Lenders shouldn’t always get back what they’re owed

What should happen to people who can’t repay their debts? In the ancient world it was common to enter “debt bondage”, a form of slavery. More recently we had the debtor’s prison, of the sort with which Charles Dickens’ unfortunate father found himself acquainted.

Personal bankruptcy acts over the 19th century phased out such severities. And for people who formed companies, funded by borrowing, the major legal innovation was modern “limited liability” in 1855. This restricted the claims of creditors to the funds you had invested in the company – in other words, aggrieved lenders couldn’t move onto your other savings after they’d exhausted the assets of the firm.

The perennial objection to such protections is what economists call “moral hazard”: the idea that they give people an incentive to take excessive risks, knowing that they can walk away from the financial consequences if they go wrong, while others have to pick up the tab.

“The directors of such companies – being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own,” griped Adam Smith in The Wealth of Nations back in 1776. “Negligence and profusion,” predicted the Scottish father of economics, “must always prevail, more or less, in the management of the affairs of such a company.”

We’re hearing an echo of that moral hazard argument today, with the swell of complaints about Company Voluntary Agreements (CVA) on the British high street. The House of Fraser department store chain, struggling like much of the rest of the retail sector, entered a form of insolvency last week. But instead of opting to wind up the company and liquidate its assets to pay creditors, it is instead attempting a CVA.

This means the historic retail name (now Chinese-owned) is asking all its creditors, including its landlords, to agree to a reduction in their claims so the company can continue trading.

Landlords say CVAs have become a form of shakedown for them. A CVA requires only 75 per cent of support of all creditors to be approved. But the creditors who take the biggest financial hit are them, in the form of lower rents than previously agreed. House of Fraser is looking for a 25 per cent rent cut on the stores it will keep open. It’s suggested that CVAs are being instigated cynically by firms, not as a last ditch bid for survival, but as a way of simply cutting their costs.

Some other retail firms who don’t enter CVAs also detect unfair competition. Why should they, successful businesses, continue paying their agreed level of rent, while a competitor who has overextended themselves gets a rent cut to help finance a turnaround? Isn’t this moral hazard in blazing neon? Only up to a point. A government review of the CVA regime, something the British Property Federation wants, seems warranted. Yet some of the claims of abuse are overblown. Entering a CVA is not a cost-free option for any firm, just as declaring personal bankruptcy is not cost-free for the over-indebted individual.

Both will find it more difficult to borrow again for their next venture. And if they can borrow it will be at a penal interest rate.

There’s reputational damage for a retailer, too. For a store with a higher-end reputation, such as House of Fraser, last week’s headlines are not exactly desirable PR. Similarly, when it comes to personal bankruptcy, we are a still, here in the UK, a long way from the American culture of wearing them as a badge of pride for the serial entrepreneur. The days of the debtor’s prison may be gone, but bankruptcy is not the subject of loud dinner party boasts.

It’s also important to think about incentives on all sides when it comes to a CVA proposal. Landlords would certainly take a financial hit if a tenant went into liquidation, as they would have to re-let the property, possibly after a long and costly vacancy period. And the new rental agreement with a fresh tenant might be at a lower rate anyway. If the troubled tenant genuinely signed up to a rent that was economically unsustainable for any firm, a CVA can be regarded as a useful institutional solution which allows market forces to operate while also minimising wasteful adjustment costs.

This leads to a related point: moral hazard is also not a one-way street. For every irresponsible borrower, there is usually an irresponsible lender. We saw this vividly in the eurozone crisis with Greece. German and French banks lobbied for full protection for their unwise investments in Greek sovereign bonds and the European Commission and the International Monetary Fund strove, for far too long and at great social cost in Greece and the wider eurozone, to give it to them.

As Ashoka Mody, a former IMF economist argues compellingly in his new book EuroTragedy, it would have been better for the inevitable default to have been allowed to happen much earlier.

It’s impossible to entirely divorce morality from the repayment of debt, whether personal or corporate.

And we shouldn’t try to: moral hazard exists. But, by the same token, it behoves us to also recognise that, sometimes, we’re all better off if creditors don’t ultimately get back what they might have once expected.

#moralhazard #landlords #limitedliability #bankruptcy #AdamSmith

Protectionism: The lessons of history

It’s 1929 and two Republican politicians, Reed Smoot of Utah and Willis Hawley of Oregon, are cosponsoring legislation to keep foreign goods out of the United States. This act of protectionism, the pair promise, will boost domestic employment and protect the living standards of the ordinary American working man.

