Serial Drivel

I usually breeze through BusinessWeek in about 10 minutes, just trying to sense the flavor of what MSM is cooking. But this week I could not just bypass this article without adding a comment, or two, or three. So below is the article with my notes attached.

There's an old saying in economic forecasting: The consensus is always wrong. But which way? The average forecast of the 52 economists surveyed by Blue Chip Economic Indicators calls for growth in real gross domestic product of 2.7% over the next four quarters, with the annual rate in any single quarter no greater than 3%. This early in the recovery, it's tough to argue that the consensus is either too pessimistic or too optimistic, but one thing is clear. The herd does not think the past tendency of strong recoveries to follow deep recessions will hold true this time. For example, in the first year after the severe slumps in 1973-75 and 1981-82, real GDP grew 6.2% and 7.7%, respectively.

The herd. The author uses the word herd to generate an impression of herd behavior or herd thinking. Too caught up in being like everyone else to see what is really occurring. Fine.

The correlation between the depth of recessions and the strength of recoveries over the last nine business cycles is unmistakable. It relates to the extent of the cuts businesses make in output, payrolls, and inventories. It also reflects the amount of pent-up demand created as consumers and businesses postpone spending. Like a rubber band, the economy snaps back in proportion to how far it was pulled down, as consumers finally upgrade old laptops and buy new clothes, and businesses replace inventories and worn-out equipment.

As he does not posit which business cycles, I will just assume he is talking about NBER's marking of recessions. But why stop there, why not 10; why not the just the last few? Do the 9 really represent what has occurred in this cycle? How about we make a comparison of this cycle to what previously occurred to see if we can rely upon a snapback, v-shaped, pent-up demand recovery that he posits.

Look in the last chart you can see cash for clunkers. However, there is much more in the CFR's report. Suffice to say I am not completely convinced that we can rely on the data from the past 9 cycles to be representative of what has happened and what might happen next. But I will continue to read with open mind in hopes of being persuaded.

If the consensus is right, the economy's departure from past experience would be striking. Economist Robert J. Barbera at the research and trading firm ITG (ITG) notes that after each of the past nine recessions, deep or shallow, real GDP has never required more than three quarters to regain its peak level prior to the downturn. If GDP staged a full recovery over the next three quarters, the economy would grow at a 5.4% annual rate. Even stretched over four quarters, the pace would still be 4.1%.

Again you must accept the wisdom that this is a normal recession just like in 1990, 2001 1981, etc. to then follow the conclusion that growth will be even better than the forecasters median expectation.

The common argument is that the usual rebound effect will be limited by the aftershock of the financial crisis: Credit growth is plunging, because households need to unload debt and save more amid lost wealth and tight credit, limiting the business sector's response. However, that's no sure thing. Data on credit flows are not particularly useful for predicting the strength of a recovery, according to economists at Barclays Capital. They note that in the strong upturns of the 1970s and 1980s, consumer spending accelerated well before the upturn in consumer credit.

My counter-factuals would be: A)that in the 1970's and 1980s Baby Boomers were entering the workforce, and for each one who entered there were more behind him/her coming. Thus, staking your place was fine, you could "buy-the-dips." Now however, those same leaders will be leading the way into retirement. The first Boomers are 63 now and in their mind's eye have been targeting the good life once they hit the Social Security mark. Now however, they will have to either work longer or save more if they hope to maintain their lifestyle. B) Also while the analyst at Barclays argue that credit may not be the major concern, as businesses have hoarded cash to survive this liquidity and solvency crisis. What should be a concern is CapEx spending.

CapEx has been dropping sequentially and year on year. So where are these revenues to come from if no one is engaged in attempting to grow their top line? The companies have done well to keep their profits up by annihilating their variable costs (labor.) So still not quite convinced but there is still more to come.

Early in recoveries, the growth of household income is a more important impetus to spending than credit. As job losses fade, pay from wages and salaries, about 60% of aftertax income, will turn up, as it did in July for the first time in nine months. Also, a lot of spending is done by households and businesses that either don't need to borrow or have good credit quality.

Aha! He has seen the light, it is hiring that will bring everyone back into spending! Let's look at the latest jobs report to see how great the job situation is going, the one that will bring us to above trend growth over the next 9 months.

