to be efficacious in another (e.g., the market). The object is to implement this microanalytic program, this interdisciplinary joinder of law, economics, and organization, in a “modest, slow, molecular, definitive” way.
A footnote explains the origins of the phrase “modest, slow, molecular, definitive,” tracing them to a (secondhand) quotation from Charles Péguy. Here’s the footnote:
The full quotation (source unknown) reads:
“The longer I live, citizen. . .” — this is the way the great passage in Peguy begins, words I once loved to say (I had them almost memorized) — “The longer I live, citizen, the less I believe in the efficiency of sudden illuminations that are not accompanied or supported by serious work, the less I believe in the efficiency of conversion, extraordinary, sudden and serious, in the efficiency of sudden passions, and the more I believe in the efficiency of modest, slow, molecular, definitive work. The longer I ive the less I believe in the efficiency of an extraordinary sudden social revolution, improvised, marvelous, with or without guns and impersonal dictatorship — and the more I believe in the efficiency of modest, slow, molecular, definitive work.”
Well, we are nothing if not pedantic here at O&M, and in that spirit, I share (with permission) a note from my colleague and former guest blogger Randy Westgren, written to Williamson in January 2007, explaining that the anonymous source has botched the Péguy quotation. Here’s Randy:
After a long search, I found the quote from Péguy that you cite in footnote nine of the Prologue of The Mechanisms of Governance and noted again in footnote eleven of the first chapter. I was not able to find the secondary quote that is printed in the footnote, but I did find the original passage from Péguy. I have been searching for this since The Mechanisms was published, because I could not fathom how Charles Péguy could have denounced sudden, wondrous conversion and sudden, extraordinary social revolution when he was (1) a famously devout Catholic; a mystic whose poetry includes an exceptional hommage to Joan of Arc, and (2) a famously ardent socialist who believed strongly in the overthrow of the bourgeoisie. In fact, after giving up on the Catholicism of his youth while at the École Normale Supérieure, he returned to his faith in the middle of the first decade of the century, when he was in his early 30s. He was slain in the first battle of the Marne in 1914 at the age of 41. (more…)
| Peter Klein |
Speaking of banks, here’s a very good survey of the entrepreneurship literature on financing constraints by William Kerr and Ramana Nanda, just out from NBER. From the introduction:
The first research stream considers the impact of financial market development on entrepreneurship. These papers usually employ variations across regions to examine how differences in observable characteristics of financial sectors (e.g., the level of competition among banks, the depth of credit markets) relate to entrepreneurs’ access to finance and realized rates of firm formation. The second stream employs variations across individuals to examine how propensities to start new businesses relate to personal wealth or recent changes therein. The notion behind this second line of research is that an association of individual wealth and propensity for self-employment or firm creation should be observed only if financial constraints for entrepreneurship exist.
These two streams of research have remained mostly separate literatures within economics, driven in large part by the different levels of analysis. Historically their general results have been mostly complementary. More recently, however, empirical research using individual-level variation has questioned the extent to which financing constraints are important for entrepreneurship in advanced economies. This new work argues that the strong associations between the financial resources of individuals and entrepreneurship observed in previous studies are driven to large extents by unobserved heterogeneity rather than substantive financing constraints. These contrarian studies have led to renewed interest and debate in how financing environments impact entrepreneurship in product markets.
| Craig Pirrong |
My previous post on the Acharya et al (AEFLS) assertion of the purported externality in bilateral OTC markets focused on whether there was actually an unpriced “bad.” I judged otherwise based on the fact that credit and counterparty risks are repriced repeatedly (and ruthlessly).
There is another reason to reject their analysis. It should be incumbent on one who justifies the existence of an externality to justify a particular policy to (a) identify the transactions costs that preclude internalization of this externality, and (b) demonstrate that their policy would create a net benefit, by, for instance, reducing transactions costs. AEFLS don’t even try to do this (another symptom of the Nirvana fallacy). And when one examines the particulars, it is highly doubtful that the costs of the purported externality are as large as AEFLS insinuate that they are.
The AEFLS story is that contracts between two counterparties to an OTC derivatives deal impose costs on other market participants, notably, the firms’ other counterparties to earlier derivatives deals, and the counterparties’ counterparties, and on and on. OTC market participants don’t take these costs into account, trade too much, and create too much risk.
Which raises the Coase Question: if these costs are so large, why don’t the affected parties craft a solution that mitigates them? If, as AEFLS argue, a central counterparty would reduce these costs, why don’t the affected parties create one to internalize the externality and enhance their welfare? (more…)
| Craig Pirrong |
Last week I wrote about one justification for exchange trading and clearing mandates in derivatives markets — the market power argument. This week I’ll examine another argument, and render a similarly skeptical verdict.
