Tuesday, June 08, 2010

To what end?

It should be obvious to the most casual observer that the financial industry is not part of the private sector. The charter it gets from the Federal Reserve, and the role it shares in the payment system with the US Treasury, means that it is a public/private partnership.

Access to reserve accounts at the Fed mean that banks can print money, just as the Government can. The reason they exist at all is so the State can have investment decisions made by the private sector, with private capital being in first-loss position before (ultimately) public capital. The actions of the Geither, Summers, and Obama perverted the role of the financial sector by putting public capital in first loss position before private capital.

The public/private nature of the financial industry also means that regulation should be focused more on the "why should we allow it" rather than the "why shouldn't we allow it"? just as, when setting up a new Government department, we should ask "why" rather than "why not?"

Here is an excellent discussion on high-frequency trading which illustrates this point. The Exchanges -- shockingly in my opinion -- sell information that can be used to front-run trades. Kid Dynamite takes the "why not" perspective:
someone will always have the data first, and someone will always have the data before you. It's a fact of, well, data transmission.

Again, the important fact is that this data is open to anyone who is willing to make the investment in it - not just a secret cool kids club that requires you to work for a specific blue blooded Wall Street firm. Anyone can do it - if they are willing to invest in the business.
Rajiv takes the "why" counter-perspective:
Generally speaking, stability in financial markets depends on the extent to which trading is based on fundamental information about the securities that are changing hands. If too great a proportion of total volume is driven by strategies that try to extract information from market data, the data itself becomes less informative over time and severe disruptions can arise. Banning specific classes of algorithms is unlikely to provide a lasting solution to the problem unless the advantage is shifted decisively and persistently in favor of strategies that feed information to the market instead of extracting it from technical data.
He also notes that HFT does not add liquidity, in fact it destabilizes it (as the "flash crash" showed) and it may not be profitable, as tail risk may destroy all profits just as the credit crash of 2008 consumed all the profits made from 2000-2008, if not more.

If the financial sector was purely private, I would take Kid Dynamite's "why not?" position. As it's a public/private partnership, I am taking Rajiv's "why?" position, just as I would any other Government program.

7 Comments:

Blogger JKH said...

Hi Winterspeak,

(Your comment enablement seems to have stabilized for the time being)

I’ve been curious about this public private partnership business since the term first appeared on my radar.

What makes it public private? Is it FDIC, TBTF, more?

Does the fact that it’s regulated make it public private?

Are hedge funds public private?

Are non deposit taking institutions public private?

Is it bigger in your view? Is it finance per se that makes it public private?

Is public private applicable to any industry when you consider externalities?

Will the nature of regulatory reform determine the public private characteristic for finance?

E.g. for banks, debt with mandatory conversion into equity seems to privatize risk more so than Moslerian fed funds on steroids. In fact, the whole gamut of Mosler proposals galvanizes public private from a structural perspective, consistent with the general MMT theme.

Is my management of my stock portfolio public private?

If not, why does a properly capitalized proprietary trading operation have to be public private?

Isn’t HFT just an extension of technical analysis and Keynes’ beauty contest? Am I allowed to do technical analysis but my bank is not?

This horrible scatter gun of questions exposes the fact I have little useful to say on the subject. Moreover, I have no idea what my final view on it is. I suspect the right call is that it’s an unnecessarily disruptive activity. I suppose that implicitly invokes public private at some level.

You have a good point at the core.

5:13 PM  
Blogger Ohm (Ώ) said...

Truly great observations here:

"It should be obvious to the most casual observer that the financial industry is not part of the private sector. The charter it gets from the Federal Reserve, and the role it shares in the payment system with the US Treasury, means that it is a public/private partnership.

Access to reserve accounts at the Fed mean that banks can print money, just as the Government can. The reason they exist at all is so the State can have investment decisions made by the private sector, with private capital being in first-loss position before (ultimately) public capital."

And I also agree that the USG panicked actions between Oct 2008-09 "perverted the role of the financial sector by putting public capital in first loss position before private capital."

