The Alternate Universe of the GOP

Every once in a while I feel like I've succumbed to partisan madness and need to back off and assume a bit more good faith and sincerity from thinkers and activists on the other side. I need to treat conservative arguments with a little more respect and a little more generosity. But then I read a story like this, telling me that the four Republican members of the Financial Crisis Inquiry Commission have refused to agree to a bipartisan final report and will instead issue their own minority report:

During a private commission meeting last week, all four Republicans voted in favor of banning the phrases "Wall Street" and "shadow banking" and the words "interconnection" and "deregulation" from the panel's final report, according to a person familiar with the matter and confirmed by Brooksley E. Born, one of the six commissioners who voted against the proposal.

I don't even know what to say about this. I could write a hundred words about it or a thousand. But what's the point of pretending to take this stuff seriously? They're not, after all.

POSTSCRIPT: OK, I'll say just a wee bit more. Let's take those phrases one by one.

I could live without Wall Street. We can just call it the finance industry instead. That works fine and spares delicate sensibilities. I could even, at a stretch, live without deregulation. You have to talk about prudential regulation and leverage rules somehow, but maybe there's a way to do it without actually using that word. It's a stretch, but maybe.

But interconnection and shadow banking? It's just literally impossible to usefully discuss the financial crisis without mentioning those things. They're absolutely central to the whole story, and I don't even know what kinds of words you could replace them with. It's like writing about the New Testament without mentioning Jesus. I guess you could do it, but what's the point?

Why Are Bankers So Rich?

Tyler Cowen has a big piece about income inequality in The American Interest that's well worth reading. However, it's not really about the growth of inequality. It's about Wall Street. In particular, it's about this question: why do financial professionals make so damn much money?

The answer, of course, is that they work in an industry that's become ungodly profitable. But how? Tyler attributes it to the practice of "going short on volatility." That is, modern finance professionals mostly gamble that what happened in the past will keep happening in the future, and disasters will never happen. In most years this makes them a lot of money (because, in fact, disasters rarely happen).

But this is mysterious. After all, not everyone is going short on volatility. In fact, by definition, only half of the punters on Wall Street are doing it. The other half are taking the other side of the bet. Tyler explains this with an analogy to a bet that the Washington Wizards, one of the worst teams in basketball, won't win the NBA championship. If you make that bet year after year, you'll keep making money year after year.

This is a useful analogy precisely because it wouldn't work. After all, to make that bet, you have to find someone willing to take the other side and bet that disaster will strike and the Wizards will win. But they know just how unlikely that is, so they're going to require very long odds. On a hundred dollar bet, they'll want $100 if they win but will only be willing to pay off one dollar if you win. That won't make you rich.

So how can you make money doing this? Answer: find someone who doesn't know much about basketball and pays off two dollars on this bet instead of one. Additionally, you need to borrow money so you can make lots of bets. So instead of placing a $100 bet and making a dollar, you borrow a million dollars, make lots of bets on lots of teams, and make $20,000. It's the road to riches.

The questions this raises should be obvious. First, why would anyone be dumb enough to offer you such mistaken odds? Second, shouldn't the interest on the loan wipe out the profit from such a tiny betting margin? Third, why would anyone loan you this money in the first place, knowing that you have no chance of paying it back if disaster strikes, one of your teams wins, and you lose your entire stake?

As near as I can tell, the answer to #1 is that Wall Street traders are bad at pricing tail risk. The answer to #2 is that Wall Street hedge funds, using techniques pioneered in the mid-90s by Long Term Capital Management, have figured out ways to borrow large sums of money at virtually no cost. And the answer to #3 is that Wall Street lenders are also bad at pricing tail risk.

Or are they? Tyler argues that, in fact, both sides are betting that as long as everyone is doing this, the occasional disasters will be so epically disastrous that central banks will bail them out. They have no choice, after all, if the alternative is the destruction of the global economic system. So the tail risk is smaller than you think. Borrowers will make money in good years and default in bad years. Lenders, meanwhile, will also make money in good years, secure in the knowledge that on the rare occasions when everything goes pear shaped and borrowers can't pay back their loans, the government will make them whole. As Tyler reminds us, "Neither the Treasury nor the Fed allowed creditors to take any losses from the collapse of the major banks during the financial crisis."