In a chapter of Restoring Financial Stability, Viral Acharya, Rob Engle, Steve Figlewski, Anthony Lynch and Marti Subrahmanyam argue that bilateral transactions in OTC derivatives markets involve an externality. Their argument is not stated that clearly, but FWIW here it is verbatim:
[A]ll OTC contracts . . . feature collateral or margin requirements, wherein counterparties post a deposit whose aim is to minimize counterparty risk. The deposit is marked to market daily, based on fluctuations in the value of the underlying contract and the creditworthiness of the counterparties . . . . The difficulty, however, is that such collateral arrangements are negotiated on a bilateral basis. Parties in each contract do not take full account of the fact that counterparty risk they are prepared to undertake in a contract also affects other players; indeed, they often cannot take account of this counterparty risk externality in an OTC setting, due to inadequate transparency about the counterparty’s positions and its interconnections with the rest of the market. While bilateral collateral arrangements do respond to worsening credit risk of a counterparty, such response is often tied to agency ratings, which are sluggish in capturing credit risk information and potentially inaccurate.
An externality means that some cost or benefit is not priced. By invoking the concept of externality Acharya et al (“AEFLS”) are asserting that something — a bad in this instance — isn’t priced. They are a very vague on just what this is, but here’s my interpretation of what they mean.
A firm that has already entered into financial contracts affects the risk exposure of its existing counterparties when it enters into new deals. A firm that has a large number of commitments outstanding can enter into additional contracts that substantially increase its riskiness, thereby harming the incumbent counterparties. The cost imposed on these incumbent counterparties isn’t, in this telling, priced. (more…)
| Dick Langlois |
Some of you may have seen Steven Pinker’s review of Malcolm Gladwell’s latest book in the New York Times this weekend. Pinker praises Gladwell’s writing and his instinct for interesting topics, but skewers him for his bad grasp of the underlying science of what he writes about, especially statistics. In Pinker’s view, Gladwell is in the end a character from one of his own essays, “a minor genius who unwittingly demonstrates the hazards of statistical reasoning and who occasionally blunders into spectacular failures.” One blunder seems to epitomize Pinker’s assessment: Gladwell’s report on an expert who talks of “igon values” instead of eigenvalues. Pinker call this the igon value effect.
As I read this, I thought back to a department seminar I had attended a couple of days earlier. Keith Chen from Yale gave one of the most dazzling presentations I’ve heard in a long time. He basically demolished 45 years of experimental results in social psychology that claim to have discovered cognitive dissonance in choices. According to this literature, it is among the best-documented results in psychology that people change their preferences after making a choice so as to rationalize the choice and make themselves feel better about their decision. Chen argues — persuasively — that essentially all these results are statistical artifacts. At a much more sophisticated level, social psychologists have fallen victim to the igon value effect. Here is the abstract of a working paper, though it gives only a hint of how clever this research is.
Cognitive dissonance is one of the most influential theories in social psychology, and its oldest experiential realization is choice-induced dissonance. Since 1956, dissonance theorists have claimed that people rationalize past choices by devaluing rejected alternatives and upgrading chosen ones, an effect known as the spreading of preferences. Here, I show that every study which has tested this suffers from a fundamental methodological flaw. Specifically, these studies (and the free-choice methodology they employ) implicitly assume that before choices are made, a subject’s preferences can be measured perfectly, i.e. with infinite precision, and under-appreciate that a subject’s choices reflect their preferences. Because of this, existing methods will mistakenly identify cognitive dissonance when there is none. This problem survives all controls present in the literature, including control groups, high and low dissonance conditions, and comparisons of dissonance across cultures or affirmation levels. The bias this problem produces can be fixed, and correctly interpreted several prominent studies actually reject the presence of choice-induced dissonance in their subjects. This suggests that mere choice may not be enough to induce rationalization, a reversal that may significantly change the way we think about cognitive dissonance as a whole.
Chen was also written up in the New York Times last year.
Oh, and by the way, that was our second seminar of the day. Earlier we listened to Bob Lucas, whom the grad students brought in to give a major lecture. (First time I had met him.) He talked about his paper in the inaugural issue of the new AEA macro journal: “Trade and the Diffusion of the Industrial Revolution.” (There wasn’t actually much trade in it.) Lucas and I had a nice conversation at lunch about Jane Jacobs, who we agreed was fantastic. “She was a theorist!” was Lucas’s assessment. High praise.
| Lasse Lien |
Ideally, the competitive process would select for productivity. It doesn’t actually do that. Presumably it selects for expected profitability, which is close enough — assuming market power isn’t too common. What has the economy been selecting for in the past year or so? The state of low demand means that it’s harder for firms to finance operations and investment, and firms depend more than ever on external capital. For most firms this means the bank. So banks’ credit decisions will to an unusual degree decide who gets to grow and who has to shut down. Simultaneously, banks are cutting back on credit — so which firms will the banks select? Since banks have no upside, they will ration credit on the probability of losses. This is clearly a worse criterion than expected profitability because it involves a degree of risk aversion that cannot be healthy. Presumably new firms, high-debt firms, small firms, and firms with mainly intangible assets can all be selected out (or unduly constrained in their growth), not because they have low productivity or low expected profitability, but because large, established, low-productivity, low-debt, tangible-capital firms represent a somewhat lower credit risk.