Wait, what is this. The BLS stating that they have overestimated how many jobs have been lost over the past 20 months. It is actually 824,000 worse, which adds an additional .6% to the already abysmal 9.83% U-3 unemployment. Though it can be said that unemployment is not per se a bad thing when it is short term. It is only when it is long term unemployment that indicates a major problem with the economy.

That is structural unemployment is the highest it has been in 40 years! I am sure this is just a normal recession so the snap back should be starting any moment now. I wonder if I should mention that there is large proportion of part time employees who will have their hours increased before a firm begins to re-hire which can be seen in the hours worked survey from the BLS as well.

The recovery's oomph will also turn on how much income households feel they need to put away to eliminate debt and restore nest eggs. A rising saving rate weighs heavily on the growth of consumer spending. However, with savings in the second quarter already at 5% of aftertax income, up from 1.2% in early 2008, the saving rate may be about as high as it needs to go to give households the cushion they want.

So since we have established that all the rehiring because of all the revenue opportunities that companies are witnessing, we can then posit that consumers will go back to their prolific ways in spending our way to success. No mention of that as an open economy and the world's reserve currency that national savings will equal investment plus net capital outflows. Since the US dollar is in fact the world's dollar and that countries must use it as a store of wealth and a medium of exchange, which, of course, keeps the savings rate in the US artificially low since domestic investment is funded by foreigners allowing us to borrow freely from them. However, it does not state why consumers after being wounded with a 14 trillion dollar loss of wealth would want to continue to live paycheck to paycheck instead of saving for a rainy day. Please continue...

Historically, saving behavior loosely tracks the ratio of household income to wealth. As that ratio rises, in this case because of plunging stock prices and home values, so does the savings rate. By the second quarter the ratio had risen to the levels of the early 1990s, when the saving rate was about 6%, close to where it is now. Moreover, households in the second quarter recovered $2 trillion of the $14 trillion in net worth lost during the recession, and rising stock and home prices imply another gain of about $2 trillion this quarter.

The author now describes how savings is calculated and then undermines his argument by stating that the saving rate in a seemingly artificial manner dropped because of the rebound in the stock market. So we should actually look at the flow of funds report to see if savings increased not by its proportion but actually cash on cash over the preceding quarter. Here is the latest data 1219.9 followed by last quarter 1311.4 and the quarter a year back 1425.9. Since the economy has shrunk the savings rate shot up despite lower numbers. Although it must be said to save you have to pay off your creditors first.

So far, the raft of surprisingly positive data in recent weeks supports the more upbeat recovery scenario. In particular, the index of leading indicators, a composite of 10 gauges that tends to foreshadow recessions and recoveries, has turned up sharply. Since March the index has grown at an 11.7% annual rate, the fastest five-month pace since the 1981-82 recession.

The ten components of the Leading Economic Index include:

1. Average weekly hours worked by manufacturing workers - negative
   
2. Average number of initial applications for unemployment insurance - negative
   
3. Amount of manufacturers' new orders for consumer goods and materials - negative
   
4. Amount of manufacterers' new orders for capital goods unrelated to defense - negative
   
5. Speed of delivery of new merchandise to vendors from suppliers - positive
   
6. Amount of new building permits for residential buildings - positive
   
7. The S&P 500 stock index - positive
   
8. Inflation-adjusted money supply (M2) - negative
   
9. Spread between long and short interest rates (i.e. the yield curve) - positive
   
10. Consumer expectations - positive

So the positives from the reports are that monetary policy has effectively lifted the spread and the stock market. This has caused consumers to feel a bit better that the economic situation is not getting worse but is stabilizing. The new building permits has risen from a depressed level because of the cash for houses government initiative. However, on the whole no one is hiring, no one is adding more hours to the work week, no one is ordering more capital to build revenues. Seems a bit like a two sided report, everything that the government can touch is being held up by it and the rest is just wishful thinking.

For now, none of this will change the minds of the more pessimistic forecasters. However, the historical pattern is on the side of the optimists.

We finally agree. The analysis is sloppy. He does try to convey that he weighed both arguments for pessimism and optimism but it is not at all as thorough as it should be. I would have felt much better if he tried to dig further into his bullish arguments by explaining what portion of the LEI that he felt gave the economy the best bet. Was it the stock market? If so than his logic circles in this manner: the LEI is going up because the stock market has gone up therefore the stock market is going to continue to go up because the LEI presages it. Huh?