But I don't find this persuasive as a behavioral explanation. The problem is that there's simply no evidence I'm aware of that Wall Street executives ever thought about this or priced it into their models. Sure, they may have been reckless or stupid. However, they weren't setting prices for financial instruments based on the idea that, yes, they were taking a genuine risk of going bust, but they could price that away because they'd get bailed out by Uncle Sugar when it happened. Rather, they really, truly, believed that they weren't exposed to very much risk. As near as I can tell, this was true on both the buy side and the sell side.

Tyler's story of private gains and socialized losses is surely true as an explanation for how the finance industry stayed highly profitable even while undergoing an epic meltdown. But I'm not sure it adequately explains why the industry became so stratospherically profitable before the meltdown. Because the problem in the pre-meltdown era wasn't that banks were taking on more and more risk, the problem was increased leverage and mispriced risk. For some reason, as Tyler puts it, "It's as if the major banks have tapped a hole in the social till and they are drinking from it with a straw."

This has always been one of the central mysteries of modern finance: Why is it so damn profitable? We're talking about an industry that's global, largely commoditized, and highly competitive. Profits should have been under extreme pressure for the past few decades. And yet, somehow, just the opposite was true. Against all theory, banks were able to consistently charge excessive prices; consistently take the better side of financial bets; and consistently persuade every other actor in the business that mispriced risk was, in fact, correctly priced. The result has been wild profitability and huge bonuses.

And where did this insane gusher of money come from? There are three possibilities: (1) banks created it, (2) their activities caused the economy to grow faster than it otherwise would have, and they reaped the benefit of that extra growth, or (3) it was somehow skimmed away from the rest of society. Possibility #1 is unlikely: banks certainly created mountains of debt, but mountains of money would show in skyrocketing monetary aggregates and high inflation, neither of which happened. Possibility #2 also seems unlikely. There's simply no evidence, either in comparisons over time or comparisons between countries, that economic growth over the past two or three decades has benefited from financial rocket science. So that leaves possibility #3: somehow, all this financial engineering was based on skimming money away from everyone else.

So, in the end, Tyler's piece really is about income inequality. The incomes of the vast middle class have lagged productivity growth by a small amount each year, and that small amount has accumulated into a gigantic pool of cash that gets funneled to a tiny number of the super rich, many of them in the finance industry.

But how? There's still a mystery here that no one has ever adequately explained. But it's important. As I've mentioned before, the primary metric for determining if financial reform is effective is the profitability of the financial industry. If it goes down a lot — by about half, I'd say — then it will have been successful. If not, then not. So far, the signs don't look good.

Two More Weeks

Greg Sargent reports on the latest maneuvering to repeal Don't Ask Don't Tell:

The announcement this morning that House Dems will vote on their own stand alone bill to repeal don't ask don't tell catapults the ball back into Harry Reid's court. If repeal is going to have any chance, the Senate Majority Leader needs to indicate right now that the Senate will definitely vote on the stand-alone bill after the House sends it over.

Senate aides involved in the discussions want Reid to make it clear that this vote is a certainty before the end of the lame duck session, not just something on the wish list. They want the White House to urge Reid to commit. They point out that repeal got a major reprieve today, when the House agreed to introduce its own bill — and they want Reid and the White House to capitalize on this momentum.

There are three big things on the liberal wish list for the remainder of the lame duck session: DADT, New START, and the DREAM Act. I might be wrong about this, but I suspect there's only time for one of them to pass. That being the case, my vote is very strongly in favor of repealing DADT.

There are a few reasons for this. First, if DADT fails now, it's dead for a very long time. With 47 Republicans in the next session of Congress, and probably about the same number for several years to come, there's simply no chance of passing it after the end of the year. It's now or never.

