The Vaulted Bank
The New Finance: Regulation and Financial Stability
by Franklin R. Edwards
(American Enterprise Institute, 1996) 221 pp.
Reviewed by Lawrence J. White
The financial services sector in the United States is experiencing a period of extraordinary turmoil and change. The dazzling improvements in data processing and telecommunications (the core technologies of financial services) of the past few decades are the primary driving forces underlying the change. Today banks and other financial services providers can do more things, more effectively, over longer distances. Inevitably, that means more competition. Firms that were previously isolated, in product space and geographic space, are now effectively in the same markets, and new firms can enter the field.
Traditional commercial banks have been the aggregate losers from that process. The winners have largely been other forms of financial intermediaries, such as mutual funds, pension funds, and finance companies. Public policy has not helped the banks. Despite two decades of deregulation, banks remain heavily regulated. They cannot own full-line insurance companies or non-financial (commercial) enterprises; they can enter the securities industry only with difficulty; and they cannot even pay interest on the checking accounts of their commercial customers.
In his recent book, Franklin R. Edwards carefully and convincingly documents the decline in the importance of banks and the rise of other intermediaries. Edwards has marshaled an impressive array of statistics to buttress his case. I suspect that future commentators, as well as Congressional aides who do not want to rummage through original statistical sources, will be citing Edwards book extensively.
Edwards does not lament the decline, though he wishes that public policy did not make life so difficult for the banks. As he points out, the decline is an international phenomenon; it is not unique to the American regulatory scene. But he hopes to forestall a similar set of impediments that could impair the efficiency of newer financial institutions and instruments. Following his documentation of the banks decline, he devotes about a third of the book to addressing specifically the claims that: (1) shareholders runs on mutual funds will present threats to the stability of the countrys financial system; (2) the banks diminished role means that the effectiveness of monetary policy has been weakened; and (3) todays greatly expanded volumes of financial derivatives and other "exotic" instruments presage greater financial fragility. In each case, he effectively refutes the case for massive new regulation and recommends either benign neglect or modest change, such as better disclosure for derivatives.
Finally, he returns to bank regulation. Despite their shrinking role, banks are likely to continue to be an important part of the financial landscape, at least for the next few decades. As the S&L debacle revealed, even a modestly sized group of actors on the financial stage can create a sizable liability (about $150 billion) for taxpayers when those institutions are covered by federal guarantees (deposit insurance) and when federal regulatory policy falters. Since banks are covered by those guarantees and since Edwards believes that federal regulators will not be able to keep pace with banks advancing technological wizardry, he argues for change.
Edwards remains convinced that runs on banks by depositors continue to pose a threat to the stability of banks and to the payments system. Consequently, though he is critical of the current system of safety-and-soundness regulation, he is not prepared to embrace free banking and the abolition of regulation. Instead, harking back to a variant on the "narrow banking" proposal that was popularized by Robert Litan a decade ago, Edwards endorses collateralized banking: all demand deposits would have to be backed at all times by Treasury bills and/or other short-term high-quality debt obligations, so as to remove virtually all risks of fund insufficiency with respect to those deposits. With those deposits collateralized, banks would be free to engage in any activities and with any structure that they chose.
It is at that juncture that I part company with Edwards. Admittedly, his variant on narrow banking does have a surface appeal. Depositors would have a safe, cash-equivalent, financial instrument available to them. Banks would be able to pursue activities and develop structures that would enhance their efficiency, free of virtually all "safety-and-soundness" regulation shackles. Only a minimal safety requirement would remain: the monitoring of the instruments providing the collateral in order to prevent problems such as fraud.
But I have never been convinced that any of the variants of collateralized banking is the "silver bullet" of bank regulation. First, Edwards proposal fails to address the over-abundance of non-safety regulations that restrict bank activities and ownership. Those regulations include: the ban on owning insurance companies or non-financial enterprises, the restriction on paying interest on commercial checking accounts, reserve requirements, the requirements that banks activities must meet the needs of their communities, the requirements that banks state their interest rates on loans and on deposits in standardized formats, and the wealth of other federal and state restrictions that take up many linear feet on any banking lawyers bookshelves. Indeed, Edwards largely ignores those non-safety regulatory areas, as well as most of the regulatory structures that surround securities, mutual funds, insurance products, and pensions.