Economists do it with models! Part 2

This post involves a lot of pictures from PowerPoint. I will add notes to each image.


The above picture shows a "normal" supply and demand curve. National savings (the supply) will increase with an increase in the real interest rate. Thus it slopes upward. Investment and NCO acting as the demand component works in the opposite manner. As The real interest rate rises the amount of loanable funds is low, lower and the quantity rises, thus it slopes downwards. ( Loanable funds are usually used to invest in capital assets, either at home or abroad, thus its relation to I + NCO)


The demand curve (in blue) represents the demand for dollars which is 100% correlated to NX. We know that NX must equal NCO from earlier discussions. Imagine you buying that BMW again. You are giving BMW US dollars but they must pay their labor in Euros. So what do they do with their US dollars, probably buying a factory in South Carolina, otherwise known as purchasing a capital asset.

The real exchange rate will be where this market is in equilibrium. The supply curve is vertical because the Quantity of Dollars is not affected by the real exchange rate, it is affected by the real interest rate. The amount of NX will affect the demand for dollars which are necessary to make transactions between foreign countries. When the exchange rate is lower will stimulate a demand for dollars, thus the demand curve slopes downward.



The real rate of interest will affect NCO. If the rate is low in relation to the Euro then more funds will leave the country. When the rate is higher (relatively) in the US then funds will flow back into the country.


The NCO graph ties together the demand for dollars/real exchange rate graph and the loanable funds/real interest rate graphs so that analysis of policy decisions can be made.


This example shows China as the home country. It wishes to lessen its trade balance by removing its subsidy to Chinese export companies. By decreasing the amount of net exports no matter what the exchange causes the demand for Yuan to fall (move leftward.) The real exchange rate drops to R2, however, it does not affect the amount of capital leaving the country. (note this example assumes that the Yuan is a fully convertible currency) NCO is only affected by changes in the real rate of interest in relation to the rest of the world.


A second example where the US is the home country. How would it be affected by having the Chinese purchase less Treasury securities? First we would see NCO increase, which would cause the domestic real interest rate to rise. This would have a secondary affect of...

Increasing the supply of dollars in the foreign exchange market. The increase in dollars would lower the real exchange rate. All in all the US would export more, import less due to the change in exchange rate. It would also save more as the real rate of interest would rise.

I added that if this had been undertaken in an orderly fashion after the dot-bomb debacle, perhaps instead of invading Iraq, there might not have been such a huge financial crisis with its epicenter in the US housing market. Instead the Chinese have continued to purchase US treasury securities keeping the real rate of interest low. This allowed a borrowing binge and an asset price appreciation in the United States housing market. Instead of appropriating the funds in more productive sectors, citizens were buying and flipping houses back and forth to each other in a Ponzi-esque fashion.

You can also imagine this set of graphs analyzing government budgets, ( a deficit will draw down on the supply of loanable funds, crowding out private investment), trade policy (quotas help one industry at the expense of all exporting industries via a higher exchange rate) and Capital Crises (it is the same analysis of China pulling its investment example from above.)

Economists do it with models! Part 1

The last time we used a model we were looking at a hypothetical closed-economy. The model previously proposed was the market for loanable funds and now we can do the same analysis again with the new tools that we built in the preceding posts.

So now we go back to our Savings and Investment identity, S = I and add on NCO. Therefore,
S = I + NCO

Remember what S (national savings) consists of, which is public and private savings or

(Y - t - C) + (t - G) = S = I + NCO
Private Savings + Public Savings = National Savings = Investment and Net Capital Outflow

As we discussed last time NCO should be affected by real interest rates which behaves in the following fashion. As the real interest rate rises this encourages more people to save and less people to invest. The higher rates cost people & businesses more money to borrow to finance a project so instead they can just earn a rate of return by saving it. The higher borrowing costs create a hurdle rate that makes businesses take on the fewer projects that can meet this barrier.

Now though we have the added variable of real interest rates worldwide. So we should consider how those rates will affect financial flows. Note that this is a model and may not explain what currently happens in all places at all times. In fact what I am about to say next does not at all reflect the reality in America for the past 30 years.

