Financial Sector Invariance

So what’s the endgame, and why are people taking so many positions? I want to illustrate one quick economics idea, keeping with the non-finance/econ background. There’s this thing called the Coase Theorem. Under a lot of insane assumptions, people can bargain themselves into the best resolution of pollution and other externalities. Part of the theorem is the Invariance principle – that no matter how the initial allocation is, it will automatically go towards the efficient equilbirium.

Say there is a village that likes clean air and a factory that makes pollution, and the efficient allocation is 30 units of pollution. If we give the village 100 right to pollute tokens, it’ll sell 30 of them to the factory. If we give the factory 100 right to pollute tokens, the village will buy 70 off of them and sit on them. If we give each 50, the village will buy 20. Etc.

Note that the initial endowment and transaction path means a lot for who wins and gains (in one case the village gets money, in the other they pay money), even though under equilibrium the final product is the same. I remember having a discussion with a dear economics graduate student friend about this back in school:

Me, Finance Graduate Student: …And yeah, there’s that part about the Coase Theorem.
Economics Graduate Student: Is that the one where the initial endowments don’t matter because they trade towards equilibrium?
Me: Well yes, they do end up at equilibrium, but the initial endowment matters a lot for who gains and loses in the transaction.
Economics Graduate Student: Well, yeah. But you’d only care about that if you were like a sociologist or something.
Both: Hahahahahaha. [evil laughter.]

A lot of economics is like that. We move towards equilibrium at all times – how we start off, and the path we take, doesn’t matter as much as where we end up. I think this explains a lot of how Economists are approaching this situation. Take the excellent winterspeak, who provocatively writes about whether or not the FDIC needs to have extra funding for this crisis: “But the Government is the monopoly currency issuer. It does not need a “rainy day fund” anymore than a bowling alley needs to keep “points” stockpiled.”

A lot of what I read Economists saying is: “We, the taxpayers, need to put $1 trillion dollars towards bad assets. It doesn’t matter at all if we do this by nationalizing banks, using the Treasury Department to buy them all up, or by using FDIC to bribe hedge funds to do it. It also doesn’t matter if the Department of the Interior pays it, or if the Coast Guard does. All of these costs roughly the same, let’s do them in order of least to most risky until they are done.” At the end of the day is an accounting identity; once $1 trillion dollars is transfered to investments from taxpayers, we can get things going again.

This is almost certainly true. However I think the “path dependence”, or the allocation of responsibility for cleaning this mess, does matter, quite a bit. I think by not revamping the financial system now while nationalization is possible, we are setting ourselves up to be in the same exact position we were in 2005. I think it matters to our sense of democratic government that our well-being is held hostage by malicious forces and our government is paying the ransom. There’s also a pervasive lack of accountability – as if this crisis fell out of the sky like a random asteroid, rather than being the concrete decisions made by specific agents at specific times.

To put it a different way – another difference we should add to the list of disagreements between those who support the plan and those who don’t is that, if the plan works, some believe we can then begin winding down the banking sector to a reasonable place where these incidents have a small likelihood of ever happening again. Others, like myself, believe if this plan works the banking sector realizes the barrel they have the government over, and have no incentive whatsoever to begin an expensive wind-down. Time will tell….

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6 Responses to Financial Sector Invariance

  1. Parthenon says:

    No comment other than that I’m a new reader, and this is a great blog. Found you via GinandTacos, and will keep reading.

  2. Pingback: Modeling an FDIC Robbery. « Rortybomb

  3. Kislaya Gautam says:

    New reader who followed the link from Felix Salmon’s page.

    That the “legacy loan progam” is a guise by FDIC to takeover insolvent banks without causing much headline and that the “securitized product program” provide the opoprtunity for some players to enrichen at the expense of levergae provided by tax payers is very obvious. However, yesterday I was illuminated by my colleague who presented a different take – the shit that we are in would in any case require the govt., and the tax payers to pony up the capital (assuming that at this time we have deemed them all too big to fail). In this light by pulling in private parties; the probabilty that private party would have to share some of the burden (through their equity participation) releives some burden for the tax payers.

    Not that bad after all..

  4. Jacob says:

    This is just to second Parthenon. I saw the link on Felix Salmon. Awesome stuff!

  5. Patience says:

    Did you mean to say “At the end of the day <> is an accounting identity”?

  6. Patience says:

    Did you mean to say “At the end of the day [the federal government] is an accounting identity?

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