Wednesday, November 12, 2008

The Looting Continues

I'm astonished by the subdued public response to the extraordinary events of recent times: we have been, and are being, looted on a scale hitherto unheard of in peacetime.

Two excellent posts from econ blogs do a brilliant job of explaining what's gong on.

First, this is a great post on the AIG situation by Yves Smith. Smith is ex-Goldman, ex-McKinsey and was head of M&A at Sumitomo, so is no pinko:

Next, Steve Waldmann looks at the implications of the bailout more generally:

His discussion of what government investment means is superb: the bailout is a disaster for all of us even if it turns a slight profit. And the distributional consequences - bad as they already are - may get a lot worse.

I don't really have anything to add except a question: why aren't people enraged by all this? It's not hard to get a sense of roughly what's going on, is it?

Tuesday, November 11, 2008

Financial innovation

Behavioural economists Richard Thaler and Cass Sunstein hav a piece in today's FT:

On financial innovation:
Not so long ago, most mortgages were of the 30-year fixed-rate variety. Shopping was simple: find the lowest monthly payment. Now they come in countless forms. Even experts have trouble comparing them ...

Which begs two questions (i) what purpose did the added complexity serve and (ii) what to do going forward? Their response:
A potential response to complexity would be to require simplicity – for example, by allowing only the standard 30-year fixed-rate mortgages. This would be a big mistake. Eliminating complexity would stifle innovation. A TiVo is a more complicated product than a VCR, but it is also better.

This analogy seems to me just a little inadequate as an explanation of the value to society of the very changes in the financial system which have been at the heart of a meltdown whose costs (direct, opportunity and otherwise) are as huge as is now becoming clear.

System complexity and highly attractive incentive and tax regimes come at a cost. The former can lead to unpredictable outcomes, the latter to perverse behaviour, in the worst case undamped by either social norms or tax structure, and the two together to the massive economic damage we are now witnessing.

So you have to justify these things. Why do we need complcated mortgage deals? Why must we allow banks to trade obscure derivative products? Clearly there are huge costs in terms of failures of this kind? Can we quantify the benefits? Are they really large enough to be worth it?

Ditto incentive and tax structures. Clearly you want outstanding people to be incentivized to do things that make us all better off. But if you're going to argue in favour of a system in which bonuses alone far exceed the entire amount spent on all scientific research and positively dwarf what we spend on alternative energy, you have to justify it: what do we get from the activities of these people and these organizations that is so superior to simpler and less lucrative alternatives?