The Smoot-Hawley Tariff is met with a thunderous wave of condemnation from the economics profession.

More than a thousand academics and practitioners petition President Herbert Hoover to veto the legislation.

But to no avail. Hoover, who campaigned on a protectionist ticket, signs the bill into law and import levies on some 20,000 items are jacked up to an average of 40 per cent. America’s great industrial tariff wall goes up – and it will not fall again until after the smoke and chaos of the Second World War clears some 15 years later.

Who says history doesn’t repeat itself? Skip forward 88 years and Donald Trump is being sworn in as US president in front of the same Congress building that witnessed the passage of Smoot-Hawley. “Protection will bring great prosperity,” the real estate tycoon and reality TV star declares before the relatively meagre crowd on the National Mall.

Economist jaws, once again, fall in horror. A poll earlier this year shows that virtually everyone in the profession believes tariffs will be damaging rather than beneficial for the US economy. It’s a conviction that spans the political spectrum. Economists who virulently disagree about over deficits, tax cuts and regulation find themselves united on this single point about the merits of free trade. But, once again, the academic consensus does no good. The massed ranks of pointy-heads are disregarded. Trump’s bite is matching his bark.

First he went after China, hitting imports of robots and high-speed trains. Then, last week, he crossed a fateful threshold. The Trump administration imposed 25 per cent levies on steel from Europe, Canada and Mexico. And, in what felt like a grave insult to these historic US allies, this was justified on “national security” grounds.

Nor is this the end. Next in Trump’s sites are imports of foreign cars. And after that – who knows? Meanwhile, Europe and Canada, knowing that a man like Trump will mistake patience for weakness, are already hitting back with countervailing tariffs against American goods, from blue jeans to bourbon.

Beijing seems to be halting its massive purchases of American soybeans, striking at the agricultural heartland of Trump support. And so the 1930s cycle of retaliation, economic pain, popular anger and evaporating trust seems to emerge from the darkness, like the ghost of trade wars past.

The US will cut an isolated, even reviled, presence at the G7 meeting of the leaders of top economies in Quebec this weekend. Some even question whether the multilateral framework governing global trade can survive a lurch into naked protectionism from the world’s largest economy and the post-war driving force behind liberalisation and openness.

Comparatively speaking

Ever since a British thinker and politician called David Ricardo outlined a revolutionary idea of “comparative advantage” in 1817, using an example of Portuguese wine and English cloth, economists have been convinced of the theoretical merits of free trade.

Ricardo argued that productive efficiency in every nation is maximised when people focus on producing what they are best at producing and exchange the results. The intellectual revolution lay in the word “comparative”. Ricardo demonstrated that any given country could drive up its prosperity, not necessarily by being a world beater in any particular category of export, but simply by focusing on its resources on what it could produce most efficiently (whether because of the natural fertility of its land, or its abundant supplies of cheap labour or its technological resources).

The theoretical implication was that every nation could benefit from trade. Ricardo thus demolished the credibility of rival theories of “autarky”, the idea that a nation should consume only what it can itself produce, and “mercantilism”, the theory that one nation’s export represents another nation’s economic loss.

Economic historians have tended to present a united front on free trade’s merits in practice too. They disagree over how much economic damage Smoot-Hawley actually did on top of the monetary and fiscal policymaking blunders of the Great Depression of the early 1930s, but virtually none argue that protectionism and tariffs made things any better.

And, for the period since the Second World War, views are even more categorical. It’s widely agreed that the US Marshall Plan, which lent generously to the bombed-out economies of Europe and dismantled trade barriers, helped to lay the foundation for Germany’s Wirtschaftswunder (economic miracle) and France’s Trente Glorieuses (30 glorious years). China’s assimilation into the global economy after the death of Mao Zedong in the late 1970s, and its emergence as a global export powerhouse, has helped to yank hundreds of millions of Chinese out of destitution.

“The world trading system has been fundamental to the post-war success of the world economy which has seen large increases in incomes and, for the first time in history, an absolute fall in world poverty,” states L Alan Winters of Sussex University, neatly encapsulating the contemporary consensus of the profession.

