Monday, October 20, 2008

Thoughts on the financial crisis and deregulation

My last posting about deregulation may have had an unfortunate timing in the midst of the current financial crisis. Many people, especially pro-deregulation politicians such as John McCain have tried to blame the crisis on “greed on Wall Street”. However, as Michael Walzer recently pointed out in Dissent Magazine, there’s always been greed on Wall Street. It was already Adam Smith who noted that the motivation of an individual in the economy is one’s own gain. That includes bankers. This is one of the main reasons why free markets don’t often function for the common good. The limitations of free markets must be understood and supported by correct and adequate regulation. The financial crisis can’t be solved by getting rid of greed on Wall Street as McCain would like to think.

One of the reasons behind the current financial crisis is flawed banking regulation. Prof. Walzer suggests that it was the main reason, but I believe that massive international capital flows and low interest rates that fed the housing boom and inflated housing prices to unsustainable levels also played a significant part. Wrong incentives in the financial markets certainly played a role, as did the overtly complex financial instruments that, in the end, nobody could put a value on. But let’s get real. At the end, the housing boom was created by house buyers, not banks. Don't get me wrong, I believe in George Soros' theory of reflexivity in financial markets, and I believe that lenders helped to inflate the housing prices. We can (and should) blame the lenders for not managing risks and misallocating capital, but the borrowers are guilty, as well. We have some personal responsibility to manage our own financial risks, as well. With or without strict banking regulation, you can always live beyond your means, and that’s exactly what Americans have been doing. It’s critical that the next President gets this message through to the public. (Had there been someone else in the White House during the last eight years, he might have understood the basic business cycle economics of building a fiscal surplus during a boom.)

But turning back to deregulation; there are cases of failed or flawed deregulation in many electricity markets around the world. Those failures and flaws teach us many lessons, of which the most important is probably that the process of deregulation, and indeed, the regulation of deregulated markets is never finished – It’s an everlasting process. The most famous case of deregulation is perhaps that of California’s. Let’s talk about the lessons from that crisis.

First of all, the crisis in California was not only due to failed deregulation, but also due to an abnormal demand and supply imbalance. Except for two months during 2000 and 2001, demand was higher than ever between 1993 and 1999, leading to severe shortages. Secondly, there was a decrease in hydro generation during that period. Thirdly, there was nuclear capacity out of service during some of the period (some claim this was strategic gaming). This meant that more expensive gas and oil fired units had to come online. In turn, higher gas prices affected the crisis, as well. But prices were capped, and there was no pass through of utilities’ cost increases, such as fuel costs. In short, there was no demand response. Thus the first lesson is: don’t deregulate into a supply shortage. Second, regardless of whether you do that, you always need mechanisms to address supply and demand imbalances. In California, there was no hedge against the spot price, and utilities were not allowed to enter into bilateral contracts.

Furthermore, there was no single agency overseeing the whole market change in California, and there still isn’t one. It can be expected that trading arrangements and regulatory arrangements don’t mesh well, if they’re not designed under the same roof. This problem is not only native to California. The role and responsibilities of FERC and state public utilities commissions are not clear - at least, not to me. In California, the trading arrangements were faulty in part, because the municipal utilities did not join the ISO. In addition, the ISO was not permitted to resolve congestion at the scheduling stage, only at the dispatching stage.

Deregulation does not work, unless it’s accompanied with well-designed and rigorous regulation that oversees the deregulated market. In California, no agency had the mandate to monitor the various operators in the market, and to stop strategic gaming that was harmful to the market. Neither was there any punishment (explicit or implicit) for breaking the rules. In the long-term, there’s clear evidence that deregulation has eventually improved incentives for efficiency in operation and development in California. But we should learn from previous mistakes with short-term success in mind, because as John Maynard Keynes famously said: In the long run, we’re all dead.

A final note: I’m not a free-market fundamentalist in terms of privatization, either. When considering privatization, one should always consider the general public’s interest, one which the U.S. privatization process of the USEC (Uranium Enrichment Company) didn’t take into account! Some basic services are also better in public hands or at least in mixed markets, because the state retains direct control over quality and price of the service. Privatization only increases welfare in the economy, if the root problem is ownership, and even then the resulting increase of profits may only increase the society’s dead weight loss (i.e. benefit only the owners). If the root problem is not ownership, then organizational reforms may achieve better results than privatization. The main benefits of privatization are often seen as stemming from aligning incentives and separating commerce from politics, although the latter is not always even possible (e.g. with utilities). However, the principle-agent problem is common to both public and private companies. Both can also become corrupted, and both may have soft budget constraints as the recent bail-out of large private banks again shows.