Second, it has the votes to pass. I don't think DREAM does. What's more, to put it bluntly, if I have to choose, I'll choose to expand the civil liberties of fellow American citizens before I'll choose to expand the educational opportunities of immigrants. I know that's a nasty choice, and I'll take both pieces of legislation if I can get them, but I don't think I can.

Finally, when all's said and done, I think New START probably can pass in the next session of Congress. Maybe I'm dreaming here, but New START simply doesn't push Republican hot buttons the same way DADT and DREAM do. Given the enormous support for New START among Republican foreign policy experts, I think it's possible to round up 15 or 20 Republican votes for it next year.

The opposing argument, I suppose, is that DADT is likely to be overturned by the courts even if it fails in Congress. But I'm not so sure about that. A district court might overturn it, and the right circuit court might concur, but I don't have a lot of confidence that the Supreme Court will agree. We have two weeks left to get DADT repealed, and I very much doubt we'll have a second bite at the apple from any branch of the government if we fail.

Fourth Amendment Update

This is good news and bad news:

In a landmark decision issued today in the criminal appeal of U.S. v. Warshak, the Sixth Circuit Court of Appeals has ruled that the government must have a search warrant before it can secretly seize and search emails stored by email service providers. Closely tracking arguments made by EFF in its amicus brief, the court found that email users have the same reasonable expectation of privacy in their stored email as they do in their phone calls and postal mail.

I assume the good news here is obvious. The bad news is that I had no idea this was even in question. Go ahead, call me an idiot. But I didn't know that the Stored Communications Act or any other act even colorably provided the federal government with the right to retrieve personal email, regardless of where it's stored, without probable cause and a valid search warrant. Jeebus.

Thinking About Alternate Universes

Felix Salmon pushes back on the idea that established companies have screwed up repeatedly by not buying startup internet companies that eventually became giants:

But how valuable were those opportunities, really? If Blockbuster had spent $50 million on Netflix, then it would just have run out of money that much more quickly. There’s no chance that Blockbuster’s management would have let Netflix grow, unencumbered, in the way that it did independently. Similarly, Google would have been stifled as part of Excite: it would have been nothing more than one of many search algorithms competing on the internet.

Buying internet companies is very, very hard: even if they are set to be very successful on their own, that’s no reason to believe that they will have similar success in-house. Google bought Foursquare back in 2005, when it was called Dodgeball, but then closed it down; only when its founders left Google and recreated the company as Foursquare on their own were they able to succeed.

I think that's right. When my grandfather's hitch in the Navy was up in 1920, he chose to be discharged in Los Angeles. At one point shortly after that he was offered the chance to buy an acre of land on Wilshire Boulevard for $500, and this naturally led to stories later in life about how it was a missed opportunity because that acre today would be worth a million dollars.

But of course, that's not what would have happened. More likely, the land would have been worth $1,000 in 1925 and he would have sold it then. A tidy profit, to be sure, but nothing more. Still no riches to hand down to his grandchildren.

It's the same with most internet startups: you have to think not about what they've become in the real world, but what would have happened to them in the alternate universe where they got purchased early in life. The answer is that most of them would wither away if they were part of some larger, more established company with powerful internal factions determined not to let a new division kill their cash cows. These kinds of acquisitions can sometimes work OK if you're buying something brand new that doesn't cannibalize an existing part of your business, but even then it's a crapshoot.

I'm curious: is there a big company anywhere in the world that has a pretty good track record buying small internet startups and then nursing them into giants? In theory, big companies do offer some benefits: money, distribution channels, legal departments, etc. In reality, that never seems to be enough to make up for the loss of independence. Are there exceptions? I can't think of any, but maybe I don't pay close enough attention.

Enumerated Powers and the Individual Mandate

Austin Frakt points to the latest figures from Massachusetts, which implemented Mitt Romney's universal healthcare scheme a few years ago, and the news is pretty good. Nearly 98% of Massachusetts residents are now insured, including 97% of working age adults and nearly 100% of children and the elderly. At a guess, the outlier result among Hispanics is mostly due to noninsurance among undocumented workers, which means the insurance rate among legal residents is probably close to 98%. Thanks Mitt!

