A response to a presentation by the Kauffman Foundation’s Carl Schramm at the Manhattan Institute.

Carl Schramm sees threats lurking on the horizon and increasing in strength. Schramm begins with broad applause for the American spirit, innovation and productivity and names it entrepreneurial capitalism. He builds it up in his book Good Capitalism, Bad Capitalism. Much of it rests on Schumpeter’s idea of creative destruction. Today, he submits “four ways to save Entrepreneurial Capitalism.”

  1. Congress changed the market’s view on risk. It has to change back.
  2. Regulation is not the answer
  3. Prohibit GSEs
  4. Do not respond with protectionism

At face value, these may appear reasonable. Blame politicians while cautioning against the same mistakes might be made in attempting to re-regulate. Count on a populist reaction to an acronym that has become infamous. And go back to the old standard of free trade. While these are phrased without controversy, they should not be taken without question.

First, to say that Congress changed the market’s view on risk is an error and reduction of the problem. To the extent that the market would increase increase its appetite for risk by way of Congress’ suggestion seems far from the truth. Congress asks as much of the market today but with little reward.

The implicit guarantee of the GSEs would appear to be a target, but the punishing losses have been by way of poorly understood, poorly performing and non-agency securities. This doesn’t point to Congress’s influence on the market’s view on risk. Instead, it indicates a combination of financial innovation and a healthy appetite for an investment.

Schramm might be better served looking at the problem through the lens of Brad Setser and Nouriel Roubini’s analysis of the concept of Bretton Woods II. They outline the process by which countries such as China have financed trade with the US through the accumulation of reserves in an effort to maintain a diminished exchange rate. The arrangement has two consequences. First, it provides a healthy appetite for investment in currency, treasury and GSEs, which lowers the yield on these securities. Second, the lower yield makes financing generally less expensive. Indeed, these policies have provided a healthy appetite for investment —Bernanke’s savings glut— that has driven so much financial innovation. The market has been desperately recycling investment dollars in search of yield, and it has been this recycling that has shaped the market’s appetite for risk more than Washington.

Regulation is not the answer, but it is a tool. In a telling quote on financial industry regulation from 2003, Republican Jim Bunning said, “It seems to me in most cases that self-regulation does not work.” A recent article illuminated this in stark detail. Changes to the net capital rule in 2004 shifted the SEC policy on capital requirements of brokerages from one with explicit capital requirements to one with none, in favor of monitoring the system for systemic risk and self-regulation. Unfortunately, the SEC’s monitoring team had limited support and leadership, and the industry did not see the need to limit the amount of leverage it took on. In the cases that the agency did find issues, they did not have the clout to mandate changes.

Schramm’s final two points alternately point to a knee-jerk don’t-go-down-that-road-again response and a plug for free trade. Neither point stands out not for their clarity and insight. Instead, they appear more as a shibboleth – a message intended to resonate with and compel like-minded individuals rather than to further a discussion about these subjects. At face value, both appear innocuous, but they are equally unexamined, and unexamined claims, especially following the previous two points, should give us pause.

It’s not clear from Schramm’s talk that entrepreneurial capitalism is under attack or that the remedy he proposes applies to our current situation. His four ways, instead, look more like the product of a mistaken analysis. On reflection, taken together, it leaves the impression that it was engineered to breath life into policy positions around regulation and trade rather than advance a response to the current circumstances.

Schramm started his presentation with an homage to Schumpeter. He suggested that Schumpeter’s creative destruction is the engine that drives innovation and will not fail us. The buggy-whip industry, as he was obliged to point out, stood no chance against the age of the automobile. Buggy-whip manufacturers went out of business, and people lost their jobs, but automobiles filled the void and enlarged economic prosperity. We are better for it, we would all agree, and Schramm intends to protect it. He has four ways to do so, that he has presumably re-hashed for countless presentations. Unfortunately, as Jagdish Bhagwati recently pointed out in the FT, faith in creative destruction has rested on the assumption “that financial innovation was like non-financial innovation…But with financial innovation, the downside can be lethal – it is “destructive creation”.”

….

Lawrence Summers’ recent editorial in the FT speaks to some of these issues:

The crisis has also reminded us of the lessons of the technology bubble, Japan’s experience in the 1990s and of the US Great Depression – that finance-led growth is problematic….Therefore we need to reform tax incentives that encourage financial risk taking, regulate leverage and prevent government policies that give rise to a toxic combination of privatised gains and socialised losses.

Lawrence Summers: FT