Most of that regulation will not vanish on the day that collateralized banking appears, or even the day after. It has arisen for a myriad of social and political reasons, many of them linked to American populist fears and confusions about the processes of finance; it wont go away easily (though Edwards and I wish that most of it would disappear).
Second, I am confident that the banking industry could and would devise new payment instruments that would technically evade the collateralization requirement. However, a run on a bank, with potential "contagion" effects among poorly informed depositors, is a classic negative externalities problem, with some managerial moral hazard problems mixed in. The incentive problems are likely to remain unsolved.
Indeed, the collateralized banking "solution" resembles the mechanism created by the National Currency Act of 1863 and the National Bank Act of 1864. Those Acts required national banks to collateralize their bank note liabilities with Treasury debt. Unfortunately, the widespread development of checkable deposits as a substitute bank liability for bank notes meant that national banks continued to experience runs and failures. Banks in the twenty-first century will surely be at least as innovative as their nineteenth century predecessors.
Alas, there is no "wooden stake" to be found for bank runs and failures. All of the primary solutions that have been suggested have serious faults as well as virtues. The "solutions" include: free banking and the absence of safety-and-soundness regulation, collateralized banking, cross-guarantees among banks, and a tighter version of todays regulation embodying more incentive-based mechanisms. After much soul searching, I continue to believe that the last of those choices continues to be the best among a set of flawed alternatives. (However, I am greatly distressed that bank regulators, despite the debacle of the 1980s, continue to succumb to bankers wails, and refuse to institute a system of market-value accounting that would greatly enhance their monitoring capabilities.) But reasonable people can differ on potential solutions, and I hope that Edwards book will stir the policy debate yet again because "steady as she goes" is not a sensible course. The financial sector is changing rapidly, and our system of financial regulation needs to be pared substantially but also to be sharpened in places.
Unfortunately, our political system often allows the maxim "if it aint broke, dont fix it" to substitute for deeper analysis of lurking, but not-yet-obvious problems. We may have to wait until the next debacle of the financial sector before major reforms are attempted. But the cauldron of a financial crisis is not conducive to rational and efficient regulatory reform. Instead, it is likely to yield hasty and costly regulatory changes that could easily proceed in the wrong directions. I hope that if and when we fall into that cauldron, we remember Edwards book and use it as a reference and guide for debate.
Lawrence J. White is Arthur E. Imperatore professor of Economics, Stern School of Business, New York University.
New Light on Electricity Reform
A Shock to the System: Restructuring Americas Electricity Industry
by Timothy J. Brennan, Karen L. Palmer, Raymond J. Kopp, Alan J. Krupnick, Vito Stagliano, and Dallas Burtraw
(Resources for the Future, 1996) 138 pp.
Reviewed by Richard L. Gordon
Resources for the Future (RFF), a public policy research institution, has succeeded admirably in providing a 138-page discussion of electric power restructuring that clearly and concisely covers the key issues. Every major issue is treated; all the main arguments are presented fairly. Thus, the intended audience, newcomers seeking information and even those familiar with the issues, will benefit from the effort to answer the remaining questions.
The treatment involves the usual introductory chapter, six chapters devoted to what the authors describe as the key issues, and an epilogue on further issues. However, the first "issue" chapter is actually a review of the current organization of the electric utility industry. The others tackle current topics: (1) possible forms of restructuring, (2) the special problems of transmission, (3) whether or not to end the prevalence of vertical integration, (4) the issue of costs "stranded" by deregulation, and (5) the implications for environmental policy.
The history chapter begins with a quick survey of the nature of the industry, the different energy sources used, and the role of private, cooperative, federal, and other public organizations in the industry. The chapter devotes the majority of its bulk to key governmental interventions. Those include the threefold federal government effort to alter the industry in the 1930s, the forced restructuring of private firms under the Public Utility Holding Company Act, the regulation of utilities by the Federal Power Commission, and the creation of federal wholesale power projects.