Leaning by doing

Yet there are wrinkles in this story of all-conquering trade liberalisation as a driver of prosperity. Not everything fits neatly into the parable of comparative advantage. During their rapid industrialisation phases of the second half of the 19th century, countries such as Germany and the United States erected lofty tariff walls to protect their domestic manufacturers from intense competition from the industrial superpower of the day, Great Britain.

The Cambridge economist Ha-Joon Chang notes that most of today’s rich countries actually “practised significant degrees of protectionism for substantial periods” during the 19th and 20th centuries. Free trade advocates can say things might have been even better for these states, but there is little reason to conclude that protectionism held back Bismarck’s Germany or Ulysses Grant’s United States, at least to any significant extent.

And there are examples from the post-war era too. South Korea’s industrial takeoff in the 1960s happened behind high tariff walls. Japan protected its nascent domestic car industry from foreign competition for 40 years after the Second World War. It was a similar story in Taiwan. Again, there is little evidence that protectionism did major damage to these states; their growth rates were some of the highest in human history.

Indeed, a combination of trade barriers and industrial subsidies actually seemed to help these Asian nations reach their economic potential. Protecting industries like steel manufacturing and shipbuilding, this argument goes, builds industrial capacity, which can then be the basis for other higher-value added technological development. Protectionism enables “learning by doing” for domestic managers and the bureaucrats who set policy – opportunities that would not be available in a world of totally open trade.

As Ha-Joon Chang points out, South Korea’s apparent “comparative advantage” back in in the 1950s was in fishing and low-grade wig-making, not shipbuilding or consumer electronics. If South Korea had merely stuck to what it was good at 60 years ago and waited, would we today have Samsung? Would we have Toyota? Or Taiwan’s Acer? Many are sceptical of any general applicability of such lessons for poor countries. And there are plenty of countervailing examples of developing states where protectionism has resulted in waste and corruption.

Yet there is a powerful weight of historical evidence that a degree of protectionism can, under certain conditions and alongside certain other policies such as export promotion, play a positive role in development.

Breaking bargains

That is not the only wrinkle. We are not merely economic animals. The Harvard economist Dani Rodrik argues that it’s important to think about social fairness when it comes to trade, not just pure Ricardian efficiency effects.

Overproduction of steel in China, dumped in world markets at prices below the true cost of production for the past decade, might have meant cheaper inputs for Western manufacturing firms and thus more productive industry, extra aggregate jobs and higher incomes in rich countries. But when it undermines intangible but crucial “social bargains” between a Western government and its domestic steel workers, who risk losing their jobs because of cheap steel dumping, people quite reasonably feel aggrieved.

Similarly, if corporate offshoring occurs not because production is more efficient overseas but because companies take advantage of laxer health and safety regulations, that too can represent a breach of the broader public’s sense of fairness.

It was this sense of a broken social contract that Trump’s “American carnage” inaugural address touched on when he raged that “one by one, the factories shuttered and left our shores, with not even a thought about the millions upon millions of American workers left behind”.

The wrong lessons

So are these wrinkles enough to salvage some respectability for Trump’s protectionist crusade? Alas, no.

America is on the technological frontier. Those “learning by doing” development effects are hardly relevant for the most productive economy in the world.

The social bargain argument does make a strong case for facing up to and tackling Chinese overproduction and other forms of industrial dumping – more than many economists and politicians accept. And this blind spot among the policymaking establishment is probably one of the reasons why populists like Trump have won an audience.

Yet the fact remains that tackling this evil can only be done sustainably through multilateral organisations like the World Trade Organisation. A free for all threatens the whole system, at huge potential economic cost.

Moreover, Trump’s anger over trade extends far beyond unfair dumping. He and his advisers want to keep out imports in general, under the primitive mercantilist believe that the raw size of the US’s goods trade deficit represents a measure of the extent to which America is being taken advantage of by swindling foreigners. Ricardo must be turning in his grave.

Back in 1929, the industrialist Henry Ford was one of those who pleaded with President Hoover not to impose Smoot-Hawley. But, when it comes to trade, the current White House incumbent seems to have absorbed a separate and simpler view expressed by Ford many years earlier: “History is bunk.”

#DavidRicardo #protectionism #DonaldTrump #HaJoonChang #tariffs #DaniRodrik #SmootHawley #HerbertHoover

You can have Wall Street and Donald Trump after all

Last week another banker had his collar felt. Goldman Sachs employee Woojae Jung was arrested and charged in the US with insider trading. Jung is accused of using confidential information on planned corporate merger activity, gathered from within Goldman’s investment banking department, to make secret trades in the companies involved. Jung, allegedly, knew which way the market was going to move when the information became public and personally positioned himself to profit from that.