So you have capital either located at home (I) or abroad (NCO). Savings will then purchase capital in either places. However, NCO can be positive or negative and will thus have an affect on the market for loanable funds in the following manner (usually): When NCO > 0, NX is greater than zero and we purchase capital abroad which increases the demand for loanable funds thus keeping real interest rates down. Conversely, when NCO <> 0, while NX < 0. How can this be so? Well as the nations that export to the US garner a bunch of dollars the countries then use their US Dollars to buy US debt.

Let's dig a little deeper into this and introduce a time differential. So in a closed economy the only way for a country to increase its investment is to increase savings. That is because S = I. In an open economy because S = I + NCO the domestic citizens do not have to raise their savings to fund investment. So if the US decides to build a nuclear plant it could import the parts from France and also borrow the funds in Euros. This will increase America's Investment (I) while increasing its NCO as well. We could also term NCO as the current account, as in the current account deficit. The reason this works is because the French have decided to save more so that the resources to build the plant are freed up for America. This is a time differential or in the jargon of economists it is an intertemporal trade, in that America imports present consumption (borrowing from the French) and exports future consumption (when it pays off the French.)

This is how the American consumer was able to spend so prolifically over the past 30 years because we kept buying present consumption and paying for it with IOUs (Treasury securities) that Asia snapped up. Because of the perceived weakness of the political and economic systems the Asians were willing to save more than their American counterpart and give up higher returns for two reasons: A) their economies relied upon the US consumer buying their goods, that is their own economies could not consume as much per capita as Americans because of the lack of a social safety net & B) the US dollar is a store of wealth and unit of exchange in the global economy.

I'll end here and begin again with the model.

Too small to bail has a nice ring to it - Breakingviews

I agree with the sentiment and the main thrust of the article but, there always is a but, it seems to make a small mistake. First the synopsis: the banking industry is seeing larger losses at the larger banks, the systematically important banks caused the financial crisis because of the interconnectedness, smaller banks have thus far outperformed their larger brethren, however larger banks lend out more of their deposits thus getting vital credit out to the financial system, one last caveat is that the larger banks employed more mark to market and thus we may see more & larger (relatively) losses on smaller banks financial statements later in the cycle.

From the article But there is a wrinkle. Small banks lent out a smaller percentage of their customers’ deposits — 83.11 percent in the second quarter, to be exact — than the big banks, which converted 94.24 percent of deposits into loans, according to SNL Financial.

That’s a meaningful difference. If all banks in the United States kept their loan-to-deposit ratios in line with smaller banks, some $830 billion less credit on total deposits of $7.54 trillion would reach American businesses and consumers than if all banks adopted the big banks’ lending ratio.

My bone is with the larger banks lending out more of their deposits. You see on the face this statement is correct, prima facie for you latin lovers. However, deposits are only one form of liability for a bank. (quick note: bank loans are assets for banks and bank deposits are liabilities for banks. Banks will also issue debt as a longer or shorter liability.) So that is where the bone is. Larger banks will have better access to the capital markets; thus, these banks can lend out more money because the liability side of their balance sheet will be larger than a bank who cannot issue debt as cheaply or as in abundance as its larger cousin. Here is the information directly from the horse's mouth, otherwise known as the FDIC.



In this case there is no story. Banks larger than 10B in assets lend out only 58.19% of their liabilities. Smaller banks lend out 70.13%. If you divide it by smaller banks being less than 1B than these banks lend out 75.26% of their assets and the banks larger than that lend out 60.32% of their assets. What is the story here?

Well the story is B.S. or as I say in front of my niece baloney, not to be confused with bologna a delicious treat for children.

The truth is that if all the banks lent out at the rate small banks are currently doing there would be more credit in the system. Don't know if that is necessarily a good thing, but the idea is on much more solid ground than the sloppy analysis from the article.