Other key influences include laws passed in 1978 in response to the Carter administrations energy initiatives, the most important of which proved to be the Public Utilities Regulatory Policies Act (PURPA). It regulated state treatment of utility power purchases from independent producers. The provisions first limited the mandates to specified forms of generation. Those consisted of various types of "renewable" energy, including small scale hydroelectric, solar, and wind energies, plus, the most important, "cogeneration," electricity produced simultaneously with steam for use by the producer. The provisions also covered small scale hydroelectric, solar, and wind energies. The states were to determine the price at which such facilities were economically viable. They would require utilities to purchase power when it was offered at or below that price.
Those topics in the history of electricity regulation are a potential minefield for any analyst. Simply describing the facts is an enormous task. Every policy treated involves considerable controversy, but the book slides over much of it. For example, discussion of holding company reform is limited, and care is taken to attribute the prevailing attacks on the old structure to the federal agencies that originated the charges. Similarly, the subsidization of federal power is dispassionately described. However, the book triumphs at reducing the complexities and controversies of PURPA implementation to two sentences. It notes that states exercised their individual discretion differently from one another.
The other chapters are more focused but still deal with numerous vexing issues. The chapter on alternative structures starts by comparing competition limited to wholesale markets with retail competition. It then compares two widely discussed models of deregulation. The first emphasizes contracting between generators and wholesale or possibly retail customers. The alternative stresses a spot market to be run by an organization dubbed "Poolco" that more clearly seeks to move to retail competition. [See Robert Michaels article in this issue.] The discussion recognizes that a combination of spot and contractual arrangements might be adopted. The treatment successfully sketches most of the critical arguments for and against the alternatives. My only complaint is that the treatment of Poolco does not possess the subsequent chapters clarity about the general drawbacks of regulation. In particular, the authors do not challenge the Poolco advocates faith that regulation can prevent abuses. Development of a well-functioning competitive spot electricity market seems desirable, and the RFF study should inspire imaginative readers to devise such a market.
In contrast, the review of transmission options is predominantly a well-modulated, carefully moderated view of regulatory issues. The validity of the conventional case for regulation is examined. Then the nature and limitations of traditional cost of service regulation and widely proposed alternatives are reviewed. Such alternatives include setting maximum prices or basing allowable prices on performance by comparable utilities. That review proves applicable to all types of public utility regulation. Attention is given to the economists traditional concern that rates should vary more with market conditions. Then the problems of non-storability of electricity, inevitable losses in transmission, and the physical laws that cause power to use all routes available to it are examined. The last problem means that if two networks are connected, power can leak from one to the other creating interdependence.
The next chapter examines whether the vertically integrated nature of the industry (when generation, transmission, and generation are combined in a single company) should be altered. The discussion goes back to basics by defining vertical integration and the economic arguments for its maintenance. Then the authors report and evaluate the concerns often raised concerning how integration can be used to undermine regulation. The discussion actually comes close to taking sides. Two of the complaints concerning the dangers of integration implicitly assume that regulators monitoring weaknesses are greater in some areas. They unconvincingly attempt to maintain their aura of impartiality by tersely denying that "anticompetitive behavior is impossible." (Moreover, this qualification is the first clause of a two-clause sentence, the second, much longer clause is a warning about excessive concern over the issue.) The chapter neglects the classic argument particularly well developed by George Stigler that integration is a good way to lessen the inefficiencies of monopoly and thus is less necessary as markets become more competitive.
In Chapter Six, the authors manage to pass safely through the stranded cost minefield. They take care to explain that market economies perennially strand costs. Then they skeptically examine the basic arguments about whether electricity is an exception and regulation the culprit and what to do about it. Between the two parts of the review of issues, the wide range of magnitude estimates of stranded costs are presented and explained. Finally, they review possible methods of recovery and their drawbacks.
