Nobel Prize Winning Economist: Core Problem Is Too Much Centralization ... In Both Government AND the Private Sector

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Nobel prize winning economist Ed Prescott has previously said that we have to break up the big banks.

Prescott notes in a new interview that centralization – of either government or banking – is a core problem:

[Question] Brussels is using this crisis to grab more powers from governments.  How does that make things even worse?

 

[Prescott] Dangerous centralization.

China … From 1,000 to 1,300[A.D.] was the richest country, the most advanced. They had done much better than Europe, and they were by far the leader.

 

But then – under the Ming Dynasty – they got centralized, and they started preserving the status quo. The provinces lost their power.

 

[The Ming Dynasty got rid of the "press".]

 

And technological regression set in there.  People from the other end of the Euro-Asia land mass came and humbled that great empire.

 

[Question] Why is the U.S. economy doomed to fail and what will happen?

 

[Prescott] They haven’t gotten rid of the too big to fail problem.

They get real big … people know who led to these financial institutes, know that they will be bailed out, will expect it, and therefore the institutes can borrow at a lower rate. So they gamble…

 

Government likes to get favors out to certain people and then big contributions ….

 

Dr. Prescott is right …

Numerous studies show that big banks are less efficient than smaller banks.

The New York Times notes:

The economics suggest that big banks are less efficient at credit creation than smaller ones.  And there is no evidence that the simpler financial system we had from the 1940s through the 1970s restrained growth. In fact, for all its innovation, the financial industry of today is less efficient than it was in the age of the railway, according to research by Thomas Philippon at New York University. That is, it charges the rest of society more for financial intermediation than it did 130 years ago.

And see this, this and this.

Indeed, it is well known that – while larger organizations can be more efficient than small ones – when any organization gets too big, “diseconomies of scale” may make them less efficient (and see this).

350px Diseconomics of scale.svg Nobel Prize Winning Economist:  Core Problem Is Too Much Centralization

Below, we’ll discuss some of the reasons this is true. But an analogy will easily make the point.

Giraffes have huge hearts, because they have to pump the blood all the way up to their heads.

Similarly, humans can’t be 100 feet tall and weigh 10,000 pounds.  Our bodies would be too inefficient to survive.

Why Centralization Can Be Bad

As Prescott notes, organizations which become too big tend to spend an inordinate amount of time in preserving the status quo, and thus have less room to innovate.  Inertia often takes over, and the organizations lose their vitality and success. This is especially true since larger organizations are more subject to bureaucratic insularity, which causes stagnation.

Organizations in the public or private sector which become too big also spend huge amounts of time, money and energy on communications between their various parts:

 Nobel Prize Winning Economist:  Core Problem Is Too Much Centralization

They also spend more time and money duplicating efforts,  political in-fighting, and other wasted efforts:

Moreover, the larger an organization, the more centralization and less diversity.   True, numerous business books have touted more of a decentralized “team” attitude in the last decade or so. But many large organizations are still very hierarchical, allowing little diversity of viewpoint.  Groupthink also commonly occurs.

More importantly, when you have a couple of giant organizations in a given market, it means that there are less competitors.  In the banking space, for example, we have extensively documented that breaking up the giant banks would allow small banks to thrive.

So – by definition – organizations that are too big decrease diversity in competition.

And the less diversity, the more vulnerable we become to “black swans”:

It has been accepted science for decades that when all the farmers in a certain region grow the same strain of the same crop – called “monoculture” – the crops become much more susceptible.

 

Why?

 

Because any bug (insect or germ) which happens to like that particular strain could take out the whole crop on pretty much all of the region’s farms.

 

For example, one type of grasshopper – called “differential grasshoppers” – loves corn. If everyone grows the same strain of corn in a town in the midwest, and differential grasshoppers are anywhere nearby, they may come and wipe out the entire town’s crops (that’s why monoculture crops require such high levels of pesticides).

 

On the other hand, if farmers grow a lot of different types of crops (“polyculture”) , then a pest might get some crops, but the rest will survive.

 

I believe that the same principle applies to our financial system.

 

If power and deposits are concentrated in a handful of mega-banks, problems with those banks could bring down the whole system.

 

***

 

Moreover, the mega-banks are huge holders of derivatives, including credit default swaps. JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley together hold 80% of the country’s derivatives risk, and 96% of the exposure to credit derivatives.

 

Even though JP, B of A, Goldman and Citi are separate corporations, they are so interlinked and intertwined through their derivatives holdings that an attack by a “pest” which swarmed in on their derivatives could take down this “monoculture” of overly-leveraged, securitized, derivatives-heavy banking.

 

***

 

Our current banking monoculture threatens not only the biggest banks, but the entire financial system. Pesticides become less effective as pests develop resistance – and, as a byproduct, we poison friendly critters. Likewise, the giants “creatively” work their way around regulations so that the regulations are no longer effective (or at least not enforced, and regulatory capture is widespread. And too much regulation stifles productivity,as an unintended byproduct.

 

Having power and deposits spread out among more, smaller banks would greatly increase the stability of the financial system. And having more power and deposits in banks using a wider variety of business models (e.g. among banks that aren’t heavily invested in derivatives and securitized assets) will create a banking “polyculture” which will lead to a much more stable financial system.

 

In other words, if we decentralize power and deposits and increase the variety of banking models, we will have a healthier financial system, we won’t have such an urgent need to try to micromanage every aspect of the banking system through regulation,and the regulations we do have will be more effective.

 

By the way, I would argue that that is one of the reasons why Glass-Steagall was so important: it enforced diversity – depository institutions on the one hand, and investment banks on the other. When Glass-Steagall was revoked and the giants started doing both types of banking, it was like a single crop cannibalizing another crop and becoming a new super-organism. Instead of having diversity, you’ve now got a monoculture of the new super-crop, susceptible to being wiped out by a pest.

 

The kinds of things which threaten depository institutions are not necessarily the same type of things which threaten investment banks, hedge funds, etc.

(Remember that things are less diversified and more centralized than they appear. And see this.)

This is true in reporting, trading, and many  other areas.

Decentralization Will Help Many of Our Problems

The Founding Fathers enshrined separation of powers as the very basis of our government, as a way to ensure that centralization would not lead to tyranny. (The Iroquois actually appear to have developed the idea of separation of powers and inspired the Founding Fathers. See this and this.)

Everything has becoming too centralized.

We’ve previously noted that liberals and conservatives tend to dislike different portions of the malignant, symbiotic relationship between big government and big corporations:

Conservatives tend to view big government with suspicion, and think that government should be held accountable and reined in.

 

Liberals tend to view big corporations with suspicion, and think that they should be held accountable and reined in.

This post shows that both are right.

We’ve gone too far in centralizing governments, the financial sector and other organizations.  We have overshot the mark … and gone from efficiencies to inefficiencies of scale.

The answer is more decentralization.

For example:

  • Decentralization – not some more bigger,  more centralized solution – is the key to our energy problems

It is time to take power away from those that are hurting all of us by putting our time, money and energy into smaller, more local organizations.