Obama’s Ersatz Capitalism.

by: Joseph E. Stiglitz
Op-Ed Contributor
March 31, 2009.

THE Obama administration’s $500 billion or more proposal to deal with America’s ailing banks has been described by some in the financial markets as a win-win-win proposal. Actually, it is a win-win-lose proposal: the banks win, investors win — and taxpayers lose.

Treasury hopes to get us out of the mess by replicating the flawed system that the private sector used to bring the world crashing down, with a proposal marked by overleveraging in the public sector, excessive complexity, poor incentives and a lack of transparency.

Let’s take a moment to remember what caused this mess in the first place. Banks got themselves, and our economy, into trouble by overleveraging — that is, using relatively little capital of their own, they borrowed heavily to buy extremely risky real estate assets. In the process, they used overly complex instruments like collateralized debt obligations.

The prospect of high compensation gave managers incentives to be shortsighted and undertake excessive risk, rather than lend money prudently. Banks made all these mistakes without anyone knowing, partly because so much of what they were doing was “off balance sheet” financing.

In theory, the administration’s plan is based on letting the market determine the prices of the banks’ “toxic assets” — including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.

The two have little to do with each other. The government plan in effect involves insuring almost all losses. Since the private investors are spared most losses, then they primarily “value” their potential gains. This is exactly the same as being given an option.

Consider an asset that has a 50-50 chance of being worth either zero or $200 in a year’s time. The average “value” of the asset is $100. Ignoring interest, this is what the asset would sell for in a competitive market. It is what the asset is “worth.” Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses. Some partnership!

Assume that one of the public-private partnerships the Treasury has promised to create is willing to pay $150 for the asset. That’s 50 percent more than its true value, and the bank is more than happy to sell. So the private partner puts up $12, and the government supplies the rest — $12 in “equity” plus $126 in the form of a guaranteed loan.

If, in a year’s time, it turns out that the true value of the asset is zero, the private partner loses the $12, and the government loses $138. If the true value is $200, the government and the private partner split the $74 that’s left over after paying back the $126 loan. In that rosy scenario, the private partner more than triples his $12 investment. But the taxpayer, having risked $138, gains a mere $37.

Even in an imperfect market, one shouldn’t confuse the value of an asset with the value of the upside option on that asset.

But Americans are likely to lose even more than these calculations suggest, because of an effect called adverse selection. The banks get to choose the loans and securities that they want to sell. They will want to sell the worst assets, and especially the assets that they think the market overestimates (and thus is willing to pay too much for).

But the market is likely to recognize this, which will drive down the price that it is willing to pay. Only the government’s picking up enough of the losses overcomes this “adverse selection” effect. With the government absorbing the losses, the market doesn’t care if the banks are “cheating” them by selling their lousiest assets, because the government bears the cost.

The main problem is not a lack of liquidity. If it were, then a far simpler program would work: just provide the funds without loan guarantees. The real issue is that the banks made bad loans in a bubble and were highly leveraged. They have lost their capital, and this capital has to be replaced.

Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time.

Some Americans are afraid that the government might temporarily “nationalize” the banks, but that option would be preferable to the Geithner plan. After all, the F.D.I.C. has taken control of failing banks before, and done it well. It has even nationalized large institutions like Continental Illinois (taken over in 1984, back in private hands a few years later), and Washington Mutual (seized last September, and immediately resold).

What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a “partnership” in which one partner robs the other. And such partnerships — with the private sector in control — have perverse incentives, worse even than the ones that got us into the mess.

So what is the appeal of a proposal like this? Perhaps it’s the kind of Rube Goldberg device that Wall Street loves — clever, complex and nontransparent, allowing huge transfers of wealth to the financial markets. It has allowed the administration to avoid going back to Congress to ask for the money needed to fix our banks, and it provided a way to avoid nationalization.

But we are already suffering from a crisis of confidence. When the high costs of the administration’s plan become apparent, confidence will be eroded further. At that point the task of recreating a vibrant financial sector, and resuscitating the economy, will be even harder.

Joseph E. Stiglitz, a professor of economics at Columbia who was chairman of the Council of Economic Advisers from 1995 to 1997, was awarded the Nobel prize in economics in 2001.

LET THE REVOLUTION BEGIN!

Thanks for all you do!
Live your values. Love your country.
And, remember: TOGETHER, We can make a DIFFERENCE!

FAIR USE NOTICE: This blog may contain copyrighted material. Such material is made available for educational purposes, to advance understanding of human rights, democracy, scientific, moral, ethical, and social justice issues, etc. This constitutes a ‘fair use’ of any such copyrighted material as provided for in Title 17 U.S.C. section 107 of the US Copyright Law. In accordance with Title 17 U.S.C. Section 107, the material on this site is distributed without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. If you wish to use copyrighted material from this site for purposes of your own that go beyond ‘fair use’, you must obtain permission from the copyright owner.

The Economics of Snooping on Internet Traffic.

March 25, 2009, 2:30pm

by: Saul Hansell

Update | 2:07 p.m. Details of the Cox and Comcast approaches modified.

Kurt Dobbins, the chief technical officer of Arbor Networks, has what he sees as a very good reason to use a machine — which his company makes — that can see every word and every picture people send and receive over their Internet service provider: Internet service providers could offer a complex menu of price plans, as cellphone companies do. He predicts you will soon see many plans that impose usage caps in peak times, but unlimited use off peak.

That thought may well be red meat to the many people who think the Internet should always be unfettered by any limits.

Mr. Dobbins invited himself over for coffee recently, not to talk about Internet pricing exactly, but to defend the honor of this technology called deep packet inspection.

