Big Players, Again

I have discussed Koppl’s theory of Big Players before (see here and here). Today, we are treated to another example. From the WSJ:

“Like many others I made the mistake of buying what I believed was ‘value,'” Mr. Gwin says, adding that investors who bought at the time believed the loans were worth more than their market price. “We did not contemplate having our first liens invalidated by a sitting president,” he adds.

It is incredibly disheartening to see the government continue to change the rules in the middle of the game. Initially, I thought that the problem was confined to the Treasury department in the final months of the Bush administration, but clearly this mentality has carried over and has perhaps even become worse. Koppl’s theory seems more prescient each day.

Big Players and Uncertainty, Part 2

Some readers may recall an earlier post in which I explained that many of the failures of the attempts at government intervention have to do with the fact that the government is exercising discretionary power that change the rules of the game on a largely ad hoc basis. Particularly, I referenced Roger Koppl’s theory of Big Players, in which a large entity that is largely immune from the profit-loss mechanism wields significant discretionary power. Under these circumstances, such discretionary power can be a major source of uncertainty and therefore causes market participants to shift resources away from productive uses and toward predicting the behavior of the Big Player (incidentally, Axel Leijonhufvud makes a similar point in his classic, “Costs and Consequences of Inflation“).

In the earlier post, I referenced the ad hoc behavior of the Treasury in developing the bank bailouts and suggested that, consistent with the theory of Big Players, such behavior only served to generate uncertainty. I have not been alone in this analysis. For example, John Taylor’s new book similarly criticizes such ad hoc behavior on the part of the federal government as exacerbating the crisis.

Thus, I was not at all surprised to read the following story from NPR, in which one bank CEO explains why he decided to give the TARP money back:

[CEO Joseph] DePaolo says Signature returned the money for three reasons: Legislation passed Feb. 17 would limit the compensation for salespeople, make it difficult to recruit bankers and cause uncertainty.

“With the new legislation, they changed the rules in the middle of the game,” he says. “We didn’t know how many more rule changes or legislation would come down, maybe telling banks, ‘This is what you can do with your lending. This is what you can do with your clients.'”

I will reiterate a point that I made in the earlier post:

If the government really wants to help, they can start by setting the rules now and following through on their promises. So long as they continue to change the rules on a daily basis, uncertainty will prevail, the stock market will remain volatile, and the credit markets will remain frozen.

Big Players and Uncertainty

There has been a great deal of discussion lately with regards to the ever-changing role of the Troubled Assets Relief Program (TARP).  Initially, the program was designed to purchase the troubled assets of financial institutions in an attempt to cleanse their balance sheets and get them lending again.  I have previously come out against this plan as it fails to take into account the limitations and dispersal of knowledge within markets.  Perhaps this and other objections were heeded by the Treasury Department, which inexplicably abandoned this stated goal in favor of direct equity injections in troubled financial institutions.  In the aftermath of this decision, little has been done to instill confidence in the financial markets and the capital infusions have done little to increase the lending by the recipient institutions.  Given that many noted economists preferred capital infusions to the purchase of troubled financial assets, recent events beg the question as to why this change in policy has been unsuccessful.

The answer can be found in Fairleigh Dickinson economist Roger Koppl’s theory of Big Players.  Koppl defines a Big Player as a market participant that is substantially large, immune to profit and loss mechanisms, and yields ample discretionary power to have an impact on the market as a whole.  Central banks are perhaps the clearest example of a Big Player and this theory indeed might explain much about the artificial boom that preceded the current mess.  However, the theory is perhaps more applicable in the aftermath of the boom.  Since the onset of the crisis, the Federal Reserve and the Treasury department have acted as Big Players.  They continue to wield significant discretionary power and often take unprecedented action – and at times unexpected restraint.  In other words, to use a tired saying, they are flying by the seat of their pants.  One need not look beyond the TARP for an understanding of the discretionary power of these entities.

The effect of this discretionary power is to increase uncertainty within the financial markets.  Firms that receive capital infusions refuse to increase lending precisely because the rules are changing on a daily basis.  The same goes for investors who must not only predict what the market is going to do, but also the behavior of the Big Players.  Of course, the ability to predict what the Treasury and the Fed are going to do next is substantially difficult.  The result is the herd-like behavior that has been prevalent in the stock market for the last few months.  When there is a high level of uncertainty in markets, participants start relying more on what they believe that others believe than the prospective yield of a particular investment.  The empirical evidence presented by Koppl and his colleagues confirms these claims.  Uncertainty breeds uncertainty.

Nevertheless, some pundits continue to press on.  The same individuals who advocated using capital infusions and who were surprised to find the institutions unwilling to lend are now advocating forcing the financial companies to lend. Markets function well when the surrounding institutional framework is sound.  If the government really wants to help, they can start by setting the rules now and following through on their promises.  So long as they continue to change the rules on a daily basis, uncertainty will prevail, the stock market will remain volatile, and the credit markets will remain frozen.