So how did Massachusetts do it? The answer, of course, is that RomneyCare includes an individual mandate. You're required to buy health insurance or else face a penalty. This, along with subsidies for poor people, has prompted nearly everyone to get insured.

Which is as good an opportunity as any to muse on the weirdness of the U.S. constitution. How is it, after all, that a mandate to buy health insurance is plainly legal for the state of Massachusetts, but a district judge can rule that it isn't legal for the federal government? The answer, of course, is that the U.S. constitution is an odd duck: it doesn't simply allot power between the central government and the states, which is a fairly common feature of democratic constitutions, nor does it merely prohibit the central government from doing certain things, which is also common. It goes further: it specifically lays out the things the federal government is allowed to do. If it's not on the list, it can't be done.

State governments, as well as most other constitutional democracies, aren't set up this way. The state of Massachusetts can basically do anything it wants as long as it's arguably rational and not specifically prohibited or reserved to the federal government. And this works out fine, which is why it's so odd to hear opponents of a federal individual mandate chatter so furiously about slippery slopes and tyranny. After all, the argument goes, if the commerce clause of the constitution is interpreted to mean the federal government can force you to buy health insurance, what can't the federal government do?

Well, they can't keep you from owning a gun, they can't deny you a fair trial, they can't stop you from voting, and they can't prohibit you from saying anything you want. Among other things. But if all 50 states in the union can force you to buy health insurance, and none of them have yet turned into tyrannies because of it, why should we think that allowing the federal government the same power might turn it into a tyranny?

There's no reason, really, except the status quo. We have this weird constitution, forged by men who were indisputably brilliant but nonetheless scarred by recent events and writing a democratic governing document for the first time in history. All things considered, they did a helluva job. But the Apple II was a helluva job too, and that doesn't mean it was the last word in personal computers. The enumerated powers of the constitution may be something we have to live with, but living with it for two centuries shouldn't blind us to the fact that it's still a pretty strange restriction on the power of our central government.

Christians Against Religious Freedom

A group of atheists recently managed to scrounge up $2,400 to put ads on four municipal buses in Fort Worth. The New York Times reports:

The reaction from believers has been harsher than anyone in the nonbeliever’s club expected. Some ministers organized a boycott of the buses, with limited success. Other clergy members are pressing the Fort Worth Transportation Authority to ban all religious advertising on public buses.

....The ads have incited anger in some places. Vandals destroyed two bus ads in Detroit, ruined a billboard in Tampa, Fla., and defaced 10 billboards in Sacramento. One billboard in Cincinnati was taken down after the landlord received threats....But nowhere has the reaction of believers been so forceful as in Fort Worth, to the delight of Fred Edwords, the national director of the United Coalition of Reason.

....Some of the fiercest criticism has come from black religious leaders. The Rev. Kyev Tatum Sr., president of the local Southern Christian Leadership Conference, has called for a boycott of the buses, saying the ads are a direct attack during a sacred time in the Christian calendar....While Mr. Tatum and about 20 other pastors have urged their congregations to avoid the buses, a smaller group met recently with the transportation authority’s president to demand that the policy allowing religious advertising on buses be reversed Wednesday at a meeting of the authority’s board. The bus system in nearby Dallas bans all religious ads.

Religious people sure are touchy. They don't seem to mind competing with each other, so what's the problem with competing against atheism? Seems like a fair fight to me.

But this is what happens whenever a minority group of any kind tries to demand reasonable treatment: the majority group instantly takes it as a vicious, personal attack. The same dynamic played out when it was blacks vs. whites, men vs. women, or gays vs. straights. Acceptance of a minority group on equal terms is almost universally deemed threatening to a majority group that considers its superior status to be something akin to natural law. Welcome to the latest incarnation of the culture wars.

