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Shrinking Wall Street


If you want to make Adam Smith, the founder of economics, and George Stigler, the Nobel Prize winning economist, spin in their graves, say the words “LIBOR scandal.”  LIBOR — London Interbank Offered Rate — is, as everyone learned this past week, the benchmark interest rate that members of the British Bankers Association collude to set. In 1776, in The Wealth of Nations, Smith wrote “[p]eople of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”  Smith would have banned the British Bankers Association altogether. But almost 250 years later, what does the Bank of England, do?  It blesses the collusion by “supervising” it.

Why would George Stigler spin in his grave?  Because to him, the LIBOR “scandal” would be nothing but regulation as usual.  It is routine for regulators to be captured by the executives of the industry they regulate, Stigler explained in his article “The Theory of Economic Regulation.”  The benefits from regulator malfeasance are concentrated on a small group of individuals–the executives of the industry–whereas the costs of such  malfeasance are diffused among tens and hundreds of millions of members of the public.   Because the executives have a huge monetary incentive to prevent the regulator from doing his or her job, they are willing to invest large amounts to get what they want.  LIBOR is just the latest example of Stigler’s theory at work.

The Bankers Association and LIBOR should never have been permitted to exist to begin with.  What did Timothy Geithner do in 2008 when, as the head of the Federal Reserve Bank of New York, he discovered that to improve their profits the banks were setting the benchmark at levels that did not reflect market forces?   Here was an opportunity to ban the Bankers Association and end LIBOR, but instead Geithner wrote a private letter to the Bank of England asking it to establish “procedures designed to prevent accidental or  deliberate misreporting.”  Certainly his discretion was a good career move; it’s hard to imagine that a whistleblower could have gone on to serve as Secretary of the Treasury.

Reforms of the regulations of the financial industry fail one after the next, and bankers continue to rob their clients and to destabilize the economy. So what can be done about Wall Street?

The most remarkable thing about Wall Street is that while it flourishes, working people wither.  How can this be?  The reason for this is the near-zero-interest-rates policy of Ben Bernanke, the chairman of the Fed.  A five year Certificate of Deposit pays now on average less than 1% a year and that has made it impossible for savers to save, except by putting their savings into stocks; this is why the prices of stocks are high.  The ones who benefit from these high prices the most are the executives, because they use these  bloated stock prices to justify their outlandish “compensation.”  As social policy, however, forcing people to buy stocks has no justification.

When individuals buy stocks it is called “investing,” but this is a misnomer, because people are not buying investment goods (e.g., machines, structures, intermediate goods, etc.).  Their trades with the people who sell them stocks are zero-sum games, not economic investments.  The correct policy would be to channel savings toward economic investment, both private and public.  In order to accomplish this, the government should take two steps.  First, it should pay on its bonds an interest rate that, after correcting for inflation, is equal to the average long term growth of real GDP per capita.  What is this rate?  In the years 2001-2010 the average rate of real growth of the economy was only .62%. But that decade saw the bursting of two bubbles, first the dot com bubble, in 2000, and then the subprime bubble, in 2007.  The real growth rate of 2% a year that existed from 1970 to 2000 is a better estimate of the long term growth rate, and the government should pay this rate (in real terms) on its bonds.  (Under this formula a five year bond that was issued in May 2009 would have paid 4% in May 2010, 5.5% in May 2011 and 3.8% in May 2012.)  In order to attract customers away from government bonds to their own CDs and bonds, banks and corporations would have to offer similar or even better terms to savers. And in order to be able to make money themselves, the banks and the corporations would have to finance investments that earn even higher returns still. Furthermore, only deposits that finance real economic investment should be insured by the government.  This will prevent banks from using regular deposits for mergers and acquisitions.  Savers and banks would, of course, be free to trade in stocks, but they would have to do so without government subsidies.

There is an additional step the government should take.  Because the trading of stocks is a zero-sum-game rather than true economic investment, the government should further discourage it by ending the tax deferment to retirement plans (401k) that “invest” in the  stock market instead of channeling that money to government bonds or certificates of deposit.

But what does all of this have to do with the regulation of Wall Street?  First, when savers are no longer forced to give their money to gambles in stocks, the share of the public that has a stake in Wall Street will be far smaller.  And when Wall Street no longer has captive clients, it will have to become more transparent and behave more honestly. Consumers will thus become the regulators.  Even a new, weaker and therefore more honest, Wall Street would still have to be regulated, and this regulation would still have the challenges that Stigler identified. But the damage from the regulatory failures that are sure to continue would be miniscule in comparison to those we have now.  Best of all, a weaker Wall Street would mean stronger investments, both private and public, lower executive “compensation,” and, as a result, as much healthier economy for the rest of us.

Moshe Adler teaches economics at Columbia University and at the Harry Van Arsdale Center for Labor Studies at Empire State College. He is the author of Economics for the Rest of Us: Debunking the Science That Makes Life Dismal (The New Press, 2010),  which is available in paperback and as  an e-book.


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