Is my pessimism justified?

I'm increasingly pessimistic about prospects for meaningful reform in the wake of the financial crisis, and feel that a repeat, quite possibly on an even larger scale, is not unlikely. Martin Wolf in the FT seems to agree. His tone is of course more sober and measured: here are some excerpts, but do read the whole thing:

What entered the crisis was, we now know, an ill-managed, irresponsible, highly concentrated and undercapitalised financial sector, riddled with conflicts of interest and benefiting from implicit state guarantees. What is emerging is a slightly better capitalised financial sector, but one even more concentrated and benefiting from explicit state guarantees. This is not progress: it has to mean still more and bigger crises in the years ahead. ... Today, the core financial institutions are, beyond doubt, a part of the state. ... The most important point is that where we are now is intolerable. Today’s concentrations of state-insured private wealth and power must surely go.

And this from Michael Pomerleano in Wolf's FT Forum (HT Mark Thoma):

In 2008, salaries of the top 10 banks reached $75 billion (up from $31 billion in 1999), while cash dividends to shareholders were only $17.5 billion. Management took 4.3 times more than shareholders at a time when shareholders were injecting capital and government was guaranteeing deposits. He pointed to the critical principal-agent fiduciary problem. Essentially, financial sector losses will be paid for by future taxation (large fiscal debt) or inflation.

The bottom line here is that we are already collectively paying (through the nose) to support the financial sector and will continue to do so. This is a scale of state subsidy that is surely unparalleled in the West. And the ultimate irony of course is that the beneficiaries of our largesse continue to kid themselves that they are "innovating" and "creating wealth", embodying the free market spirit!

What next for Britain?

Right-wingers are now arguing that because of the crisis, we have to reduce public spending and reduce income taxes. For these people, whatever the data, the remedy is the same - during the boom/bubble they said essentially the same thing, i.e. cut income taxes, free up "innovation".

I share the Right's disdain for Labour, although perhaps for different reasons. They are a disgrace, and certainly not a social democratic party: in all their years in charge they have done little to move Britain towards the kind of high-human-capital society I would like to see, and instead were cheer leaders, if not prime movers, in the banking fiasco.

Equally, while I have sympathy, even a natural liking for, the notion that technology and good management can raise productivity in public services, my feeling is that the gains that can be realized are hugely exaggerated. Britain still lacks a lot of basic, fairly physical stuff: accessible training, facilities for quality education (especially at the lower end), public sporting facilities, public spaces; on-the-ground comparison with our neighbours in Northern Europe really bears this out. Does anyone really think it is possible to see more of such things with a reduction in spending? Equally, in Britain's (many) deprived areas, by all accounts in most cases a small number of social workers/doctors/nurses are overwhelmed by the troubles of a poorly educated, often dysfunctional populace. Where are these huge numbers of public servants who can be let go without impact? I'm sure there are a few, maybe even quite a few, but enough to make a serious difference?

Britain needs a fundamental re-think of it's spending priorities. First, we need massive investment in public physical infrastructure and facilities, especially in deprived areas, and especially when this impacts human development (i.e. learning skills and abilities, early childhood experiences and so on) and in particular those many young people who are neither in training or employment. Second, a real move towards quality vocational training: we have a dire lack of people who can really do things well, from bakers to cooks to builders. This is where there is a real opportunity to both improve productivity and reduce expenses that arise in managing the fallout from having a vast number of untrained, often unemployable people. Third, a reduction in the size and importance of the financial services sector. It is not clear that the sector is at all profitable at the margin, absent implicit and explicit government support. However, it is clear that the distortions induced by this support enjoyed by the sector damage the wider British economy: what might all the smart young scientists and engineers have done if they hadn't gone into the City? Been brilliant teachers? Genuine entrepreneurs? Worked in R&D? Fourth, we need an infusion of technical expertise into management. In Britain most senior management, even at engineering firms, appear to know very little about the business they run. Thus, a CEO is almost always a lawyer/PPE/MBA or the like, rather than a PhD engineer or scientist. This is emphatically not the case in Germany, for instance, certainly not as often, and I think this is a major reason why Britain's scientific excellence does not translate in successful businesses.

But doing these things requires taking on the City and it's increasingly deadly grip on the national psyche. And that is where none of our political parties will go.

When, not if.

I wanted to apologize to readers for my silence and offer some explanation of why I have not been continuing with my post-crisis blogging. First of all I've been even busier than usual at my day job, doing science.

But second, I now feel that there is little real point in continuing (I will continue to blog, but less often on the crisis itself). This really is preaching to the converted. Most people in the econ blogosphere now agree - at least broadly - about the kinds of things that need to be done. Yet it has to be said that the vast eruption of post-crisis blogging, while intellectually stimulating, has politically been a failure. Most of our politicians seem unable to discern either the scale or nature of our problems, and many are, I think, simply intellectually corrupt. People are already suffering, but treat the crisis and its aftermath as a random event, akin to a weather calamity, rather than the consequence of repairable systemic flaws coupled with criminal behaviour on the part of an avaricious minority.

