18 December 2008

Too Big to Fail, Too Well-Connected to Jail: The Economic Underworld of Bankruptcy for Profit


In her brilliant essay, NY Times Pulls Punches on Wall Street Bubble Era Pay, Yves Smith at Naked Capitalism quotes a 1993 research paper from the Brookings Institution titled Looting: The Economic Underworld of Bankruptcy for Profit.

"Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society's expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.

Bankruptcy for profit occurs most commonly when a government guarantees a firm's debt obligations. The most obvious such guarantee is deposit insurance, but governments also implicitly or explicitly guarantee the policies of insurance companies, the pension obligations of private firms, virtually all the obligations of large or influential firms. These arrangements can create a web of companies that operate under soft budget constraints.

To enforce discipline and to limit opportunism by shareholders, governments make continued access to the guarantees contingent on meeting specific targets for an accounting measure of net worth. However, because net worth is typically a small fraction of total assets for the insured institutions (this, after all, is why they demand and receive the government guarantees), bankruptcy for profit can easily become a more attractive strategy for the owners than maximizing true economic values...

Unfortunately, firms covered by government guarantees are not the only ones that face severely distorted incentives. Looting can spread symbiotically to other markets, bringing to life a whole economic underworld with perverse incentives. The looters in the sector covered by the government guarantees will make trades with unaffiliated firms outside this sector, (such as Enron, and even the 'deep capture' of agencies like the SEC, and the placement of your people in key government positions - J) causing them to produce in a way that helps maximize the looters' current extractions with no regard for future losses...."


We wonder if the authors Akerlof and Romer realized that their paper of appropriate warning would become a prophetic, virtual guidebook for an historic looting of the United States economy by a few financial institutions under the government guarantee of 'too big to fail' and 'too well-connected to jail.'

Impossible? Who would have believed that a paper from a neo-conservative think-tank, The Project for the New American Century titled Rebuilding America's Defences: Strategies, Forces And Resources For A New Century would become a blueprint for a program of deception and invasion?

The conclusions and the title of this blog are our own. Yves is one of the most level-headed of economic commentators. Her site is a 'must read' for the serious every day. We do not wish to put words in her mouth.

Having said that, the solution for non-US investors is simple. Do not hold US dollars or dollar assets to any significant degree until it proves itself to be responsible again. Bring your money back to your home economy. Build something useful for yourself and your children. Do not be a renter in your own house. If you are not for yourselves, who will be?

Do not allow your own bureaucracies to enforce an industrial policy of domestic deprivation and low wages to support an aggressive expansion of exports in return for increasingly worthless paper. When will the benefits come if not when times are good?

If your country is large enough you may become self-sufficient. If not, you can join one of the regional trade associations such as the European Union.

Commodities such as oil and industrial raw materials will continue to be pivotal, highly manipulated and disputed, for quite some time until the world regains its economic and political balance. Why would you allow one country to essentially set all the prices with its own paper?

For US investors the solution is not as easy. The dollar is an essential component of any portfolio and almost all day to day transactions.

There is promise in the new administration, despite early disappointment in some of the appointments to date. Let's give them time to show progress and programs. One needs capable individuals in place to act quickly. How can we forget the stumbling missteps of the Jimmy Carter administration?

However, too many of the appointments are cyncial verging on the outrageous for a government with a mandate to reform. Actions will speak much louder than words.

Excessive secrecy is incompatible with a democracy. More transparency in government is a reform of the first order.

It took years to lose our integrity, and to regain it is the work of a generation, one day at a time. There has been an ongoing program of overturning all the reforms and regulations of the 1930's, one by one, to discredit and repeal them, and to ultimately put the country under the control of an oligopoly. The pattern is unmistakable.

If you would like to give your children and grandchildren something worthwhile and lasting at this holiday season, then resolve to reform and replenish the Republic that your parents and grandparents gave to you, and not trade it away for some short term security and profit.