Thursday, March 19, 2009

It’s not Rock Scissors Paper, it’s Chess

I’m not sure whether the Obama administration knows it or not but it is painting itself into a corner by getting behind the anti-bonus rhetoric and I think this is a serious problem. This is not to say that Wall Street compensation has not been excessive. It has. This is not to say that there should not be consequences for poor judgements and decisions. There should be. But by hopping on the populist bandwagon and encouraging congress to vilify the rescue of Wall Street the Obama administration is closing off options for itself in the future that it may come to regret.

Here’s why.

Over the past two weeks or so there has been a parade of bank executives in America and abroad who have announced how well their banks are doing in terms of revenue and how much money they are making. This should surprise no one. If the government insures all the loans you made that will never be paid back and funds you at the risk free rate no matter how much risk you have on, you can make money.

But generating revenue is only half of what banks do. The other half is managing the risk and the balance sheet and this is where it gets tricky. Whether because they are now making money again or because the government puts together a program to move toxic assets off the balance sheets of banks sooner or later there is going to be a lot of questionable assets for sale. This will mean that the value of a lot of what the government has insured on the balance sheets of AIG, Bank of America and Citibank will finally be known, that is we will know what the government will have to pay out on those guarantees. There’s a good chance the number will be high. So the US taxpayer will wind up holding the bag for the Pandit rally.

At the same time as the taxpayer finds out what his losses are so will all the other banks, which do not have government guarantees as yet. Then what will the government do? Having spent all this time railing about the outrage of the AIG bonuses and the greed on Wall Street what will the appetite be for yet another package to repair the capital of the damaged banks? What if, as seems likely, the lesson drawn is not that bankers should take Grasselys advice and kill themselves but rather that the taxpayers should sit on their hands and let the banks go under.? Sure Obama & Co. have already asked for $750 billion in their new budget but Congress is a capricious thing and when the constituent mail starts pouring in 10 to 1 against further bailouts what will the government do then?

It won’t have a lot of options. It will have to let a lot of financial institutions be wound up or force merged into other financial institutions. This will in turn shake the confidence of taxpayers and investors both that we are really out of this mess and the whole thing could begin again.

I think generally what bothers me is that so many people involved seem to think that this is a one turn game. By one turn game I mean a game like rock scissors paper. You choose a move, your opponent chooses a move, you reveal, one of you wins: game over. The financial crisis, however, is not a one turn game. It is a multi-turn game more like chess. Each action a given market participant takes sends signals to all the other participants which they then take into consideration when they take their own actions. This is true of all participants, CEOs, traders, investors, but most particularly of the government because, though not omnipotent, it is the single strongest actor.

When people in the government make a decision they need to be thinking about how other participants will interpret their actions, how they will react to them, and how that will constrain or enhance their field of action in the future. I would say that what has actually been happening is that the government is behaving as if this were a one turn game. They think that this or that action is the last one and that’s it. With the possible exception of Ben Bernanke they all seem to focus on the here and now rather than the later and then.

There has been a lot of criticism of the Obama team lately for this but the Bush team was just as guilty of it. The people in government are acting this way not because they are Democrats or Republicans but because they are human. It is human nature to see the world as you would have it be rather than it is and to imagine that your capacity to affect outcomes is greater than it actually is. I recognize that the Obama administration probably feels as though it has been unjustly attacked for its handling of the crisis so far and I can understand their very human desire to score points by joining the populist outcry. But they have a bigger job to do and the only way they can really do that is to overcome their human impulses and try to think a few moves ahead. This is why most are asked to follow and only the few are called to lead.

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