What is the end game here? My prediction is that we will (continue to) suffer considerable short-term economic fallout and (truly huge) longer-term social costs and missed opportunities. The systemic flaws will not be substantively addressed, and the actors involved not held responsible in any serious way. Moral hazard will grow, as it's now abundantly clear that not only is it permitted (if not encouraged) to be too big and/or interconnected too fail, but that even when you do fail there are essentially no consequences. There will be a second crisis, probably larger, whose timing will depend on precisely how little action is taken in the present.

But what is clear is that it's now a question of when, not if.

A tale of two press conferences

The tale of two pre-G20 press conferences (Obama/Brown and Merkel/Sarkozy) is being played in the UK press as a Anglo-Saxon versus (old) Europe story, with headlines like "France and Germany throw down the gauntlet" and "Franco-German demands upset G20 unity". This press reaction is surely greatly exaggerated, and the politicians themselves are no doubt doing a lot of posturing for their home audiences, but it is interesting to consider the political and economic background that gives these stories traction.

The crisis really does have a great deal to do with the political economy of the US and UK in particular: these two countries were its economic, political and intellectual epicentre. European countries which have been most directly affected - Ireland, Spain and Iceland among them - were precisely those which were most influenced by the business culture of the US and UK. Indeed, until recently these countries were often hailed by the Anglophone business press as economic poster children, and examples for "sclerotic" Europe to follow.

While Germany and France have been hit hard by the crisis, it is important to distinguish between first-order effects due to asset price bubbles and opaque financial products, and second-order effects due to the reduction in demand brought about by first-order problems elsewhere. While the banking sectors in "second order" countries face very real problems, it is important to note two things. First, the asset write-downs and financial (mis)innovation at the root of these problems took place mostly in the Anglo sphere of influence (in many cases even when the firms in question were European). Second, it was a very Anglo influence that drove what now appear to have been deleterious changes in the banking culture in these countries in the first place. (Indeed, in the last decade it became commonplace to see starry-eyed European students at business and finance schools in the UK and US, eagerly imbibing the wisdom on offer. This influence likely had a major role to play in reshaping financial institutions in Europe.) It is fortunate that Germany, for example, did not heed advice to loosen mortgage restrictions: there was no real house price bubble there, but if there had been we might now have been facing an even worse crisis.

With recessions looming or underway almost everywhere, isn't this first-order/second-order distinction just splitting hairs? I don't think it is. The fact that Germany is suffering due to a sudden drop in US demand for its cars is simply a different type of problem from the primary economic problems in the US. I would argue that these second-order problems are less fundamental and will prove easier to adapt around. Think of it this way: Germany has fewer major fundamental changes that it will needs to make in its business culture. Certainly like everyone else it will have to undertake major banking reform, but mostly this will be a matter of shaking off a recent, foreign influence on that sector, rather than the much deeper rethinking that will be needed here and in the US. This is surely part of the reason why the German government seems inclined to wait until the crisis is resolved elsewhere and in the meantime simply keep their manufacturing sector in one piece, ready to pick up again once global demand is restored.

This background is important in reading quotes like this:

Action to regulate bankers' pay in order to discourage excessive risk-taking could not be taken by a few countries alone as they would be penalised in the competitive global marketplace, [Sarkozy] said, adding: "This has to be a worldwide decision to inject new ethics into trader remuneration."

Mr Sarkozy said: "These are our red lines. We are totally prepared to discuss other things so long as these issues are clearly dealt with and solved."

( I don't know how serious Sarkozy is about this, but for what it's worth I agree with the sentiments he expresses about ethics and remuneration.)

Is the seeming optimism of Obama and Brown matched by a real desire to undertake serious reform? Certainly these two leaders appear to remain much more wedded to a finance-centric worldview than their counterparts elsewhere. Gordon Brown was Chancellor during the long run up to the present crisis, and played a role in fostering the political and economic climate that made the crisis possible. Meanwhile, Obama's economic team has, to put it mildly, some conflicts of interest with respect to fundamental reform of the financial sector. Perhaps European cynicism is unwarranted, and Obama and Brown will indeed recognize the role played by the Anglo business culture in bringing about the crisis and try to rectify it. But if not, we are likely to see more real political disagreement in the months to come.

Norms follow-up

Just a quick follow-up to my previous post on norms in the financial sector. To summarize and clarify that long post:

• Norms matter: strong regulation is no substitute for good norms, both because of enforcement costs and the likelihood of regulatory capture and gaming.
• I am not saying that all - or even most - employees in financial services have no interest in the social value of their work: my claim is only that there appears to be a critical mass with a more cynical viewpoint who have effectively set the cultural tone.
• The issue not really a lack of altruism, but something less lofty: caring about the work itself as opposed to earnings alone.
• Financial services have, of course, considerable social value and I do not doubt that many entrants into the sector are motivated in this way. But I think that such people quickly find themselves in a culture where their views are not much heeded. Consider the position of a (hypothetical) young recruit into AIG's Financial Products division who may have been concerned about what was going on.
• I used a contrast between bankers and doctors to bring out some differences in norms. This contrast is probably much more extreme in the UK than the US: doctors here earn far less than their counterparts in the US*. In the UK at least, it is pretty clear to me that doctors care far more about the social impact of their work than bankers. There are of course many exceptions to any such statement about averages.