There are a lot of other things deep packet inspection can do that are perceived as rather creepy. It is great for spies and secret police, who want to know when people read or write about certain topics. It can identify people who send copyrighted files and block people from using certain programs, like BitTorrent. Advertisements can be shown based on what sites Internet users visit. And it can help Internet providers degrade the service of rival offerings, such as voice calling or video over the Internet.

Tim Berners-Lee, one of the creators of the World Wide Web, recently said in a speech to the British House of Lords that deep packet inspection is the equivalent of opening people’s mail.
The Free Press, an advocacy group, published a report on the subject last week, warning that the adoption of deep packet inspection “will open a Pandora’s box of unintended consequences that could spell disaster for the free market online.”

Mr. Dobbins said that he wished the technology had a different name. “Deep packet inspection conjures up all kinds of evil images,” he said, frustrated that what he helped invent 10 years ago has earned such a bad reputation.

Arbor isn’t in the Big Brother business, he insisted. Its technology doesn’t read the content of what people send and receive, he said; it just analyzes how much bandwidth they use and the type of information they are sending — e-mail, video, Web pages or whatever.

It is like looking at the stamp and addresses on the outside of mail, not opening the envelopes, he said.

It’s not quite so simple, however. Mr. Dobbins explained that Arbor’s machines don’t scan for copyrighted songs, for example. But they do identify packets being sent by peer-to-peer file trading programs, and they can send them to machines made by other companies meant to identify copyrighted content.

I’m not sure this is going to reassure Mr. Berners-Lee and other critics of deep packet inspection. Arbor, to continue the postal imagery, is like a person who sorts through the mail looking for suspicious packages, handing them to another person to open.

What about the business Arbor says it is in: helping Internet providers reduce costs and increase revenue by adjusting their pricing plans to the way each customer uses the Internet?

Mr. Dobbins said Internet providers in the United States should follow the lead of Plusnet, a British I.S.P. that uses Arbor equipment to offer various service plans. The cheapest plan costs 11.99 pounds ($17.67) per month. Use is capped at 10 gigabytes a month, except for unlimited use between midnight and 8 a.m. In addition, traffic is divided into seven categories, each with a different priority. At the top are fee-based services, like video on demand movies and voice over Internet phone calls. At the bottom are downloading of files from peer-to-peer networks and Usenet newsgroups.

The company offers two separate upgraded options, each at 19.99 pounds ($29.45) per month. One has unlimited bandwidth, but similar slowdowns for downloads. Another “pro” plan has a 15-gigabyte-per-month peak limit, but promises priority treatment for downloads and other sorts of traffic. That plan also will move traffic for online games to the head of the line, because a split second sometimes can make a difference in the outcome of a fast-twitch war game.

The point of all this is to shift as much of the heavy bandwidth use to off-peak times. Most of the costs of running an Internet provider are fixed; customers pay whether they are using the network or not. But I.S.P.’s do have to invest to expand the maximum capacity of their networks to accommodate peak usage.

How much of an expense all this extra downloading actually costs is a bit of a debate. Dave Burstein, the editor of DSL Prime, says it isn’t more than the equivalent of a dollar or two per user per month. That’s hardly enough, he says, for Internet providers in this country, which have very wide profit margins, to cry poor. (In Britain, the marginal costs are higher and competition has lowered margins, he said.) But that is not keeping Arbor from selling its products as a way to cut costs.

So far a few Internet providers in the United States, including Time Warner Cable, are just exploring bandwidth caps and price tiers. More common has been an effort to use techniques, including deep packet inspection, to manage the congestion at peak times. Comcast was slapped by the Federal Communications Commission for blocking some BitTorrent file sharing without proper disclosure.

Now Comcast is using a system that will slow down the connections of heavy users at peak times, regardless of what they are doing online. Cox Communications is using the sort of approach Arbor recommends, giving priority at peak times to some uses, like voice calling and streaming media, while relegating others, like file downloads, to the slow lane. Cox’s limits apply only when customers are uploading, not downloading, informatin.

On one level letting the urgent traffic go first makes a lot of sense. But Ben Scott, the policy director of the Free Press, said that Internet providers, like Cox, shouldn’t be allowed to differentiate between different uses of the Internet.

“Some customers will value what they see as low priority as high priority,” he said. I asked Mr. Scott what he thought about the approach of Plusnet, which lets consumers pay more if they want higher priority given to their game traffic and downloads. Surprisingly, he had no complaints.

“If you said to me, the consumer, ‘You can choose what applications to prioritize and which to deprioritize, and, oh, by the way, prices will change as a result of how you do this,’ I don’t have a problem with that,” he said.

If this sort of approach does in fact satisfy the critics, I think we are very likely to see Internet providers move to more multiple price tiers, using deep packet inspection to juggle different users and quotas. And in the process we may very well expand a technical infrastructure that has the potential to assist those that want to snoop on our electronic communications.

LET THE REVOLUTION BEGIN!

Thanks for all you do!
Live your values. Love your country.
And, remember: TOGETHER, We can make a DIFFERENCE!

FAIR USE NOTICE: This blog may contain copyrighted material. Such material is made available for educational purposes, to advance understanding of human rights, democracy, scientific, moral, ethical, and social justice issues, etc. This constitutes a ‘fair use’ of any such copyrighted material as provided for in Title 17 U.S.C. section 107 of the US Copyright Law. In accordance with Title 17 U.S.C. Section 107, the material on this site is distributed without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. If you wish to use copyrighted material from this site for purposes of your own that go beyond ‘fair use’, you must obtain permission from the copyright owner.