Open note to my congressman

Below in bold is a note I forwarded to my congressman. I also included a link to a more eloquent argument than my own, which is below in italics. I would urge you to send forward the italicized argument to your own congressman (especially if it is one of the following names who make up the financial service committee:
Rep. Barney Frank, MA
Rep. Paul E. Kanjorski, PA
Rep. Maxine Waters, CA
Rep. Carolyn B. Maloney, NY
Rep. Luis V. Gutierrez, IL
Rep. Nydia M. Velázquez, NY
Rep. Melvin L. Watt, NC
Rep. Gary L. Ackerman, NY
Rep. Brad Sherman, CA
Rep. Gregory W. Meeks, NY
Rep. Dennis Moore, KS
Rep. Michael E. Capuano, MA
Rep. Rubén Hinojosa, TX
Rep. William Lacy Clay, MO
Rep. Carolyn McCarthy, NY
Rep. Joe Baca, CA
Rep. Stephen F. Lynch, MA
Rep. Brad Miller, NC
Rep. David Scott, GA
Rep. Al Green, TX
Rep. Emanuel Cleaver, MO
Rep. Melissa L. Bean, IL
Rep. Gwen Moore, WI
Rep. Paul W. Hodes, NH
Rep. Keith Ellison, MN
Rep. Ron Klein, FL
Rep. Charles Wilson, OH
Rep. Ed Perlmutter, CO
Rep. Joe Donnelly, IN
Rep. Bill Foster, IL
Rep. Andre Carson, IN
Rep. Jackie Speier, CA
Rep. Travis Childers, MS
Rep. Walt Minnick, ID
Rep. John Adler, NJ
Rep. Mary Jo Kilroy, OH
Rep. Steve Driehaus, OH
Rep. Suzanne Kosmas, FL
Rep. Alan Grayson, FL
Rep. Jim Himes, CT
Rep. Gary Peters, MI
Rep. Dan Maffei, NY

Republican Members

Rep. Spencer Bachus, AL
Rep. Michael N. Castle, DE
Rep. Peter King, NY
Rep. Edward R. Royce, CA
Rep. Frank D. Lucas, OK
Rep. Ron Paul, TX
Rep. Donald A. Manzullo, IL
Rep. Walter B. Jones , NC
Rep. Judy Biggert, IL
Rep. Gary G. Miller, CA
Rep. Shelley Moore Capito, WV
Rep. Jeb Hensarling, TX
Rep. Scott Garrett, NJ
Rep. J. Gresham Barrett, SC
Rep. Jim Gerlach, PA
Rep. Randy Neugebauer, TX
Rep. Tom Price, GA
Rep. Patrick T. McHenry, NC
Rep. John Campbell, CA
Rep. Adam Putnam, FL
Rep. Michele Bachmann, MN
Rep. Kenny Marchant, TX
Rep. Thaddeus McCotter, MI
Rep. Kevin McCarthy, CA
Rep. Bill Posey, FL
Rep. Lynn Jenkins, KS
Rep. Christopher Lee, NY
Rep. Erik Paulsen, MN
Rep. Leonard Lance, NJ

Mr Frank, I am sure your aides have alerted you to this article as your name appears in it but I thought I might forward it along with a plea.

I have an undergraduate economics degree. I have a Masters of Business Administration in Finance. I have worked for financial services companies; negotiated contracts that were 20 pages deep, which were filled with hereafters and proper uses of semi-colons. So I can read a credit card disclosure or a savings account disclosure, but that is not the point. The point is that these products and their requisite disclosures are supposed to be easy and not required two degrees and 40 free minutes to wade through the nuances of how the contract will function when there are multiple variables at play. As Mr. Waldman eloquently argues below disclosure is not a transfer of information. Pages of dead trees layered upon each other in a type that is credibly said to be legible because font sizes are regulated does not mean that they are understandable to a lay person.

That is what I plead to you as a reasonable person, to instate a prudent person act that recognizes the information asymmetries exist that include benefits which are opaque and do not favor your constituents. One of the key arguments that I have studied over the length of this financial crisis that beset the global economy is that improved transparency and education could enhance outcomes.

However, it was Herbert Simon though who posited a long time ago "...in an information-rich world, the wealth of information means a dearth of something else: a scarcity of whatever it is that information consumes. What information consumes is rather obvious: it consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention and a need to allocate that attention efficiently among the overabundance of information sources that might consume it..."

So per se, literacy in any subject is a good thing but the amount of information and the subjects are too consuming for any one person to master while maintaining their day job.

Thank you for your time and please reconsider your position,
Harry Coleman




Vanilla is a commodity

Do we have no fight left in us at all? Mike Konczal and Kevin Drum are excellent as always, but must we really write eulogies? Is one of the best regulatory proposals so far dead just because a single well-bought congressman says so?