Willem Buiter's latest blog post makes many of the same points, but perhaps less politely. Some excerpts (but the whole post is worth reading, even if you find yourself in disagreement with him):

"I am, however, as more detailed evidence accumulates about the genesis of the financial collapse, becoming more and more impressed with the importance of misfeasance and malfeasance - of negligent, unethical and outright criminal behaviour, ranging from high crimes to misdemeanours."

"...to enrich themselves by robbing their shareholders blind. ... Where are the class actions suits by disgruntled shareholders? Where are the board members in handcuffs?"

"What we have seen and continue to see in much of the border-crossing financial sector, however, is a rather more literal form of moral hazard: a lack of morals in some key participants in the financial system dance causing major hazards to the financial well-being of millions of powerless victims. Corrupted morality putting at risk genuine, wealth-creating financial intermediation, innovation and risk-taking."

*A side note: US doctors are very well paid by international standards, and there is considerable evidence and mounting concern about the many conflicts of interest in the US medical establishment, see for example the book by Marcia Angell, or many recent examples, including the recent Harvard Medical School controversy or the JAMA case. To the extent that these issues are especially prominent in the US, this would support the general thesis that extremely high earnings can have a deleterious effect on norms.

Why the culture of the financial sector has to change

I want to say a little about business and cultural norms in the financial sector, how they affect tangible outcomes we all care about, and why they need to change. Norms are inherently less tangible than items on balance sheets, so it can be hard to see the role they play. I want to focus on norms in the financial sector, but to bring them out of the background I’ll start with a comparison to another field.

Doctors and bankers are alike in that they can inflict enormous damage by doing a bad job, doctors with a flick of the scalpel, bankers with a click of the mouse. Both are therefore subject to regulation which tries to trade-off costs of enforcement against risk of damage. But there’s a huge difference in the way doctors and bankers view their work.

Doctors, for the most part, care very deeply about the social impact of their work. Their ethos is one of wanting to do a good job for its own sake. Some make a lot of money, others do well but are not super-rich (this is the typical case in Europe), but from day one at medical school, the ethos is pretty evident. In contrast, bankers tend not to care - or sometimes even think about - the social impact of their work. It is very clearly a fundamentally different ethos. I do not want to idealize doctors - there are clearly some real exceptions - but only to put bankers alongside them to bring out some of the differences in culture.

You can see this difference in culture play out on the supply side of the labour market. Doctors are usually smart, hard-working people who could do well in other areas, but in most countries they have to go through a very long and genuinely tough training phase before they earn really good money (and in many countries the money isn’t even that great). Yet this doesn’t seem to deter applicants: medical schools can almost everywhere afford to be highly selective. This is because medical school applicants are, for the most part, people who actually want to make ill people better: that is, they have a sense of mission. In some sense, the “delayed gratification” acts as a filter: if you don’t care about the mission, you’ll find it hard to make it through to the latter, more lucrative stage of the medical career.

It’s not just medicine where there is a sense of mission, an ethos in which substantive social impact means something. Think of engineers, teachers, technology innovators. People who start tech firms want to get rich, sure (who doesn’t?) but a big part of their motivation is a desire to develop products that are widely used and make things better for people. (In open source you have the extreme case of people – often highly skilled – who care mostly about impact, not earnings.) Analogous to the delayed gratification in medicine is the high risk and opportunity cost of getting involved in a start up. If you’re finishing CS grad school, and have a bright idea, at that point in time it’s by no means clear that pursuing it will make you a millionaire. Yet to chase the dream you may have to pass up on other opportunities (e.g. a steady job). It’s a high risk, high reward choice. Note also that in technology (as in music or sports) a long-running passion for the job is almost a pre-requisite for doing well; in this sense the opportunity costs kick in as early as high school, or even primary school.

In fact, if you look across the economy, it’s hard to find another line of work that offers high rewards as quickly and with as little risk as finance. If delayed rewards in medicine and high risk in technology act as a filter, selecting the passionate over the merely greedy, the quick riches and relatively low risk of finance perhaps act in the opposite manner, selecting for people who simply want to become wealthy as quickly as possible. This view certainly accords with anecdotal evidence. Entrants into finance are often very smart and ambitious, but I would argue that many do not really care very much about anything other than making money and certain positional concerns (i.e. doing well relative to their peers). This is a stark contrast with most other “elite” fields, where money and rank matter, but so does mission.

We can extend this analysis in time and across people by looking at how norms evolve in groups. When groups of like-minded people get together, they tend to reinforce their initial views. So if you like science at high school, four years with like-minded peers at Caltech may take your passion to another level. This effect of reinforcement by clustering can work for good or evil: it helps us all to put wannabe tech innovators together in CS departments and places like Silicon Valley, because they spur each other on in mostly a good way. But it can work against us too: think of criminal gangs, or extremist political groups.

My feeling is that at present because finance offers high rewards with low risk but does not emphasize social value, it attracts a disproportionate number of people who are smart and competitive but who lack a real mission. Note that I am not saying financial activity does not or cannot have social value, only that at present this is not something that is very much emphasized or thought about in the sector.

