Covering the Front and Back Pages of the Newspaper
January 26, 2009
BUSINESS: The Doctor is Making Street Calls
Our old friend and occasional guest blogger Dr. Manhattan is back, this time blogging at The Atlantic's Business section. Adjust your bookmarks accordingly. His first entry cautions against oversimplifying the argument, now in vogue, that the root of Wall Street's downfall was public ownership (i.e., firms capitalized with shareholder money rather than owner-operated), noting that closely held hedge funds have also fallen prey at times to excessive and imprudent risk-taking:
[S]uppose we have an employee-owned investment firm, organized as a private partnership, which aims to become a major financial institution. In Lewis' formulation, it should be the least likely candidate to run excessive leverage and blow itself up with untrammeled risk-taking. In fact, it might spare no expense on the risk-management side and only use the most highly sophisticated analysis to protect the franchise.
Read the whole thing. This is a useful caution, but I'm skeptical of argument by anecdote (and I note here that Dr. Manhattan is simply marshalling one anecdote against a handful deployed by Michael Lewis), as all it does is demonstrate that partnerships are not wholly immune to the problem. In fact, defenders of free markets will almost always tell you that the whole point of a free market system is that you can get a variety of different responses to the same set of incentives, and inevitably some of them will be successful responses and some will be failures. Like democracy itself, the free market is designed not to be error-free but error-correcting; by contrast, replacing free market systems with concentrated, centralized decisionmaking does nothing to reduce the natural tendency to human error, but simply reduces the number of decisionmakers working on a problem, restricts the range of possible innovations and removes the mechanism for flushing erroneous decisions out of the system.
If you accept for the sake of argument that (1) large and thinly-evaluated risks are bad and (2) publicly owned firms are more likely to take them than private partnerships, you can make the case that publicly traded financial firms are riskier than privately held ones without necessarily having to shoulder the burden of proving that privately held firms are always prudent in managing risk. That's a point that at the end of the day is one for systematic study, not anecdote.