Extracting the vanilla from the CFPA is not, as Felix Salmon put it "the beginning of the end of meaningful regulatory reform". It is the end of the end. Vanilla products were the only part of the CFPA proposal that was likely to stay effective for more than a brief period, that would be resistant to the games banks play. All the rest will be subject to off-news-cycle negotiation and evasion, the usual lion-and-mouse game where regulators are the rodents but it's the rest of us that get swallowed.

Wall Street's favorite comedian-politician, Barney Frank, was very savvy in framing the debate over the issue with his well-placed mischaracterization of vanilla products as "anti-market". That is bass-ackwards. The vanilla option is pro-market, because it is procompetitive. Of course, that is precisely why banks hate it: Vanilla products would turn basic financial services into a commodity business, and force providers to compete on price.

Ezra Klein is suitably depressed, but he's wrong when he writes that "the 'plain vanilla' provision was never likely to do that much." Vanilla products would be very popular, which is why they are so threatening. Financial services are an area where markets not only fail due to informational problems, but where participants are very aware of that failure. Consumers know they are at a disadvantage when transacting with banks, and do not believe that reputational constraints or internal controls offer sufficient guarantee of fair-dealing. Status quo financial services should be a classic "lemons" problem, a no-trade equilibrium. Unfortunately, those models of no-trade equilibria don't take into account that people sometimes really need the products they cannot intelligently buy, and so tolerate large rent extractions if they must in order to transact.

The price of assuring that one is not taken advantage of by financial service providers is not participating in the modern economy. You cannot have a job, because payments are by check or direct deposit. You cannot buy a home or a car, because for the vast majority, those purchases require financing. Try travelling with only cash for plane tickets, hotel rooms, and car rentals. People will "voluntarily" participate in markets rigged against them for the privilege of being normal. And we do, every day.

But define a reliable vanilla option, and the dynamic flips on its head. Instead of tolerating rent-extraction as a cost of participation, consumers put up with one-size-fits-all products in exchange for peace of mind. Most consumers benefit very little from exotic product features, and I suspect that many are made deeply nervous by the complex contracts they can neither negotiate nor understand, but nevertheless must sign. Vanilla financial products would be extensively vetted and and their characteristics would soon become widely known. Inevitable malfunctions would be loudly discussed in the halls of Congress, rather than hushed-up in rigged private arbitrations. Vanilla products would face discipline both from private markets (no one is suggesting we forbid other flavors) and from a very public political process. Politics and markets are both deeply flawed, but they are flawed in different ways, and we should take advantage of that. In Arnold Kling's lexicon, a market in which vanilla and exotic financial products coexist and compete offers the benefits both of exit and of voice.

Rather than being anti-market, vanilla financial products would help correct very clear market failures that arise from imperfect information and high search costs. It is the status quo that is anti-market.

I'm sympathetic to the principled libertarian objection to having the government require that private parties offer a product they otherwise might not. No one should be forced to offer vanilla financial products. Small-enough-to-fail boutiques should be free to offer only the products they wish. However, if an institution wishes to avail itself of government-provided deposit insurance or to access Fed borrowing facilities, it is perfectly legitimate for the government to set requirements. The government can choose not to offer its safety net to institutions that don't offer vanilla products, just as banks currently choose not to offer me a credit card unless I sign up to binding arbitration and unilateral contract changes. I fail to see why one is coercive and the other not. (The government has no monopoly on deposit insurance. Private insurers are free to provide similar insurance, and do so for many financial service companies already.)

An Economist anonobloggeer has some peculiar non-compliments about the vanilla products proposal:

The vanilla offering seems to be intended to substitute for sophistication or research on the part of the customer, but I'm just not sure that's a good way to approach the issue. As best I can tell, the vanilla plan wouldn't mandate the price of the simple option; just because a bank would have to offer a vanilla mortgage loan doesn't mean it would have to offer a competitive vanilla mortgage loan. If that's the case, banks could easily use high rates on the simple products to steer individuals toward the complex offerings. Or, the vanilla rule could actually serve to direct bank collusion toward high-priced, high-margin products.