Republicans and the Tax Deal

Hmmm. Last week I wrote a post suggesting that, in the end, Republicans would get scared off by their tea party wing and leave it up to Democrats to pass the Obama tax deal. So I proposed a pool: how many Republicans will actually end up voting in favor? I figured 30 in the House and five in the Senate.

But I never published the post. Republican support at the time seemed so strong and so widespread that I figured I was wrong. This time, Lucy wasn't going to pull away the football. Republicans really did lust after those tax cuts for the rich so much that they couldn't not vote for them.

But maybe I should have had the courage of my convictions. I see that Mitt Romney denounced the deal today, and Ezra Klein notes that Rush Limbaugh, Sarah Palin, and the Tea Party Patriots are also opposed. His conclusion: "I'd bet there are plenty of elected Republicans looking to bail. What they need is an excuse. If the House Democrats manage to make any real changes to the deal, they'll have one — and so will John Boehner and Mitch McConnell." Added to that, there's the dawning realization that the stimulus from the tax deal might be just big enough to all but guarantee Barack Obama a second term in the White House.

So we'll see. The cloture vote did pass 83-15 yesterday, so signs of a revolt are pretty muted right now. And maybe I'm overestimating Republican cynicism — though that's pretty damn hard to do these days. But an awful lot of them would probably like to see the bill pass, just not with their vote attached to it. In the end, I still wouldn't be surprised to see it get just barely enough votes to make up for a few Democratic defections. Maybe ten votes in the Senate instead of five, but no one should be shocked if it's nothing higher than that.

Quote of the Day: Ending the War

The last words of Richard Holbrooke, President Obama's chief envoy to Afghanistan and Pakistan, before he was sedated for surgery on Friday:

"You've got to stop this war in Afghanistan."

That would be a fitting memorial.

Judge Hudson's Weird Decision

Judge Henry Hudson's opinion declaring the individual mandate unconstitutional is a curious thing. The federal government basically argued that (a) PPACA regulates the healthcare market and (b) the healthcare market is plainly an instance of interstate commerce. So broad regulation of the healthcare market is well within the purview of the Commerce Clause of the constitution. Furthermore, since individuals get sick and receive medical care whether or not they have healthcare coverage (and whether or not they can pay for it), a decision not to buy health insurance has a significant effect on the healthcare market. Therefore, forcing people to buy healthcare coverage is a reasonable provision in a bill meant to regulate the healthcare market.

But here's what Hudson has to say about that:

If a person’s decision not to purchase health insurance at a particular point in time does not constitute the type of economic activity subject to regulation under the Commerce Clause, then logically an attempt to enforce such provision under the Necessary and Proper Clause is equally offensive to the Constitution.

I'm no lawyer, but that's just not right. As defined by Hudson, the Necessary and Proper Clause serves no purpose at all, because anything that isn't specifically authorized elsewhere in the constitution logically can't be authorized by the Necessary and Proper Clause either. But the Necessary and Proper Clause isn't meant to merely add an exclamation point to other provisions of the constitution. Rather, it says that rationally related subsidiary means are constitutional as long as the overall ends are constitutional. To make Hudson's paragraph meaningful and non-tautological, it would have to read like this:

If regulation of the healthcare market does not constitute the type of economic activity subject to regulation under the Commerce Clause, then logically an attempt to enforce an individual mandate under the Necessary and Proper Clause is equally offensive to the Constitution.

This would be true. But no one is arguing that Congress can't regulate the healthcare market, so it also doesn't matter. The entire issue at stake here is whether the individual mandate is a reasonable means to implement a piece of regulation that, broadly speaking, is clearly within Congress's purview. But because Hudson peremptorily sweeps this away with his odd tautology, he never really engages with the key question in the entire case. 

For reasons that Jack Balkin summarizes well here, I think the Supreme Court will end up agreeing that the individual mandate is well within the range of means that Congress can choose from in order to regulate a large and important sector of interstate commerce. But whether they do or not, it's hard to believe that they or any other court will take Hudson's facially preposterous reading of the Necessary and Proper Clause seriously.