Norms are intangible, but they have very tangible economic consequences. Enforcement alone is a costly and crude tool: if you had to police everyone all the time, many activities would no longer be wealth creating, net of enforcement costs. In this sense, productivity is a function of both norms and enforcement: if you have good norms, you can get away with less enforcement, but if you have bad norms, you’re better off with strong enforcement (but will do less well overall). The upshot of this is that improved norms can have enormous benefits in terms of concrete wealth creation.

Even a year ago, I think many outside the financial sector (and not a few inside it) would have recognized at least a kernel of truth in this analysis of its norms and ethos. But norms being as intangible as they are, any concerns would not have made it as far as impacting policy. But the events of the last few months have shown us that we ignore bad norms at our peril.

We are in a situation where bad norms in one systemically important sector have brought us almost to the brink. A short-term analysis of the crisis has to take bad norms as given, and construct tough regulation and enforcement regimes which keep the system stable despite its poor ethos. But such stability comes at a price. First, the level of enforcement required for stability will be difficult to achieve and sustain. Second, if the mindset of the sector does not change it will only be a matter of time before enforcement is undermined, by regulatory capture, lobbying, corruption etc. Only a change of norms can reduce this tension, by re-aligning the motives of agents in the financial sector and the society that they supposedly serve. Changing norms is hard, but not impossible. Now is the time to start.

All roads lead to reform

These are remarkable times. There has been the build-up of a historic asset bubble followed by a global financial collapse, unparalleled since the Great Depression. As many have noted, a key characteristic of the crisis has been the fact that it was caused largely by the financial system itself (rather than an exogenous shock), through the actions of individual agents coupled with failures of regulation, corporate governance, policy and politics. The breadth and inter-connectedness of these failures has made it increasingly clear that we will need wholesale reform: not just recapitalization of those institutions in the worst trouble, but changes to major parts of the financial system, including firms and their governance, the regulatory framework, as well as the broader culture and norms of the financial sector (the latter being perhaps the most challenging).

If this sounds exaggerated, consider where we are, how quickly we've got here, and how ridiculous it would have seemed, even a year ago, that any of this would come to pass. Indeed, both Obama and Gordon Brown (in the UK) pay at least lip service to the need for this sort of wider reform. Their substantive actions to date have not matched the rhetoric, either because they are hoping it will all "blow over", or (optimistically) perhaps because they intend to really proceed on these issues once things have stabilized a little.

I want to make the case that despite the politicians' evident reluctance, major reform will almost certainly be needed. The only real question is whether we get round to it sooner or later. Given the rapidity with which crisis can spread and deepen (making "contagion" a very apt metaphor), I think it is very much better if we act sooner. This would not be pre-emptive by any means: it would be in response to what is already a crisis of historic proportions (rather than waiting for something even more extreme.)

To get some sense of what might happen next, it is helpful to think of a tree of possibilities. For simplicity, let's restrict this to two possibilities at each stage. First, the Geithner plan (or some minor modification of it) can either succeed or fail: either the injection of government funds (essentially via non-recourse loans) is sufficient to restore the system to some semblance of normality, or not. If the plan is successful (as it might be, in this narrow sense, even if you object to its unfairness and lack of transparency) there are two further possibilities. Either the administration presses on with systemic reform (this is the optimistic view) or it decides that the worst is over and that minor, even cosmetic, changes will be enough. In the latter case, I would expect to see a replay of the crisis, perhaps during the following Presidential term (in this scenario, the bailouts did indeed work, so it would perhaps be a second term for Obama). Even if this sequel was not as bad as the cataclysm I fear, coming on the heels of this crisis, it would, I think, make reform unavoidable for even the most reluctant administration. And if the current bailout doesn't work? If it's a clear failure? This is not a pleasant scenario. Things will be even uglier than at present (unemployment is already touching double figures with U-6 at around 15%) and the calls for fundamental reform almost impossible to dismiss. This covers all the leaves of the tree: it therefore seems very likely that however things play out with the administration's short-term plans, the need for reform will at some point become too obvious to ignore.

System-wide reform cannot be avoided for the same reason bubbles have to burst: reality can be wilfully ignored for some time, but not forever. Clearly the political obstacles in the way of wholesale reform are formidable, and in that sense some reluctance on the part of the administration would be understandable. So the question for Obama and his team is this: do you start on reform now, or wait for even stronger evidence of its necessity? And when the weaker evidence is the present state of the economy and the associated human costs, do you really want to wait for more?

Why a second best bailout may not be good enough

It’s not often I find myself disagreeing with Mark Thoma, but on the issue of the Geithner bailout plan I think I do. Thoma is a careful and reasoned writer, so what comes below I say cautiously, but nonetheless with some conviction.

Thoma writes:

So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none — to me — is so off the mark that I am filled with despair because we are following a particular course of action.

Let me start by nailing my colours to the mast: I am not convinced the Geithner plan is a good one, and would greatly prefer to see a much more thorough reform of the financial sector, including a bankruptcy-like reorganization of insolvent firms. I understand that this sort of “solution” is much easier to consider in the abstract than implement in the real world and that such a plan would encounter formidable political obstacles at a time when the policy response needs to be rapid. So my argument below against Geithner-type plans is made neither lightly, nor simply to play devil’s advocate to optimists.