That chapter contains the only citation from another study, and it inspired me to start searching for literature. My effort quickly showed that the RFF discussion omitted a key issue. Anyone advocating stranded cost recovery is tacitly ignoring the inherent limitations of regulation that have inspired a search for reforms. Recovery measures must determine the changes in earnings from restructuring and compare them to the unamortized value of existing investment. Failures to forecast accurately are a major cause of the current malaise, and future forecasts are unlikely to be better. Advocates of continued regulation cite the difficulties of cost measurement as the reason for proposing alternatives to cost-of-service rules. In short, stranded cost recovery is a goal that will surely be implemented badly.
The bulk of the environmental discussion deals with concerns that the restructuring will undermine conventional environmental policies. The authors believe that any initial harm may ultimately be offset by the subsequent reduced impact of newer, less environmentally destructive generation facilities. In any case, the appropriate response to environmental concerns is change in environmental policy rather than electricity policy. However, the discussion also deals gingerly with concerns over proposed social costing, demand-side management (subsidies of reduced consumption), and optimum promotion of renewables. It is noted that to date, social costing has not been well implemented; a better system can be devised and could be maintained if the Poolco route were taken, but it must be determined whether it would produce a net gain.
The authors begin the treatment of demand-side management by questioning its advantage. They suggest that such programs should compensate precisely for the price rigidities eliminated by restructuring. The discussion concludes with a paragraph discussing the difficulties of program maintenance under deregulation. The last sentence describes, without comment, a solution proposed by the Natural Resources Defense Council. The bulk of the treatment of renewables is descriptive. One paragraph then reviews the uncertainties about the effects of restructuring. The last paragraph rather elliptically suggests that renewable energy policy should be treated separately from restructuring. The punchline is that the best policy for renewables "may be" increasing tax breaks and eliminating all other preferences. The impatience of economists with complex, indirect ways to treat problems is evident.
The epilogue deals with entry into telecommunications, support of research and development, social programs, and utility taxation. Claims of benefits from mergers and the criticisms evoked from them precede statements that appraisal will be difficult and it is unclear whether anyone has authority to act. The telecommunications discussion qualifies the recognition of benefits to the markets entered with concern about the alleged abuses associated with integrating a regulated company. The research and development section mostly expresses concern that deregulation will lessen the support for cooperative research projects. In contrast, the paragraph on social programs clearly recognizes that they should not be financed through electricity rates. Finally, it is noted that special taxes on utilities are a barrier to efficient operation under deregulation. With the exception of the research and development paragraph, those breathless overviews are precisely on target. The research discussion is unbalanced. A single sentence at the end notes that there may be no need for cooperative programs. Moreover, it is unclear whether deregulation can be any worse for cooperative research than the present regulatory climate. Companies have already withdrawn, and the program has been curtailed.
The book seems to adopt the tacit premise that a review of literature on the subject would serve nobody. The material is vast, scattered among a small number of publications, and wildly variable in quality. The most consistent sources are the Electricity Journal and Public Utilities Fortnightly. Other material is scattered throughout economic journals and law journals interested in those policy issues, numerous government documents, and various books, typically anthologies of assorted views. None of them stand out as useful guides to casual readers. The informed already know where to look.
Richard L. Gordon is professor of mineral economics at the Pennsylvania State University.
The Sinner and the Saint
Betrayal of Science and Reason
by Paul and Anne Ehrlich
(Island Press, 1996) 335 pp.
Reviewed by Wilfred Beckerman
I really must get out of the environmental policy field. Not merely does one find oneself in a lot of company that one would rather not keep. Worse is the sadness that one cannot help feeling at seeing the way some distinguished scholars behave outside their own specialized fields; a manner in which they would never dream of behaving within it. One such case is Paul Ehrlich.
Ehrlich is no doubt a distinguished scientist in his area of biology. He is also, judging by the book he co-authored with his wife, on the side of the angels, concerned with the aesthetic and spiritual values of nature, human welfare, and future generations. I happen to agree with much of what he writes on environmental issues. I also sympathize with Ehrlichs criticism of ill-founded anti-green rhetoric. Like all good causes, including appeals for a more balanced approach to environmental policy, it is very difficult to avoid being taken over by extremists. It is therefore sad and ironic for somebody of Professor Ehrlichs scientific stature to set such a bad example.
