Limit Wall Street’s political power too, says economist Acemoglu

The debate about financial regulation in the banking sector is in full
swing. "I certainly understand why people are angry at bankers,"
prominent American economist Daron Acemoglu says in an interview with
NRC Handelsblad.

NRC Handelsblad (Netherlands)
6 August 2009

By Marc Leijendekker

The American investment bank Goldman Sachs saw a profit of 2.7 billion
dollars in the second quarter of 2009. Should we be happy about this?
Is it a sign that at least the United States is scrambling its way out
of the financial crisis? Daron Acemoglu, a prominent American
economist, has his doubts.

He points out that Goldman Sachs was in danger of bankruptcy last
autumn and received billions in aid from the US government. Ten
billion dollars was recently paid back, with interest.

"In a way, it is a good thing that Goldman Sachs is making profit
again," says 41-year-old professor Acemoglu. "Profit pumps capital
into society. That is the function of the banking system. But is it a
‘fair’ profit?"

Business as usual

Not when you realise that these profits would have been impossible
without state aid, he says, which moreover came at a time when no one
else was willing to lend Goldman Sachs money. The fact that so much
profit was made again so quickly, that bonuses are once again to be
paid out and that banks now want to return to business as usual
worries him.

"The financial crisis would be a good time to restructure the American
financial system. But at the moment, I don’t see that happening."

Acemoglu, a professor of applied economics at the Massachusetts
Institute of Technology (MIT), was in Utrecht for two days for a world
conference of economic historians. In his keynote speech at the
conference, he stressed the importance of legislation and regulation
for the economy. Are property rights being protected? Are there
controls on the actions of both the business elite and the government?
If not, he says, problems will arise.

In an interview wi
Before the crisis a political, ideological choice was made to equate
the market economy with a lack of regulation, he says. In this
equation ‘the market’ is good ` a sentiment Acemoglu wholeheartedly
endorses. ‘Regulation’ is not; regulation disrupts the market ` and
this is a notion that Acemoglu challenges. "Markets cannot function
without institutions. There have to be rules."

Wall Street’s political clout

He thinks, for example, that clear limits should be imposed on
leverage, on what you can do with borrowed money. He also argues that
deposit guarantees should be regarded as government subsidies that
justify government control and influence. And if the government says
that some financial institutions are simply "too big to fail," then
there should be oversight and regulation on those as well.

Acemoglu: "Why was Goldman Sachs not bailed out the same way the
American auto industry was bailed out? Don’t give banks billions of
dollars to use as they wish, but take shares in the banks. That
enables you to keep control."

He also feels more attention should be focused on the political power
of Wall Street: "We should not only regulate the financial world, but
the politics of the financial world as well."

This is not just about campaign contributions for politicians either.

Acemoglu: "The system was designed to give the financial sector’s vote
the greatest influence possible. The Fed, the American system of
central banks, is in many aspects a part of the financial sector. The
oversight is exercised by the Federal Reserve Board and the bosses of
the large financial institutions. The idea itself is not a bad one,
because this ensures a great deal of communication among the various
people in the sector. But it also means that they do not do the right
thing if this would mean going against the interest of the financial
industry."

For example, Henry Paulson, the last treasury secretary under
president Bush, had previously served as chairman and CEO of Goldman
Sachs.

"Paulson did what he did and gave t
billions in support not only because this was the right thing from an
economic point of view, but also because it was a good political
move. He came from Wall Street. The fact that Obama’s treasury
secretary Geithner is continuing this line is no surprise. He too
worked in the system. He was president of the central bank of New
York, the most important of the central banks. It was inconceivable to
them to allow that financial system to fall apart."

Did Paulson and Geithner make the wrong decisions?

Acemoglu: "We don’t know that. We still don’t know exactly what
happened. Where was the real power in the large institutions? What was
the relationship with the government? Would these financial
institutions really have gone bankrupt otherwise? And would that
really have been so tragic?

"All things considered, I think that on the whole the right decisions
were made. President Obama acted statesmanlike and managed to reassure
people, for the time being. But beneath the surface, there is a great
deal of dissatisfaction. I certainly understand why people get angry
about an extremely costly bail-out operation paid for by the taxpayer,
designed by bankers and intended to help bankers and limit the damage
for those responsible."

How do you manage that, devote more attention to the political power
of the financial sector?

"This has become standard in developing countries. We are aware that
you cannot talk about the development of Indonesia, for example,
without looking at the political and institutional factors. But in
Europe and the United States, such factors are barely taken into
account. People actually suggest that these are apolitical solutions,
technical measures. That is how you end up with Goldman Sachs telling
its former executives, who now formulate government policy, that a
costly bail-out operation is the only possible solution from an
economic perspective. That is very convenient of course, if you can
present it like that."

What other lessons are there from the crisis?

"We need better econometric
ly and in practice at financial institutions, in order to be able to
better assess risks. The fact that weak companies collapse is part of
the dynamics of capitalism. It is a form of reallocation ` economist
Joseph Schumpeter called it ‘creative destruction’. That term is
already more than 50 years old and is the essence of a capitalist
economy, but we still do not know much about it."

You also argue that people should be reallocated.

"We have a problem when all our best people go into the financial
sector. If an MIT student who graduates with a degree in computer
science or physics goes to work for Microsoft, Apple or Google, the
salary for the first ten years is one tenth of what he can earn at
Morgan Stanley or Goldman Sachs. Are they more productive there?

"The profits that Goldman Sachs has made over the past months derive
from the fact that they can rapidly trade in shares, options and
futures. Their computer programmes are better. What is the value of
that? Are all financial innovations really innovations? Doesn’t it
just mean that Goldman Sachs made the profit instead of some other
institution? As nice as that is for those involved, it becomes a
problem when your ambition is channelled in a way that is purely about
taking profit from others. On the other hand, if you improve a search
engine or make and apply biotechnological inventions you contribute to
real innovation, to economic growth, to social benefit."

How can this banking culture change?

"We have to think about our payment structure. There has to be a limit
on the financial compensation for traders and bankers on Wall
Street. It is good for people to be paid on the basis of
performance. But if they are paid on the basis of short-term
performance and without any risks when things go poorly, there is
something fundamentally wrong.

"Can you change that without government intervention? And if the
government must intervene, can this occur without consequences for
innovations in the financial sector? In any event, we can no longer
leave th
rld."

PHOTO CAPTION: Acemoglu: "Goldman Sachs’ profits derive from the fact
that they can rapidly trade in shares, options and futures. What is
the value of that?"Photo Reuters

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