My opposition to the Geithner plan stems not primarily from outrage, concerns about equity, or even book losses borne by taxpayers, but from major concerns about future economic output and stability. The other issues are important and certainly things I care about, but my feeling is that even these are of secondary concern next to the signal issue of how today’s bailout will affect tomorrow’s broader economy.

For the moment, let’s categorize bailout plans into those which seek to recapitalize the banks while maintaining the current system in roughly its present form and those which go the route of bankruptcy-type proceedings and (given the breadth of the current crisis) would involve a much more thorough overhaul of the financial system. The Geithner and Paulson plans are of the first kind, and the “Swedish” plan (and its many variants) of the second kind. I’ll call these “bailout” and “restructuring” plans respectively. Clearly this nomenclature hides a lot of detail, but I think captures a key axis of difference between the various plans.

Two things about the aetiology of the crisis stand out. First, perverse incentives for agents within the financial sector played a central role in bringing about the crisis. Second, there were (and remain) issues of poor system design in the financial sector: even perverse incentives might have had limited consequences in a robust system. The problem with the Geithner plan is that even it works in terms of stabilizing the economy in the short-term, it does relatively little (the uncharitable would say almost nothing) to correct either incentives or system design. But the business and cultural norms and system-wide conflicts of interest which form the backdrop to the crisis run deep, and will not change without substantial impetus. It is precisely these deeper issues that we must address if we are to reduce the risk of a re-run of the crisis, probably on a larger scale, in a few years time.

I sympathize with the point of view which says that the political window of opportunity is narrow and the need for action urgent, so let’s accept the bailout plan for now, and deal with these wider issues later on. But the very fact that political momentum is limited means that if these wider changes are to be brought about, the process has to begin in earnest at once. Does anyone seriously believe that in a years time, if following massive government support the banks are stable - or can be made to appear stable – there will be any political will to break up very large institutions, or any real change to underlying norms in the financial sector?

However, absent these deeper changes, it is entirely possible that we will see a replay of the crisis - but on a larger scale - in a few years time. Naturally, one cannot say with certainty that such a cataclysm (and if it were much larger than the current crisis, it really would be a cataclysm) will occur. But if it does, the resulting costs will be huge. Martin Wolf has written persuasively about the costs of major economic dislocation. Net of unemployment, political instability and even wars, the human costs of a sequel could dwarf even the current crisis. Then, the choice in the present between the “bailout” and “restructuring” plans hinges on whether expected cost (in the broadest sense), conditioned on the “bailout” strategy is higher than expected cost conditioned on “restructuring”. One could formalize this argument as a decision problem, but it comes down to a judgement call on the relative probability of such a cataclysm under the two strategies and the magnitude of the dislocation. My feeling, admittedly subjective, is that the gloomy cataclysm scenario is substantially more likely under the “bailout” than “restructuring”, and that the costs would be immense.

This case can be put very simply: if we do not use current political momentum to fundamentally reform a system which has shown itself to be unstable and even dangerous, a second opportunity may come at a very high price. And this is not a gamble I wish to see our leaders make.

On toxic cars

Mark Thoma comes up with a terrific analogy for the issues around "toxic" assets held by financial institutions. Among other things, he gives a particularly clear explanation of the Paulson, Geithner and "Swedish" plans for dealing with these assets.

Thoma concludes with the important point that even if a government intervention loses the taxpayer money on the toxic assets themselves, it may still in a broader sense be a good strategy, once we account in our risk function for the high probability of very severe economic disruption absent any intervention.

Suppose we agree, on these grounds, that some intervention is better than no intervention, even if it loses the taxpayer money in the narrow sense of a book loss on the toxic assets. The question then shifts to which of the plans on offer is best (or least bad)?

In terms of the short-term book loss to the taxpayer, I doubt there will be a huge difference between the plans. As a Deutsche Bank economist memorably put it: "Ultimately, the taxpayer will pay one way or another". This is surely true. I don't want to trivialize such differences as there may be - this may still add up to a huge amount, which could literally have been spent saving lives - but only to emphasize that this is unlikely to be large relative to the costs of inaction for the broader economy.

Why then should we care about precisely how taxpayers end up picking up the tab? To my mind it is crucial here to recognize two things about the present crisis. First, the very fact that so many of the assets held by banks are toxic in the first place has much to do with the behaviour of agents within the financial sector and the regulatory environment and business and cultural norms within which they operate. Second, the entire game is iterated: whatever we do now will provide the backdrop for further rounds of play.

Going back to the beginning of the Thoma analogy:

Imagine a car lot that has 100 cars on it. However, some of these cars have problems. Half of them will have engine troubles that total the cars - the engines blow up and the cars are then worthless - and this will happen just after purchase. The other half are perfectly fine.

Now imagine something further (and I realize I'm stretching the analogy a little): what if the engine troubles that some of the cars will experience were caused by employees in the dealership swapping out good engine parts for bad ones? Or if all the while they had been currying favour with the local authorities and pushing for a relaxation of the town's laws prohibiting such activities? Or even that they were using op-ed pieces in the local newspaper to argue that this new way of selling cars was fundamentally better, and that the old-fashioned car dealer in the next town who suggested otherwise was an old fogey? And that the local dealer whose firm is now in such trouble that it is threatening the very social and economic fabric of the town continues to live in the biggest mansion and drive the fanciest car in town (and opines in the local paper that everything's fine)?