Just because a commodity exchange standardizes the quality of corn that must be delivered into a futures contract doesn't mean that any seller has to offer corn at a good price. So true! But sellers that offer commodities at above market prices don't usually find buyers. Since vanilla financial products would be commodities, banks would have to universally collude to offer them at inflated prices in order to bilk consumers. Competing vanilla project offerings would (at least they should) vary only on a single dimension (e.g. an interest rate). Points, fees, penalties, etc. would be homogeneous or uniformly pegged to the core price. Banks are very, very good at forming tacit cartels, but colluding on complicated terms and conditions is easier and less likely to attract the antitrust authorities than fixing a headline price.

More from the econoanonoblogger:

To me it seems like the more effective solution would be to require that financial institutions explain, in detail, each and every fee they are assessing (or might potentially assess) to customers. That would inform consumers of what's going on in the monthly bill, and it would create an incentive to reduce the number and complexity of fees, as lengthy explanations would be a hassle for all involved and would reduce business.

One of the great errors in modern policy is to confuse disclosure with information. It is not the case, currently, that banks secretly take your money without itemizing the charge on some statement. (Sometimes when they take your money they call it "service fee" or something equally nondescriptive, and it'd be nice if that practice went away.) Rather, banks intentionally define contracts in such a way that the cost to many customers of understanding and competitively shopping all the dimensions of the product seems higher than the cost of terminating the search and signing the dotted line. More detailed disclosure doesn't eliminate, and can sometimes exacerbate, the real information costs customers face, which derive from the complexity of the required analysis and lack of information about alternatives, not from an absence of product data. Of that we all have pages, with more arriving every month. You might think there'd be a market for ostentatious simplicity, and there might be. But no bank's lawyers would sign off on a single page, 12 point text, no-extratextual-incorporation-or-unilateral-modification contract. When routine contracts get more complex than that, it's just gibberish competing with gibberish for people who have lives. Some financial products are necessarily complex. But one way of managing complexity is standardization. It may be worth it for consumers to carefully study the one contract they will probably sign in a way that it would not be worth poring through 100 freeform contracts, 99 of which they will never sign.

The most serious objection I know to vanilla financial products is that they would be harmful precisely because they would catastrophically succeed. The theory is that nothing is more dangerous than a commodified bank, and the evidence is May Day, 1975, when the SEC ended fixed stock trading fees in the brokerage industry. Some commentators (e.g. Barry Eichengreen) claim that by eliminating a stable, cushy profit center, the May Day deregulation forced gentle investment banks to become hungry innovators, that the financial system has grown progressively less stable because under cut-throat competition risk-takers dominate (until they self-destruct and take the rest of us down with 'em). I don't buy the May Day story, but for the sake of argument, let's suppose it's true. Let's suppose that, in the name of stability, the best policy would be to ensure banks easy profits so that they needn't dabble in dangerous things. Then two conclusions follow:


1. If we are going to strike a policy bargain whereunder banks get a nice sinecure in exchange for a promise of stodgy mellowness, it seems reasonable that they should commit to the stodgy mellowness. Dull, subsidized banks should be heavily regulated banks, or, to use the term of art, "narrow banks".

2. If we are going to impose a regime that ensures bank profitability, we ought to do so in a reasonably equitable way. Business models that hide profit generators in complex contracts, or that extract fees especially from the disorganized and naive, are not reasonable instruments of public policy for keeping banks healthy. If we do go with the coddled but heavily regulated model of banking (not my preference!), and we're not willing to have the Treasury end the capitalist charade and just cut checks to its payment-systems subcontractors, then a decent approach would be to have narrow banks offer only vanilla products and provide monopoly rents by putting floors under fees and ceilings above deposit interest rates (as existed in the US until the 1980s). Under either a competitive or "regulated utility" model, the fairness and informational case for defining standardized vanilla products remains compelling.

I think people like Barney Frank, when they try to sleep at night, have been sold on the "we need healthy banks, so let's protect their profit centers" story, although they'd never admit to it while scoring points comparing powerless people with furniture. I wonder if it even occurs to Mr. Frank that maybe something serious should be demanded of banks in return for state protection of market power at the expense of the weak and disorganized. But then Mr. Frank has already gotten very much in return.

Not so much M&A but the trouble with financial disclosures and consent.