Hopefully, the period of bank-driven selection will be short and expected profitability will be restored. The only thing worse, I guess, is selection by lobbying productivity (or scale).
| Peter Klein |
Useful information for undergraduate instructors, provided by students, from the Chronicle (via Ross Emmett). Sample:
There is no need to put those “just for fun” optional readings on the syllabus. We will never read them. If I even see the word “optional” my eyes glaze over and I will go back to thinking of something pointless, like how many grapes I can possibly stick in my mouth without suffocating. There’s a better chance of me shimmying into class followed by a conga line of maroon pandas than actually reading your optional paper.
And this: “seeing you in a place outside of the academic setting is one of the most awkward moments ever. When you’re done with class everyday we like to think that you disappear, surfacing at random moments to check your email, and then slinking back into oblivion.” When you live in a small college town, as I do, and occasionally do crazy stuff like go out to eat or go to the movies, this can be a problem.
| Peter Klein |
Speaking of Peters, the McKinsey Quarterly site has a video interview with the late Peter Bernstein on risk. Bernstein was a deep thinker and an excellent writer. I once found myself on a plane next to an investment banker who was reading Bernstein’s Against the Gods. I mentioned that I too was a fan, and he told me he re-read the book at least once each year, out of professional obligation.
A reader objected to my recent portrayal of Keynes as a crank, as a man who never really studied economics or took it very seriously. Note that I never denied Keynes’s intellect, his great skill as a rhetorician, or his personal charm. But Keynesian economics is, in a sense, non-economics or even anti-economics, in that it ignores or contradicts many basic lessons about the allocation of scarce resources among competing ends. Mario Rizzo feels the same way:
Keynesianism is not concerned with the allocation of resources and related niceties. One can see this is the policy prescriptions of the stimulators. Just get people back to work. If a market is depressed: Prop it up. Labor, other resource-owners and entrepreneurs need to stop worrying about searching for the appropriate use of resources. Bankers have to stop fretting about to whom they should lend. They should abandon their ultra-restraint. Those who are holding money should invest; they should buy bonds. No need to worry about inflation because the potential output of “stuff” (however it is allocated across industries) is above the actual less-than-full-employment output.
Where did my microeconomics go?
Keynes and his followers proudly trumpeted his framework as a re-do of standard economics (what he called “classical,” though Keynes was not well versed in the history of economic thought). Standard economics is OK during periods of “full employment” (another aggregate concept, of course), but not in the “general” case, in which case the Keynesian magic comes into play. Credit expansion, according to Keynes, performs the “miracle . . . of turning a stone into bread.” As Mises noted, “Great Britain has indeed traveled a long way to this statement from Hume’s and Mill’s views on miracles.”
| Peter Klein |
Geoff Manne to me and others: “The Intel-AMD settlement, over an alleged Sherman Act Section 2 violation, seems to violate Section 1 of the same act. I’ve written an informed and thoughtful blog post on this. What do you think?”
Me: “This is further evidence that antitrust law is inherently contradictory, that the enforcement system is irretrievably broken, and that antitrust laws should be ditched entirely. Is that flippant?”
Geoff: “Just because it’s flippant doesn’t mean it isn’t true!”
| Peter Klein |
Peter Drucker, that is. The great management guru died in 2005 — and even then, he didn’t blog, unlike some other guys named Peter. If Drucker were alive today, what would he say about the financial crisis, health-care reform, climate change, and the other Big Issues of our day? Rosabeth Moss Kanter asks in the current issue of HBR, and thinks Drucker’s writings have important lessons for today’s problems. E.g.:
- Drucker would not have been surprised that incentives to take excessive risks contributed to the recent global financial meltdown. Back in the mid-1980s, he warned about a public outcry over executive compensation — a main theme on the U.S. government’s agenda following the fall of banks in 2008.
- Years ago, he warned of troubles ahead if GM executives remained stuck in memories of previous successes and failed to ask his famous “what to stop doing” question. GM was an iconic example of failure to see the need for significant innovation; its structure had become ossified, and its top management couldn’t consider a change.