If this were the broader context within which the townspeople had to decide on a rescue plan for the dealership, I suspect many would lean towards some version of the "Saab" plan (i.e. Swedish plan or variant thereof) so as to mitigate the chance of another batch of exploding cars appearing on the streets of the town in the near future.

The key point I want to emphasize is this. Once we recognize the role of incentives and regulatory capture in the crisis, and the fact that once the immediate problems are dealt with the game will start again, this gives us another element to include in the objective function through which we evaluate competing policy proposals. What do such proposals do to incentives going forward? What do they say to players preparing to take part in the next round of the game? The magnitude of the economic fallout from inaction would almost certainly dwarf book losses taxpayers suffer on toxic assets. So it's vital we take action. But the magnitude of future losses from the wrong action, might dwarf even the current crisis. So it's also important we get intervention right.

In denial

Over in the parallel universe that is the financial sector, people are not happy about the "clawbacks":

http://www.ft.com/cms/s/0/4ff2f77e-1584-11de-b9a9-0000779fd2ac.html

There are some terrific quotes in the piece. Here are a few:

“Finance is one of America’s great industries, and they’re destroying it,”said one banker at a firm that has accepted public money.

“The work we have all done to try to stabilise the financial system and to get this economy moving again would be significantly set back if we lose our talented people because Congress imposes a special tax on financial services employees,” [Vikram Pandit, Citigroup CEO] wrote.

“There are three big industries where the US has global leadership: financial services, media and technology. Introducing this 90 per cent tax is like taking one of those industries out the back and shooting it,”

Leaving aside people who were knowingly fraudulent, or borderline fraudulent, my feeling is that the majority of people in the sector did not have bad intentions, but were simply greedily responding to wage signals. If you could make several times as much working the City or on the Street as you might in an alternative career, why not go for it? If you were the thinking type it might have occurred to you that something was a bit odd about the sheer size of your pay packet relative to equally or better qualified friends who were working long hours doing seemingly useful things like medicine, teaching or technology. But you figured, hey this is what the market's saying, it must be right. Plus there would have been persuasive voices (not least in the FT, WSJ and Economist) explaining that your sector was indeed magically creating wealth on a scale large enough to justify your pay packet.

But now that reality has made a belated appearance, where do these people go psychologically? Do they accept that much of the justification for their earnings was false? That perhaps some of the people they admired for their drive and ambition were in fact frauds? This is a lot to take on board, so these people are now in denial.

If we allow things to drift, they will stay in denial, and there will be none of the broad changes in sectoral culture and norms which are needed. And in a few years we will have a replay of the crisis, but on an even bigger scale. Yes, you can change regulation - and we should - but one-off legal and regulatory changes alone are never enough, you have to somehow change the culture and norms as well. Else, once public and political attention is elsewhere, regulatory capture will rear it's ugly head again and the seeds of a new crisis will be sown.

This is why it's so important to get the policy response right, not just in terms of the immediate economic impact of the bailout, but in terms of psychology, in terms of the message it sends to actors in the financial sector.

Biting the hand that feeds

AIG is suing the US government to get back tax payments it made, but figures it can argue its way out of using the usual array of barely legal tax avoidance tricks:

http://www.nytimes.com/2009/03/20/business/20aig.html

Oh, and they're probably using Federal funds to pay for the law suit! You couldn't make it up.

Of course, in a certain sense all this is a perfectly rational response to the regulatory and legal framework*. Which just underlines how much work is needed to overhaul the entire framework to rehabilitate the financial sector as a normal corporate citizen, rather than the renegade it appears to have become. I realize all firms engage in some of these sorts of activities, but at least they mostly create wealth. Plus, I somehow don't think a Google, Microsoft or Apple offers clients services as dubious as "regulatory arbitrage"...

(*Although net of negative publicity and related downtream effects perhaps not so rational.)

Crisis Quote of the Day

Britain's Chancellor (= Finance Minister) Alastair Darling doesn't want to restrict bankers' salaries*:

“It is good that excesses in the banking sector are brought to an end but it does mean our revenues [via taxation] suffer as a result.”

This makes about as much sense as saying, for any person X (X=Compulsive Theorist, for instance): "We should double X's salary, this will put him into the high tax bracket and increase revenues.". Which is to say it doesn't make any sense at all.

A more serious post tomorrow on wages and incentives.

(*To be fair to Darling, I don't know the full context of his remarks, and he may have meant something more sensible.)

Financial extortion?

Andrew Sorkin makes a case in favour of the AIG bonuses in today's New York Times. The article - I think unwittingly - provides a remarkable snapshot of all that is wrong with the financial industry today, and why, for the sake of efficiency if nothing else, it has to be radically reformed. I think it's worth reading in its entirety, but here are some excerpts with comments:

...more sobering thought: A.I.G. built this bomb, and it may be the only outfit that really knows how to defuse it. ... A.I.G. employees concocted complex derivatives that then wormed their way through the global financial system. If they leave — the buzz on Wall Street is that some have, and more are ready to — they might simply turn around and trade against A.I.G.’s book. Why not? They know how bad it is. They built it.

