Current Reading: Finance

Getting ready to teach a finance class to law students, again after an eight months' break, I figured I ought to do some mainstream reading to see what kind of notions were in the showcase. On the eve of the new semester, I squeezed in four (well, three plus--I'm still not quite finished with the last one). All worth my time, in instructively different ways.

The best of the lot is surely Charles Barnard, The Two Trillion Dollar Meltdown. It's hard to imagine a more helpful account of what has gone haywire in the financial system over the past few years, including an accessible under-the-hood account of some of the more momentous banking innovations. I look forward to stealing from this guy a lot, or at any rate paraphrasing a lot of what he has to say, and perhaps the worse for the paraphrase.

I'd say almost as much for Paul Krugman, The Return of Depression Economics. Krugman is kind of a cult villain in moonbat land, but even those who don't like his politics or his combatative style will have to admit he is (a) state-of-the art technician in macro theory; and (b) a top-notch explainer of abstruse concepts. You can see why Princeton students would want to pay 30 (40? 50?) thou a year to sit at his feet and listen (to what the rest of us can get for 20 bucks, or free). The book is hampered by the fact that it was first written ad an account of the Asian meltdown of the late 90s, then reengineered, rather hastily I must say, for the current uproar. There is a connection, of course, and history is part of the point here. But if he'd written from scratch, he wouldn't be quite so top-heavy with the collapse of the bhat. Also, I can't imagine how the publisher let him get away with that title. While it does, in a sense, accurately represent the contents, I suspect that the kind of reader he's looking for will simply not recognize that this book is for him (her).

Niall Ferguson's The Ascent of Money, I wrote about earlier. I got snide with him for getting confused about bankruptcy but then I conceded that the book was, overall, quite an excellent general over view of a long and complicated history. Still true, although after reading Morris and Krugman, you're reminded of just how broad-brush his presentation is--and must be, considering how broad the task he has set for himself. I oonfess that after having read the book, I couldn't bear to watch the PBS special: the sonorous anecdotes and the jump-cut video was new when I first saw Alistair Cooke's America nearly 40 years ago, but by now the formula is getting kind of stale.

Raghuram G. Rajan and Luigi Zingales Saving Capitalism from Capitalists, is a somewhat more complicated matter. As I say, I'm not quite finished with it, but I think I get the drift: if this were a Victorian political tract, it would be entitled Incumbency: An Account of the Evil Thereof, with Proposals for a Remedy. Their point is intelligible enough: crony capitalism is not capitalism; incumbents dig in and protect themselves against (further) competition. Freeing us from the dead hand of incumbency can make life better for all, and in particular, can give opportunities to the otherwise dispossessed. This is an important, if often overlooked, home truth. I'd say it is fairly generally accepted among economists* --perhaps particularly by economists writing about development, like Dani Rodrik or William Baumol. Indeed, it probably helps to explain the disconnect between self-conceived "liberal" economists (Krugman is a sufficient example) and the voting public on issues like free trade.

RZ hew consistently to their theme and they offer a collation of helpful instances of the evils of incumbency. They make passing reference to their recipe for reform: secure property rights; transparency (which would include mandated disclosure and quality accounting standards). They are also insistent on a point that is a hobbyhorse of mine: a market is a cultural artifact--markets don't just fall from the sky they can be tweaked and formed for good or evil, and we can't expect good results just by leaving them alone.

So far, so good. But unless they are planning a boffo final chapter, they don't seem as systematic as I would like. They cover a lot of ground at a brisk pace. I complained earlier that they really stewed the pooch on the details of bankruptcy and I while I haven't spotted that kind of slipup elsewhere, I must say it does make me wonder about how good they really are at other issues I know less about. So, well worth the effort, and I do expect to finish it, perhaps this afternoon. But to be used with caution.

Oh, and one other that I almost forgot: Kenneth Pomeranz and Steven Topik, The World that Trade Made. Perhaps the reason I forgot it is that it is not a book so much as a collection of anecdotes--a kind of readers' digest of snippets from the economic history of the (post-Medieval) modern era. Apparently these were written piecemeal for some sort of trade journal. There are no footnotes (although they do add a helpful bibliography). But the stories, one by one, are well told and mostly instructive. Amazon reviewers say that this would be a great prep book for the AP history exam. All I can say is that history must be a lot more interesting than it was when I went to high school.

Takeaway point: there really is an awful lot of good, intelligent, nontechnical writing out there. I'd love to kick back and just read a dozen more (isn't that what being a professor is supposed to be about?). But as the philosopher says, stuff happens. I know that 14 weeks from now, I will look back on a semester of either success or failure and wonder--what the heck happened to all my time?
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*Maybe it is the definition of an economist. Cf. Adam Smith:

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is im-possible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and jus-tice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary.

Bankruptcy: Two More Guys Who Don't Know What They're Talking About

It's always unsettling to read an author you think is really really smart and then observe him writing about something you actually know something about and find him falling flat on his face. I felt that way a few weeks ago when I read Niall Ferguson (in The Ascent of Money) on bankruptcy (link; and note the comment). Today I'm reading Raghuram Rajan and Luis Zingales, Saving Capitalism from Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity (2008). It's an admirable book, really—accessible and well argued, strong testimony in favor of the power of financial markets for the betterment of humankind.