In his latest book, we see far more examples of Ehrlich the preacher than of Ehrlich the scientist. One striking feature of the book is his frequent reference to the high standards of scholarship found in the work of "real scientists." Unfortunately, the Erlichs book contains far too many examples of failure to meet those standards.
On page 230, Ehrlich castigates some of his opponents for attributing to him a "totally made-up statement." Yet, on the very next page, he distorts my work. Criticizing my latest book, he attributes to me a precise figure for the growth rate of the world economy since Ancient Greece that I have never mentioned.
On page 231, he quotes me with the proposition that greens believe "rising income levels are inevitably and at all times associated with a deterioration in the environment." In fact, in the passage concerned, I made no assertion at all about what "greens believe." In my part of the academic world, we interpret deliberate distortion of what people have written as intellectually equivalent to faking the data.
In his review of my book, he concludes, "Thus its a shame that Beckermans book . . . had to be published." Does he mean that it is a pity that we live in a free society in which it is impossible to prevent the publication of books by an Oxford economist who has the temerity to query the world-shaking Doomsday predictions of great prophets like Paul Ehrlich? Suppression of dissent is another characteristic of those who are convinced that they alone hold the key to world salvation. Still, at least he did not go as far as to say that my book ought to be burnt.
Scientists respect for rigorous argument also suffers in the Ehrlichs book. On page 135, the authors refer to the estimates of economist William Nordhaus. He argues that the effect of global warming on U.S. gross national product need not be very great since agriculture and forestry constitute only 3 percent of it. They attempt to ridicule that argument by referring to the fact that the heart constitutes only 3 percent of the bodys weight. That is no refutation at all. Whilst nobody can live without a heart, it is perfectly possible for any individual economy to survive without any given economic sector, including agriculture. Many societies in the world survive with agriculture representing much less than 3 percent of GNP. In some cases it is virtually non-existent, as it is in Hong Kong or Singapore.
Ehrlich refers to a seminar in which the Nordhaus point was argued, and a questioner asked, "What does he think we are going to eat?" Ehrlich cites that question as another allegedly devastating refutation of the Nordhaus argument. Actually, over the past few years there has been a drastic fall in the percentage contribution of agriculture to GNP in the United States, but there has not been an accompanying fall in food consumption. Ehrlich ignores the role of international trade and the fact that many of the goods that Americans eat, drink, drive, and wear are imported.
On the same page, the authors take me to task again for maintaining that the likely costs of global warming are small compared to the value of total world output. They say that I have limited myself to "private costs" and hence have overlooked other costs, "including millions of deaths and enormous destruction from severe storms." In the first place, those are private costs. In the second place, it is stated on pages xxv and xxvi of "Climate Change: The IPCC Scientific Assessment" (for the 1991 report of the Intergovernmental Panel on Climate Change) that there is no evidence yet that storms will increase in a warmer world. So where do the Ehrlichs obtain their evidence for the view that they will not only increase but will do so to the point where they will cause millions of deaths?
The Missing Dead
One of the claims rightly made for serious scientific work is that it is founded on a respect for the empirical testing of predictions. Yet Paul Ehrlich is famous for making predictions not borne out by events. In The Population Bomb, published in 1968, he maintained that the world was facing widespread starvation on account of the inevitability of population outgrowing food supply (not even an original false prediction; Malthus beat him to it by nearly two centuries). Ehrlich brushes that false prediction aside in an amazing manner in his current book. He argues first that the starvation did take place, and, second, if it didnt take place, the world heeded his warnings. In other words, Ehrlich has invented a law that neatly sidesteps the requirement of Popperian methodology; namely, that Paul Ehrlichs predictions can never be falsified. Either they come true or, if they dont, it is because hispredictions were heeded.