[CT here] First, isn't that illegal? If it isn't, shouldn't it be? Second, isn't this nothing less than extortion (not even by analogy, but literally)? It's the most explicit example of rent-seeking you could hope to find. The crucial thing here is this: it is now clear that these particular actors have never created any wealth (only destroyed it) but because they can do still more damage, we have to pay them whatever they want. If you think about it, this is even worse than the looting that takes place when financial systems are in chaos: it's the financial equivalent of a gun to the head (and really not so different from a demand from terrorists or kidnappers).

“We cannot attract and retain the best and brightest talent to lead and staff” the company “if employees believe that their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury,” [Edward Liddy, AIG CEO] said.

[CT here] How about "arbitrary adjustment" by the market? Isn't that how markets work? These people are not schoolteachers, adding value far away from any explicit revenue stream, and therefore needing protection from market failure in the provision of their wages. Far from it: they're benficiaries of a market failure in the reverse direction - they've been overpaid for too long. At best, they're meant to be at the mercy of market forces, or at least that was the story they gave us in (what seemed like) good times, to justify their earnings.

Would you want to work at A.I.G.? Sure, maybe for $3 million. But not if you could go somewhere else for even more — or even much less.

[CT again] Sadly, this is probably true. Yet, you may ask, how can there possibly be a bidding war (and at wage levels that make the President look like an underpaid janitor) for "talent" between bankrupt firms? The answer is of course that on account of the "too big to fail" situation, these firms are now neither private firms nor publicly-operated utilities, but (and I'm being polite) but "zombies" (to continue the analogy you might say they are feasting on our national wealth).

Moreover, for the financial sector as a whole, the relationship between wages and marginal product has completely broken down. We're not talking about subtle issues, minor failures in labour markets, but a near complete breakdown of the link between what these people are paid and what they contribute to society.

This is glaringly obvious in the AIG case, but I would argue has been true for some years, for the financial sector as a whole. I'm not saying no net wealth creation took place, averaging across the entire sector and say a ten-year time window (although this may still turn out to be the case). What I am saying is that it is increasingly clear that the huge rewards flowing to this one sector (in recent years in the US and UK, ~30-40% of all corporate profits, net of a massive wage bill) bore little relation to the true value of the sector, under any reasonable definition.

What's going on right now is simply looting and in at least one case extortion. What happened until recently was legal, but a massive market failure of sorts which led to an extreme misallocation of wages.

One last quote form the Sorkin piece:

“The jobs are terrible,” said Robert M. Sedgwick, an executive compensation lawyer at Morrison Cohen who represents a number of employees of banks that have taken government money. “You have to read about yourself in the paper every day. These people are leaving as soon as they can.”

No comment.

Obama on AIG

Barack Obama ponders the AIG situation:

The President said the bonus situation underscored the need for overall financial regulator reform and said the government needed “some form of resolution mechanism in dealing with troubled financial institutions, so we have greater authority to protect the American taxpayer and our financial system in cases such as this".

Is he joking around? The Federal government needs "greater authority"? It has a huge controlling stake in an otherwise bankrupt firm. That is authority. You just have to want to exercise it.

There's crime, then there's...

To get some perspective on what's going on, I looked up the total direct losses from property crimes in the US. This totalled $17.6 billion in 2006. Meanwhile, the cost to US taxpayers, for one firm alone (AIG) are around $170 billion (and quite possibly going to increase further). That's almost 10 times more than all property crimes.

These property crimes were committed by many thousands of people. Those who were caught are now languishing in prison in the US (often under truly horrific conditions). Amazingly, just a few hundred people at a single AIG division in London were responsible for much of the insurer's woes, and thereby played a key role in getting the world economy to where it is. These people, having been rewarded very handsomely all these years, are now getting another half a billion dollars in "retention bonuses". These people and their managers don't seem to care one bit about the economic chaos and mass hardship their actions have helped cause, so it's not entirely surprising that they don't seem to be taking much notice of Obama's disgust or Geithner's harsh words either.

If there are just two things about the financial crisis I think are worth stressing they are this. First, the crisis was not an outside shock (like a hurricane or asteroid collision) but a consequence of things people in the system did, acting "rationally" under perverse incentives (which still largely remain in place). Second, however you tally up the numbers, the scale of the hit to your wealth absolutely dwarfs things like "normal" crime and benefit cheats.

Why we need to nationalize. Now.

Nothing better illustrates the urgent need for nationalization of bankrupt financial firms than the latest news from AIG:

http://www.nytimes.com/2009/03/15/business/15AIG.html?em

AIG are in any meaningful sense, insovent. The firm survives only because of government support. The government owns nearly 80% of the firm. Yet execs are enjoying further bonuses, essentially direct from taxpayers money.

Robert Reich puts it very clearly:

...illustrates better than anything to date why the government should take over any institution that's "too big to fail" and which has cost taxpayers dearly. Such institutions are no longer within the capitalist system because they are no longer accountable to the market. To whom should they be accountable? As long as taxpayers effectively own a large portion of them, they should be accountable to the government.

But if our very own Secretary of the Treasury doesn't even learn of the bonuses until months after AIG has decided to pay them, and cannot make stick his decision that they should not be paid, AIG is not even accountable to the government. That means AIG's executives -- using $170 billion of our money, so far -- are accountable to no one.

