Alford: Why Dismantling Too Big To Fail Firms Makes Economic Sense

[Joanne98]

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

Economists have joined the debate about the merits of requiring the downsizing of too big to fail (”TBTF”) financial firms. However, these debates have almost been devoid of theoretically based economic arguments.

Some economic analysts have argued that the TBTF institutions have captured and will manipulate the relevant regulatory and political structures to their advantage. This a political argument and economists as economists do not have any greater insight into the political dimension of issues than Joe and Mary Sixpack. Other economists have decried the TBTF institutions and their contribution to a further skewing of the distributions of income and wealth. Again, economists as economists have no greater insight in to issues of economic fairness than the next person.

With the exception of citing moral hazard incentives to greater risk taking, economists speaking as economists have been virtually silent about the fact that TBTF (and wanted-to-be-TBTF) firms were the center of a process of designing, underwriting, and issuing a variety of structured capital market products that contributed not only to redistributions of wealth in their favor, but (and more importantly to economists as economists) also contributed to the misallocation of resources on a massive scale. And the efficient allocation of resources is the sine qua non of economics.

This post outlines one line of economic reasoning that leads to the conclusion that TBTF financial firms should be dismantled on the grounds that the highly concentrated financial sector can give rise to informational asymmetries, the mispricing of risk and the misallocation of capital and other resources.
It is not a general theory of the recent crisis, but an argument suggesting that in financial markets dominated by a few large firms, those firms will be in a position to exploit informational asymmetries and enrich themselves even as their excess profits are dwarfed by the costs to society of the misallocated resources.

Informational Asymmetries
http://www.nakedcapitalism.com/2010/04/alford-why-dismantling-too-big-to-fail-firms-makes-economic-sense.html

[bemildred]

1. "Too big to fail" == "Too big to be private". nt

[zipplewrath]

2. Too big to take risks

I suspect the real answer her is not so much to prevent "too big" organizations from existing. The answer is merely to have an escalating standard for minizing risk such that "too big" becomes "too limited".

[econoclast]

3. Alford is off base here...

I like Alford, I really do. But I think that he is off base here.

While we agree that TBTF is bad, his Information Asymetry argument doesn't cut the mustard. He asserts that asymetric information results in inefficient markets and misallocation of capital. This is true. But the problem arises because some players have too little information, not because other players have too much!

Alford argues that the very scale and broad reach of TBTF institutions gives them access to better information:

"Large financial firms may also possess non issue specific information of a kind unavailable to other market participants by virtue of the size of their activities in market making, underwriting, issuing structured products, advising, prime brokering, or via knowledge of their counterparties or some combination. "

Following Alford's line of reasoning, the logical solution to the asymetry problem is to make smaller players BIGGER. If the thing that gives rise to better information is "the size of their activities in market making, underwriting, issuing structured products, advising, prime brokering, or via knowledge of their counterparties or some combination" then the way to get better information into the hands of those who currently don't have good information is to make them bigger!

If it is size that gives better information, then making TBTF institutions smaller reduces the amount of total information in the market. My Game Theory is a little rusty, but I'm hard pressed to think of how less information leads to more effecient markets and better allocations of capital.

Surely Alford doesn't want less information or more TBTF institutions. But that is exactly where his argument logically leads. For that reason it is a non-starter.

A better argument should be constructed around Nassim Taleb's example:

Why does NYC have, on average, such great food? Because bad restaurants don't last long!"

[abelenkpe]

4. Lots of smaller

local banks would increase employment and improve service. That alone should be a good enough reason to break them up as we need to combat unemployment in order for the economy to truly rebound.

We should also break up big media and corporate farming for the same reason.

[upi402]

5. Too big = too damn much power and control

Then regulation is neutered by corruptible politicos. Some people think too damn much and common sense departs.