The claim that governments in many parts of the world increased food supply and reduced the rate of population growth due to Ehrlichs warnings is so mind-boggling that one expects massive evidence to be provided in support. Well, two references are supplied. One is to a book by W. and P. Paddock published in 1967, a year before Ehrlichs book was published. The other is a private communication from a certain M. Swaminathan. Now Mr. Swaminathan, whoever he is, may be an eminent expert on the subject, but we social scientists prefer to be provided with evidence that is in the public domain, especially when such extraordinary claims are made.
Ehrlichs contention that fast population growth relative to world food output has led to terrible famines ignores the work of established authorities. For example, of Amartya Sens work on that topic, he writes that Sen, "among other errors, badly underestimates the serious environmental impacts of population growth." But he does not explain exactly what Sens errors are, another technique usually banned in serious scientific circles; namely, the unsubstantiated smear.
Ehrlich is also famous for another falsified prediction. In 1980 he and two colleagues made a bet with University of Maryland Professor Julian Simon. Ehrlich wagered that the price of a basket of five metals would climb over the following decade; Simon bet that it would fall. Simon won.
Ehrlich is a bad loser, however, and devotes a lot of space to arguing that he really won a moral victory. First, he says that prices of "three of the five [metals in question] went down in the 1980s, in part because a recession in the first half of that decade slowed the growth of demand for industrial metals world wide." But he fails to mention that there was strong economic growth in the world in the second half of the decade and that, in spite of it, by the end of the decade prices of all the five metals in question had fallen. In fact, the real prices of almost every important natural resource experienced a real decline between 1980 and 1990, manganese and zinc being the only exceptions, so it would have been virtually impossible for Ehrlich to have won his bet whatever basket of five minerals he had selected.
The Ehrlichs second line of defense is that the minerals in question were not indicators of welfare anyway. Perfectly true, but back in 1976 the Ehrlichs had predicted that "before 1985 mankind will enter a genuine age of scarcity . . . in which the accessible supplies of many key minerals will be facing depletion." In other words he had long been in the business of making predictions about supplies of minerals, whatever he may have believed about welfare.
So Simon then challenged Ehrlich to make a bet about indicators of welfare. According to the book under review here, Ehrlich proposed a long list of items, predicting an increase in the atmospheric carbon concentration, extinction of many species, and so on. Most of those and other trends on his list are beyond dispute. What is a matter of dispute is to what extent they are indicators of human welfare. Simon, sensibly thought that they were not and, preferring to bet on welfare indicators such as life expectancy, declined to bet on the Ehrlich list. That the Ehrlichs can report this as a great victory merely demonstrates the extent to which an obsessive and arrogant belief in ones infallibility can take control over an otherwise well-functioning mind.
Summing Up Ehrlich
So, taken overall, what do we have? Fudged data, gross logical errors in argument, unsubstantiated smears, two monumentally falsified predictions, and other serious flaws too numerous to enumerate here. He focuses on the weakest targets. His indexing is sloppy. For example, some of the references to my work in the book are indexed and others are not. There is an absence of any bibliographical list of references, making it virtually impossible to follow up some of the sources to which the authors refer. I assume that in their professional work in biology, the Ehrlichs do not let the side down and produce such shoddy material.
I would not dream of saying, howeverlike the Ehrlichs said of methat it is a pity their book had to be published. On the contrary, it is a salutary reminder that many distinguished scientists sometimes talk nonsense, particularly when they stray outside their own fields. The history of science is littered with examples of eminent scientists who believe that their achievements in their particular specialty must be proof of their omniscience. One is reminded of the pre-war metaphysical nonsense of Sir Arthur Eddington, or Sir Fred Hoyles recent views about evolution or the origin of life in Outer Space, and many others. Another distinguished contemporary scientist, Stephen Jay Gould, writes of the "false stereotypes that scientists often like to convey about their disciplinescience as a dispassionate search for objective truth through untrammeled observations; great scientists as people who can free their minds of prejudice and hear natures own voice." One can understand Paul Ehrlichs psychological need to shout about his scientific credentials. No informed reader of this book would have guessed them.
Wilfred Beckerman is an Emeritus Fellow at Balliol College, Oxford University.
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