In yesterday’s post, I half-jokingly pointed out Arnold Kling’s quotation that you can imagine government spending like charity run by the mafia.  Well, it’s getting to the point where you can think of government iself as run by the mafia.  You basically have Knuckles and Vinny telling banks that they went and took the money (sometimes by force), and now they have to sing the government’s tune.  I think that Lindgren is right concerning the public choice aspect of this:  government officials see this as an opportunity to gain real power over the financial industry (more than they have with their onerous regulations already in existence).

What Lindgren misses, however, is that there is an internal rationale for forcing solid banks to keep the money, outside of gaining additional control over them.  Basically, TARP funds were to tide over failing banks.  However, it’s a fairly obvious signal if, whenever a bank receives TARP money, that bank is failing.  In that event, people would make a run on the bank regardless of the federal money, and that bank would likely go bankrupt.  As a result, the “brilliance” behind TARP (scare quotes intended for full snarky effect) was that all banks would receive the funds.  That way, you couldn’t tell which banks were solid, which were bad, and which were teetering.  If individuals could not get that information, they wouldn’t make a run on any banks.  That was the idea that Hank Paulson had and Tim Geithner continued.

At first glance, the signaling aspect is good in theory, and could potentially have worked out.  However, what happened next was that politicians decided that now that they “owned” the banks, they owned the banks and could do whatever they wanted:  pay caps, new regulations and guidelines, etc.  Those solid banks which went along with the plan either out of a sense of self-preservation or (more likely) because of Treasury pressure now want out, as they can see that taking this money was a curse.  They also can use this handback to signal that they are successful banks, thereby boosting their reputations at the expense of the weaker banks and unraveling the cartel.

Actually, talking about cartels is a great way of explaining why TARP was going to unravel from the beginning, and why “at first glance” doesn’t hold up.  The idea of a cartel is that all of the firms in an industry (say, oil) get together and decide that they want to raise prices above the market clearing level and up to the level of a monopoly so they can maximize their economic profits.  They generally have to find a way to freeze out competition, either by having a natural monopoly (or natural oligopoly) of supply or government regulations which make it difficult for outsiders to come in and steal away disgruntled customers.  At any rate, if we assume high barriers to entry, it is possible to make a cartel work, at least in theory:  all of the agents meet and set a price that each agent will sustain*.  This price is the profit-maximizing price for the set of firms.

For a numeric example, let’s set up a simple demand curve where D = 9000 – 80 * P.  This means that, for example, at a price of $100, consumers will demand 1000 units.  To make things simple, we’ll set the marginal cost = average cost = $50**.  In a truly competitive market, the sale price would be $50 and they would sell 5000 units.  In our non-competitive situation, we want to maximize profit T, there T = D * (P – 50).  Without going through the motions of setting up a Lagrangian and solving the problem, I’ll just tell you that the monopoly price is where T is maximized, which is $81.25.  At this price, we would expect to see 2500 units produced and a total economic profit*** of $78,125.

So, now that we’ve calculated the amount and the price, we get together with all of the other firms in the industry and agree that everybody will produce and sell goods at $81.25 a unit.  Then, we’ll split the profits however consumers choose and laugh our ways to the bank.

Of course, it all starts to unravel, though, because this analysis is missing something:  best responses.  If all of the other firms are selling at $81.25 and you do, you might get X% of the market.  Let’s say, just for the sake of argument, that you can get 25% of the market if you go along with this.  That means you would pull down $19,531.25 in profits for your firm.  But if you sell at $80, you can get 100% of the market, and that would get your firm a profit of $78,000.  Obviously, you would want to do that instead, but so would every other firm.  That means they all drop to $80.  At $80, you play the same game:  you want to drop, but once you drop, so do the other firms.  This goes on until the first firm reaches $50.  They aren’t making any economic profits there, but they get the full market share, so it still benefits them to move down to that point (since they are still making accounting profits at that point).  Of course, the other firms want market share as well, so they drop down to $50 as well.  So once you start playing this game out, it unravels.

Now, how does this tie back to the banks?  Well, the answer is that banks are competing with one another for business.  In this instance, they are competing based on expectations of solvency, and thus the expected value of your bank account.  Your expected value at Fail-O-Riffic Banks Of America might be $450,000 but $500,000 at Pinstripes And Solvency Banking Conglomerate, as the first bank is likely to become insolvent and you would lose $50K.  In the Treasury Department’s scheme, they want individuals not to be able to form those expectations in a realistic fashion, and instead decide that all banks will return a value of X for all firms, where $450,000 <= X <= $500,000, but you cannot differentiate X1 from X2.  The problem here for the Treasury schemers is that it behooves the second bank to signal that they are on solid footing and won’t lose your money, and the best way to do this is to return the “papering-over” money.  Because this was a “loan” (after all, Treasury was trying to sell this as “We could even make money in the long run!”), banks are going to pay it back at some point anyhow, but the good ones can pay it back right now, thereby showing the public that they are good.  Meanwhile, the bad ones cannot pay it back, as they want to use the money to cover themselves.  This will lead to the public losing faith in those bad banks and moving accounts over to the good banks, thereby increasing good banks’ percentages of the market share.  And short of Mafia tactics, there’s nothing that Treasury can do to win at that signaling game.

* – Technically, this is called a “Bertrand cartel.”  A “Cornot cartel” is one in which the companies get together and set a fixed quantity  of supply and then decide which firm produces what amount.  The system will unravel in a similar way (though the extent to which it unravels depends on the number of firms involved—as a market has more firms, things get closer to the perfect competition result).

** – There are, therefore, no fixed costs, so they cannot act as a barrier to entry.  Instead, new competition is limited because the government gave a certain number of companies rights to produce this good.

*** – Remember that economic profits are different from accounting profits.  We expect all firms to make a return at least as great as their next-best alternative:  investing in the market.  Economic profits are the amount above and beyond what that investment would bring back to us.


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