Just another unremarkable tale of alleged corruption on Wall Street? Perhaps the significance is greater than that. For, by coincidence, last week also saw the Federal Reserve, America’s lead financial sector regulator, propose to water down the “Volcker Rule”, a centrepiece of the legislation enacted by the US in the wake of the global financial crisis a decade ago. The Fed, led by recent Trump appointee Jerome Powell, is giving the banking lobby what it has been hollering for ever since the rule was devised by the Barack Obama administration back in 2010.

What does the Volcker Rule, named after the former Federal Reserve chair Paul Volcker who designed it, do? It prevents Wall Street banks, such as Goldman, from “proprietary trading”, that is to say directly making bets on the movement of financial markets using their own money. This might sound a bit odd to many people. Because isn’t this precisely what these financial institutions do to generate their profits and bonuses? The answer is no, at least in theory. These banks’ traders are supposed to facilitate foreign exchange and bond buying orders etc on behalf of their corporate clients.

While they can legitimately make a profit from such market making – pocketing the difference between what they buy the various assets for and what they sell them for – they are not supposed to nakedly speculate for their own institution’s profit. There’s inevitably a grey area here: one traders’ speculation is another’s simple pre-emptive buying of assets to facilitate an expected future client transaction. Yet what Volcker did was to shrink the grey area considerably and make the speculation element considerably more onerous and expensive.

And rightly so given the catastrophic hidden risks banks turned out to have been running in the years before the financial crisis. Rightly, too, given the fact that these banks still benefit from a de facto taxpayer guarantee. There’s no case for publicly subsidised gambling – certainly not for underwriting gamblers with trillion dollar balance sheets.

The Jung allegations remind us why this functional separation is not only appropriate for banks but ethically necessary too. Wall Street banks have a hugely privileged position in the flow of financial information. Their investment banking divisions find out early about possible market moving mergers.

Their share dealing and asset management divisions register big buy or sell order from clients which are likely to move markets simply due to their size. The opportunities for banks to profit from such information are vast. It’s a testament to the degree to which banks like Goldman effectively wrote their own rules before the global financial crisis that regulators sat back and allowed them to gamble in such patently conflicted ways, even to the extent of having in-house highly-leveraged hedge funds.

This is not just a tale of American folly. Where Wall Street treads in financial markets, history shows us that the City of London ultimately tends to rush in too

The primary argument of the banking lobbyists is that the Volcker rule now constrains “liquidity” in financial markets, specifically because it limits banks’ ability to take positions in the assets they trade. But the benefits of liquidity in financial markets for the wider economy are grossly exaggerated. Ordinary people do not turnover their pension share portfolios multiple times a day. Even large multinational corporations, which do need to buy and sell currencies and hedge themselves against rising interest rates regularly, really do not require the kind of hyper-liquidity that the banks are talking about.

As Denis Kelleher, the head of the Better Markets pressure group in Washington, puts it: “There is no evidence that the Volcker Rule has had any negative effect on financial activities related to the real economy.”

The real beneficiaries of hyper-liquidity in financial markets are speculators. And, of course, dealers, such as the large banks. The watering-down of Volcker is not about benefiting the US economy, but further boosting the profits of the large banks and the bonuses of their employees. And as we saw happen with the tight financial regulations that prevailed after the Second World War, such as the strict separation of investment and retail banking, Wall Street tends to play a long game of suffocation: breach the spirit of the law and then hollow it out gradually until there’s nothing left.

This is not just a tale of American folly. Where Wall Street treads in financial markets, history shows us that the City of London ultimately tends to rush in too.

Trump, readers might remember, campaigned as a champion of Main Street, accusing Wall Street of “getting away with murder”. He pilloried his opponent Hillary Clinton for once making a speech to Goldman for which she received $225,000. So effective was this anti-finance shtick that the whistleblower Edward Snowden even tweeted in February 2016 that the presidential election represented a dismal “choice between Donald Trump and Goldman Sachs”.

As the assault on the Volcker Rule confirms, this was one of the worst pieces of analysis of recent history.

You can indeed have the nightmare combination of Donald Trump and Wall Street – and America is now getting it good and hard.

#WallStreet #DonaldTrump #proprietarytrading #PaulVolcker #GoldmanSachs #Volckerrule