But then they come to bankruptcy and fall right off the cliff. Well—their general point is correct, but when it comes to the details they make hash.

The general subject is lending, and impediments to borrowing. RZ make the point that you are likely to be able to borrow only if the lender is confident he will be repaid. They identify three common impediments to lending: one the inability to give good collateral (inadequate land titling systems, for example); two, slow or expensive or impossible collection mechanisms; and three, “exemptions.” It's the third point that causes the trouble.

RZ start by discussing the Bankruptcy Commission of 1973 which, as they say, “advocated that a substantial portion of household assets be exempted from seizure by creditors,” adding “these assets are called “bankruptcy exemptions.” They go on to say that “following these recommendations, a number of states adopted exemptions” (my emphasis). They say that “high state bankruptcy exemptions led to a significantly higher probability that households would be turned down for credit or discouraged from borrowing.” And that, for poor people, “since their house is often their only form of collateral, the exemption laws effectively deprived them of their only means of obtaining finance.”

There are so many things bollixed up in this paragraph that it is scarcely possible to know where to begin. But try this: exemptions do not begin with the Bankruptcy Commission. So far as I know, every jurisdiction in any commercial economy exempts some assets from execution, and has for centuries. The Bankruptcy Commission did think that these “state” (sic—i.e., “non-bankruptcy”) exemptions were mostly too cheesy, and advocated a system of more generous exemptions for use in (and only in) bankruptcy cases—to be called “bankruptcy” (sic, and note the difference) exemptions.

The commission did not get its way. Instead, Congress hashed together a not-very-intelligible compromise, whereby debtors in bankruptcy might claim "Federal" exemptions, or they might claim their “home-state” exemptions. Congress also provided that individual states might opt out and leave their debtors only with “state exemptions.” As it happens, most states have opted out. I suspect (although I admit I don't have chapter and verse) that the opt-outs are the ones with the most cheesy exemptions. If that is true, it would leave the “bankruptcy option,” if not exactly a dead letter, still perhaps a slender reed.

Note also that while most old exemption laws may have been cheesy, some were famously generous. RZ give the example of the unlimited Texas homestead. Texas does have an unlimited homestead; so does Florida and so do a couple of farm states in the Great Plains. But these unlimited homesteads—like most state exemptions—have been part of the law all along. Bankruptcy law had nothing to do with them. Well, with one exception: some of the more recent amendments to the bankruptcy law make it harder for debtors to use these old exemption laws, not easier.

But the biggest blooper is still to come. Read the last quoted sentence carefully: “since their house is often their only form of collateral, the exemption laws effectively deprive them of their only means of obtaining finance” (emphasis added).

Take a deep breath—here's something every student learns in the bankruptcy law class: you can't use the exemption against the secured creditor. That's a black-letter rule. Giving security effectively surrenders the exemption, as far as the secured creditor is concerned. It is the unsecured creditors—the ones without collateral—who take it in the shorts. Indeed, when your client is in trouble, what you tell him is: if you want to keep the collateral, keep paying the secured creditor, and forget about everybody else. So ironically, the effect of the exemption law is to increase, rather than decrease, the likelihood that the secured creditor will be paid.

RZ go on to say that “high state (sic) bankruptcy (sic) exemptions led to a significantly higher probability that households would be turned down for credit or discouraged from borrowing.” They cite one study.* The statement is intuitively plausible, but it's remarkable how hard it is to find general support—indeed, one of the remarkable facts of American economic life is how little evidence we find that debtor protections have done anything to dampen credit markets.

And RZ go on to make a further point which, though interesting, is in a sense the opposite they just stated above. They argue that “the passage of exemptions” (?) made it harder for poor people to borrow—but easier for the rich,”because more of their assets could be protected from seizure” (they seem to be drawing their point from the study cited earlier, although they don't cite it here). Of course this might be true; but if so it badly undercuts the plausibility of the more general statement above.

As a final irony, I want to stress that I agree with the general point here: financial markets are (well: “can be”) a great thing, not least for the liberation of the poor. I agree that we need well-defined property rights and decent collection procedures. I suspect that liberal exemption laws must under some circumstances limit the power to incur debt, though I think it is far easier to say than to prove. But if this is the kind of argument that they are going to make, they'd better restrict their audience to people who really don't know anything about the topic. The phrase “D* S*” comes to mind, but I've used that one too often already.
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*The citation is incomplete, but they seem to be citing this paper: Gropp, Reint; Scholtz, John Karl and White, Michelle. "Personal Bankruptcy and Credit Supply and Demand." Quarterly Journal of Economics, 1997, 217-252.

Update: My friend Barry points out that Bankruptcy Code does allow the avoidance of certain personal property security inerests that impair exemptions. He is right, but this is pretty clearly not what RZ were talking about.