At that time, nobody was thinking straight, neither the Govts nor the public, so we had that perversion. The establishment and functioning of the Financial Resolution Authority should put private Capital squarely in the first loss position. I do share the thought that, given its ability to draw credit from Fed and lend it forth, the banking system is but an quasi-extension of the Government, a Private-Public system. I further opine that reckless cheap credit creation via zero interest rates is no different than running a Fiscal Deficit. In fact, running a fiscal deficit is better than artificially cheap credit - at least the fiscal spend is in the control of the Govt (distorted by lobbying though), it can be specifically laid out on investments such as Education, Health, Nutrition, Transportation Infrastruture, Fundamental Research, Green Energy et al. The monetary mechanism, on the other hand, gets everything out of hand - the helicopter load of money could go into Gold, Stocks, Property, and what have you bubbles, finally yielding more pain than what was attempted to be averted.

Thanks for the article, it was a great read.

5:38 AM  
Blogger winterspeak said...

JKH:

The finance sector got a massive bailout, but other hard hit sectors (like restaurants) did not. If they are all "private", clearly some are more "private" than others ; )

More seriously, I think it is reserve accounts at the Fed, access to the overnight interbank market in extremis, and access to the discount window in extreme extremis that creates the "partnership". Other industries cannot create (horizontal) money the same way banks can.

Hedge funds, VC, PE, and your personal stock portfolio are all private.

But I'm not being doctrinaire here. I don't necessary extend 100% laissez faire to purely private enterprises either, but I do lean more in that direction.

8:19 AM  
Blogger Ramanan said...

I used to believe it but no longer sure. Since banks have to provide collateral to central bank for the usage of the discount window/marginal lending facility, aren't they effectively private ? At times, the central bank is loose about the collateral. But the same is true with banks sometimes.

In the Chartalists' proposed solution banking will necessarily be PPP because the central bank doesn't require any collateral and provides unlimited usage of settlement balances.

I hadn't realized the importance of collateral till recently. Since banks are not allowed to purchase any security other than illquid IOUs - loans in the proposal, it has to be like that. (Since they cannot create marketable ABSs either in the proposal)

The question I am going to ask the Chartalists sometime is: what if someone is looking for a license for banking. Does the central bank immediately allow the usage of the discount window without collateral ? How does one acquire a banking license since there is no collateral? If one provides some corporate bonds as collateral for a license, then it goes against the rule that there is no collateral.

12:20 PM  
Blogger winterspeak said...

Ramanan:

If I could borrow at the discount window, with "approved" collateral of course, then I would be on the same page as you! But I cannot, and neither can my pizza place (now sadly out of business, unlike GS etc.)

Just as in the recent (and very good) discussion at Mosler's about whether or not the Treasury can run an overdraft at the Fed, it comes down to what you think is a better description of reality: what's on paper, or what actually happens in real life. We've seen exactly what happens at the discount window, and what the collateral requirements are or are not, when the interbank market breaks down.

The strongest argument for why banks are public/private partnerships is 2008-201?.

10:29 AM  
OpenID pebird said...

Ramanan:

I believe that some Chartalists would think the question of collateral meaningless since in their proposals banks would function primarily as payment clearing and consumer saving vehicles (like the Japanese postal bank network), and not commercial investment houses.

Banking would be boring - few would want banking licenses. Mostly those that received C's in college. More intelligent people would become school teachers.

Such a set of policies would drastically shrink the size of the private financial sector, perhaps even to its proportion of the economy in the 1950s or 60s.

It would be interesting to speculate as to what entity would undertake large scale investments, particularly in those areas deemed of national interest, such as energy, environmental remediation, health care, education, etc.. Possibly the same as that which funds investment in the military infrastructure.

9:33 PM  
Blogger winterspeak said...

pebird: Yes, in Chartalism, banks would borrow unsecured at the discount window as a matter of daily operations, thus eliminating (needless) counter-party risk.

Many entities could undertake all of the activities you suggest.

3:29 PM  

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