Reverse Robin Hood: The $30 Billion Question

posted by Frank Pasquale

Remember the controversies over the State Children’s Health Insurance Program (SCHIP) last fall? The Bush Administration was very concerned that spending an additional $30 billion over the next five years to cover more children would put the country on the road to “socialized medicine.” Even if economic reports indicated that only one in five families in the coverage expansion would drop private insurance to purchase government sponsored insurance, that was seen as far too high a cost to pay to allow even a bit more publicly-financed insurance to “pollute” children’s health care.

Yet the administration has recently endorsed the Fed’s $30 billion guarantee for JP Morgan as it purchases Bear Sterns. I’ll let the accountants figure out exactly how much of that money will end up being provided by taxpayers, but I think it’s safe to assume that more guarantees like this are coming, and that the market itself priced it in in response to the toxic subprime securities Bear still counts as “assets.”

So what are the practical consequences when a country allows millions of kids to go uninsured, but structures financial regulation so that leaders of banking firms face nearly no downside, and high upside, on extraordinarily risky investment strategies? It appears that we only worry about moral hazard in the health care arena (where it has been largely discredited), and not in the financial world (where it has been amply confirmed). Internationally, the US is looking less like a leader in financial innovation and more like a haven for crony capitalism. The New York Times describes the situation as “socialized compensation” for the connected:

Bankers operate under a system that provides stellar rewards when the investment strategies do well yet puts a floor on their losses when they go bad. They might have to forgo a bonus if investments turn sour. They might even be fired. Their equity might become worthless — or not, if the Fed feels it must step in. But as a rule, they won’t have to return the money they made in the good days when they were making all the crazy bets that eventually took their banks down.

The costs of such a lopsided system of incentives are by now clear. Better regulation of mortgage markets would help avoid repeating current excesses. But more fundamental correctives are needed to curb financiers’ appetite for walking a tightrope. Some economists have suggested making their remuneration contingent on the performance of their investments over several years — releasing their compensation gradually.

In a recent hearing questioning the extraordinary gains at top financial firms (for pioneering strategies that now may lead to massive government bailouts), Henry Waxman suggested that current policies may lead to a crisis of faith in the market system:

“There seem to be two economic realities operating in our country today. Most Americans live in a world where economic security is precarious and there are real economic consequences for failure. But our nation’s top executives seem to live by a different set of rules.”

To contexualize Waxman’s point, here is Paul Krugman with the back story:

[By the 1990s], Wall Street chafed at regulations that limited risk, but also limited potential profits. And little by little it wriggled free — partly by persuading politicians to relax the rules, but mainly by creating a “shadow banking system” that relied on complex financial arrangements to bypass regulations designed to ensure that banking was safe.

For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages — with nary a regulator in sight.

As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned.

Fortunately, it is now market fundamentalism that can be “dismissed as hopelessly old-fashioned.”

Finally, I want to provide readers with an extended quote from David Cay Johnston’s book Free Lunch, which chronicles the way in which government policies systematically redistribute income regressively. After surveying a panoply of such policies, he sketches their effect on the distribution of income in today’s economy:

To appreciate fully how much the fruits of economic growth are, under current government policies, being concentrated in the hands of the few, it is useful to . . . examine the ratio of income growth between different groups over several long periods of time, starting with a comparison between the lower 90 percent, our “vast majority,” and the top 1 percent.

Let’s consider three eras. The first would be from 1950 to 1975, a quarter century when a rising tide did lift all boats and the nation was transformed into a land of broad prosperity. Setting the second era from 1960 to 1985 allows us to incorporate an early part of the era in which government began changing its policies in ways favored by many of the rich. Finally, it would be good to compare 1980 with 2005, but that will not work mathematically because the ratio would include negative numbers, since the income of the vast majority declined slightly. So instead we will use 1981, a recession year, to compare to 2005. The vast majority’s average annual income was $114 higher at the end of those 24 years.

The measure is a ratio. For each additional dollar going to each person in the vast majority, how many went to each of those in the top 1 percent? For 1950 to 1975, the ratio is four dollars more at the top for each dollar going to the vast majority. For 1960 through 1985, the ratio is $17. And for 1981 through 2005, it is almost $5,000.

Dramatic as those numbers are, they understate the concentration of income. Let’s now compare income growth for the vast majority with the top 1/100 of 1 percent, those 30,000 Americans at the very top of the income ladder. For 1950 to 1975, the ratio was $36 to one. For 1960 through 1985, it was $459. And for 1981 through 2005, it was $141,000 to the dollar.

It’s probably safe to say that all of the executives at Waxman’s hearing were in the top 1% at some point (and may well be kept there by capital gains on their current wealth). It’s likely that they were in the top one hundredth of one percent during the boom.

When will the ratio of gains between those at the top and the “vast majority” become so great that academic defenders of inequality (like Greg Mankiw) will become concerned? Is a 10,000 to 1 ratio too much? 100,000 to 1? And at what point will conventional economic theory recognize the extraordinary importance of relative position to economic welfare? It’s currently clear that inequality of income affects such important goods as education, housing, and access to the political sphere. If the fall of the dollar continues and commodity prices continue rising, more brutal consequences of inequality are sure to come to the fore.

PS: Here is one more reminder, from Thomas Pogge, on why, in an era of increasing inequality, it is very misleading to focus on growth alone in economic policy generally:

Consider what difference such a pro-poor assessment of economic growth would make to an economic planner—in a high-inequality country, say, such as Bolivia. If such a planner focuses on (per capita) GNI, she will ignore the poorest decile who, though they make up 10 percent of the national population, constitute just 0.3 percent of the national economy. One percent more income growth for the poorest decile adds 0.003 percent to national growth—one percent more income growth for the richest decile adds 0.472 percent. But if such a planner assesses her performance in terms of the economic position of the poor, she will realize that substantial improvements in the position of the poor are possible at tiny opportunity cost to the rich.

Perhaps by focusing too much on GNP as a measure of economic well-being, the US has inadvertently prioritized income growth for the richest decile.

 March 21, 2008 at 7:24 am   Posted in: Corporate Law, Economic Analysis of Law, Health Law, Law and Inequality, Politics, Securities    Print This Post

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