Doom and the Big Banks

Tyler Cowen has an interesting essay that’s ostensibly about income inequality but in practice presents a very gloomy portrait of modern finance as both utterly dysfunctional and also irredeemably so. Ross Douthat responds by invoking a conservative version of the “break up the big banks” agenda whereby bank smashing is paired with balancing the budget.

I think this actually misses the full force of Cowen’s saga of doom, which doesn’t say that we won’t restrain the financial sector because it’s too politically powerful. It says we won’t restrain the financial sector because we actually can’t. For one starters, I think everyone should read Tim Fernholz on the myth of “too big to fail” where he persuasively argues that the basic logic of bailouts has very little to do with institution size. But I would also note that even though Cowen ends up dwelling on bailouts a bit in his piece, fundamentally the problem he highlights exists independently of bailout issues:

To understand how this strategy works, consider an example from sports betting. The NBA’s Washington Wizards are a perennially hapless team that rarely gets beyond the first round of the playoffs, if they make the playoffs at all. This year the odds of the Wizards winning the NBA title will likely clock in at longer than a hundred to one. I could, as a gambling strategy, bet against the Wizards and other low-quality teams each year. Most years I would earn a decent profit, and it would feel like I was earning money for virtually nothing. The Los Angeles Lakers or Boston Celtics or some other quality team would win the title again and I would collect some surplus from my bets. For many years I would earn excess returns relative to the market as a whole.

Yet such bets are not wise over the long run. Every now and then a surprise team does win the title and in those years I would lose a huge amount of money. Even the Washington Wizards (under their previous name, the Capital Bullets) won the title in 1977–78 despite compiling a so-so 44–38 record during the regular season, by marching through the playoffs in spectacular fashion. So if you bet against unlikely events, most of the time you will look smart and have the money to validate the appearance. Periodically, however, you will look very bad. Does that kind of pattern sound familiar? It happens in finance, too. Betting against a big decline in home prices is analogous to betting against the Wizards. Every now and then such a bet will blow up in your face, though in most years that trading activity will generate above-average profits and big bonuses for the traders and CEOs.

It’s true that the possibility of bailouts somewhat exacerbates this tendency. But it would exist even in a totally bailout free world. Richard Fuld and other Lehman Brothers honchos didn’t get bailed out. But Fuld and other key Lehman executives still earned far more than most Americans during the good years, and even those who are still unemployed today are far richer than the average American. Looking back on the whole saga in retrospect, I’m sure they wish they’d gotten a bailout or somehow manipulated the situation a bit better. But if the alternative to getting rich and then going bust was to never get rich in the first place, then the alternative looks bad even without bailouts.