- He focused on how organizations could best achieve their purpose, not on business per se or on profit as the main indicator of success. He championed a robust civil society of voluntary nonprofit organizations as an essential foundation on which business could thrive and people could prosper, because this sector plays a vital role in promoting health, education, and well-being. The role of government is fuzzier in Drucker’s writings, although it is clear that he mistrusted centralization of power and saw bureaucracy as a source of rigidity rather than innovation.
I hadn’t known before that Drucker’s father was friends with Schumpeter, often described as a major influence on Drucker’s thinking. “Regular guests of the Druckers included the economists Schumpeter, Hayek and Mises, with whom Drucker’s father had business relations in his function as director of the K.& K. trade museum,” according to Drucker’s official biography. Unfortunately the young Drucker was more attracted to Othmar Spann, described by Mises as an “anti-economist.”
| Peter Klein |
The man indeed has a unique talent, as described here by the witty and clever Steve Landsburg:
It’s always impressive to see one person excel in two widely disparate activities: a first-rate mathematician who’s also a world class mountaineer, or a titan of industry who conducts symphony orchestras on the side. But sometimes I think Paul Krugman is out to top them all, by excelling in two activities that are not just disparate but diametrically opposed: economics (for which he was awarded a well-deserved Nobel Prize) and obliviousness to the lessons of economics (for which he’s been awarded a column at the New York Times).
It’s a dazzling performance. Time after time, Krugman leaves me wide-eyed with wonder at how much economics he has to forget to write those columns.
The subject is Krugman’s latest proposal to combat unemployment, namely laws making it harder to fire workers, which of course increases the cost of labor, leading firms to hire less of it, increasing unemployment.
| Peter Klein |
I’ve written before on Fed “independence” and why I don’t support it. The vast majority of economists, especially the more prominent ones, are strongly in favor of independence and against Congressional attempts to limit the Fed’s discretion in monetary and regulatory policy. The standard argument is that a “politicized” — i.e., accountable — central bank will be more expansionary than an unaccountable central bank, assuming that credit expansion affects output first and prices (inflation) second. Last week’s piece by Kashyap and Mishkin follows this script. On the face of it, this seems absurd, as — to take only the most obvious example — the Greenspan-Bernanke “independent” Fed has been the most expansionist in modern history, with a ballooning money supply throughout the 2000s and near-zero interest rates and injections of giggledysquillions of dollars into the banking sector in the last 18 months. The independence crowd cites cross-country studies finding a negative correlation between central-bank independence and inflation, but these studies are controversial (many problems with reverse causation, omitted variables, sample size, etc.).
My question today is different: Where, in those arguments, is the comparative institutional analysis? After all, in policy analysis, we are always comparing imperfect alternatives. We try to avoid the Nirvana fallacy. Craig does this in his post below, asking if a centralized financial regulator would be less bad than the competing regulatory bodies we have today.
But the macroeconomists entirely ignore this problem. Consider Mark Thoma’s defense of independence:
The hope is that an independent Fed can overcome the temptation to use monetary policy to influence elections, and also overcome the temptation to monetize the debt, and that it will do what’s best for the economy in the long-run rather than adopting the policy that maximizes the chances of politicians being reelected.
This naive wish is simply that, a hope. Where is the argument or evidence that a wholly unaccountable Fed would, in fact, “do what’s best for the economy in the long-run”? What are the Fed officials’ incentives to do that? What monitoring and governance mechanisms assure that Fed officials will pursue the public interest? What if they have private interests? Maybe they’re motivated by ideology. Suppose they make systematic errors. Maybe they’ve been captured by special-interest groups like, oh, I don’t know, the banking industry (duh). To make a case for independence, it is not enough to demonstrate the potential hazards of political oversight. You have to show that these hazards exceed the hazards of an unaccountable, unrestricted, ungoverned central bank. The mainstream economists totally ignore this question, choosing to put a naive faith in the wisdom of central bankers to do what’s right. Guys, have you never heard of public-choice theory?
| Craig Pirrong |
All of the legislative proposals relating to over-the-counter derivatives would impose seismic changes on the way that these instruments are traded, and the performance risks related to them are managed. Indeed, it is fair to say that these proposals, if implemented would dramatically shrink the OTC market, and perhaps destroy it altogether. Under either the House (Frank) or Senate (Dodd) bills, most derivatives would have to be traded on exchanges, and be cleared. (Clearing is a way of mutualizing default risks. At present, default risks in a particular contract are directly limited to the buyer and seller.) (BTW, when you hear “Frank and Dodd” do you think Fannie Mae and Freddie Mac? I do. Does this inspire confidence? Self-answering question.) These efforts are strongly supported by Treasury Secretary Timothy Geithner, CFTC head Gary Gensler, and SEC head Mary Shapiro.
These legislative proposals are clearly predicated on a very strong belief: participants in the derivatives markets routinely chose the wrong institutional arrangements. That this immense market is and was in fact arguably the largest market failure in financial history. (more…)