The execs in question hide behind the letter of the law. But the natural, legal course of events (i.e. bankruptcy) was set aside when AIG received its first huge injection from the Federal government - in that sense, the spirit of the law was violated some months ago.

Opportunity costs

People respond to incentives and over time their very view of the world is moulded by them. I teach at a British university. Most of the undergraduates I encounter (in math-heavy subjects) want to go into finance. I talked recently to a final year student who was worried about the job market (in finance). I put it to him that it'll probably be pretty bad for a while. His response? To apply for an Masters in financial mathematics and see if it's better next year.

The bloated compensation in finance isn't just unfair in some social-democratic sense. It's also inefficient. An entire generation of mathematically gifted kids can scarcely imagine doing anything else, even though we need solutions to all sorts of problems which require efforts from people like them. This is one of the opportunity costs of what's happened: we have missed out on all the cool stuff that would have got done if these bright people had been doing something other than devising elaborate scams in the City and on Wall Street.

Will this scarce human capital now get allocated more efficiently? The answer to this depends on what our governments now do.

British press RIP

Another flat-earth piece in a major British newspaper:

http://www.telegraph.co.uk/comment/columnists/christopherbooker/4990704/Nobody-listens-to-the-real-climate-change-experts.html

This "real" climate change conference he attended was organized by the Heartland Institute, yet another one of the odious think tanks funded in part by - you guessed it - the Olin Foundation and the always unbiased Exxon-Mobil.

For a take from someone who can actually read, check out this piece by Google research director (and AI pioneer) Peter Norvig. An excerpt:

...an amazing amount of research went in to building up this consensus on global warming, but I hadn't heard much about the specifics. Reporters think (with some good reason) that the public is not interested in hearing about Analysis of some direct and indirect methods for estimating root biomass and production of forests at an ecosystem level and so they never cover such things. But by failing to talk about the years of research and the building on the works of others that go into producing a paper like that, reporters give all ideas equal footing: a half-baked whim with no evidence gets equal footing with a proven theory with hundreds of confirming studies, because it is too complicated to talk about the confirming studies.

Just to be clear: I'm not saying it's not ok to question the climate change consensus, of course it is (although I would argue that the media makes it sound as though there is much more disagreement between experts than is the case). What's not ok is to misrepresent what is in every sense a fringe view as the voice of the "real experts".

It's a weird time when...

... a major US newspaper talks about mainstream financiers as looters:

http://www.nytimes.com/2009/03/11/business/economy/11leonhardt.html

Some excerpts:

In effect, the bankers had siphoned off this bailout money in advance, years before the government had spent it.

Either way, the bottom line is the same: given an incentive to loot, Wall Street did so.

If we don’t get rid of the incentive to loot, the only question is what form the next round of looting will take.

Blame Game II

Harvard's Dani Rodrik seems to agree in spirit with my gentle critique of the economics profession and the role it played in the political economy of the crisis:

http://www.guatemala-times.com/opinion/syndicated/roads-to-prosperity/887-blame-the-economists-not-economics.html

I like - and agree with - the distinction he makes between economics and economists. Even for an outsider such as myself, it is apparent that there is a great deal more to economics than the "free markets rule, down with regulation!" caricature. What's sad is that many economists have been happy to promote that caricature and provide intellectual support for what the regulatory errors that got us to where we are.

Parallel universe

Some people are still living in the parallel universe of Big Finance. This comment piece by Anatole Kaletsky has to be read in its entirety for full effect, but I will whet your appetite with one choice passage:

If, on the other hand, public opinion rejects this message and forces American and British politicians to drive their banks into insolvency and full-scale nationalisation, then this week will mark the end of 200 years of market-based capitalism throughout the world.

Moral Hazard 2.0

If you'd asked bankers a year or two ago whether, if they'd just bankrupted their own institutions and brought financial calamity upon the world, they would get bailed out by the taxpayer on the scale they have with as few strings attached, I suspect all but the most optimistic would have hesitated to say "yes". And now? Surely most would nod their heads in agreement and confide that even in their most optimistic moments they hadn't realized just how far you oculd take this game.

If the bailouts continue in the manner they have (as opposed to some mix of full nationalization, bankruptcy, new "good banks", prosecution) what does this portend for the future? In a few years, the immediate feeling of crisis may have abated, but the memory of what happens when it all goes wrong (you keep your beach house, everyone else gets fleeced) will stay with the financial industry. The implication is this: moral hazard will become an even bigger issue after the dust has settled on these bailouts than it already is. The next generation of bankers will really believe that they can get away with almost anything. We have to get the bailouts right, now.

(I'm using the term "moral hazard" pretty loosely here to mean the propensity of agents within financial firms to engage in risky activities because of their insulation from the consequences of those activities. There's a huge principal-agent problem here too, with the principals being firms and shareholders and the agents being employees.)

A plot I'd love to see

Income level (on the horizontal axis) with the proportion of people in that income bracket who are in finance, real estate or closely related to either (e.g. mortgage broker, lawyer working primarily for financial clients) on the vertical axis. I would guess it shoots up to close to 100% for very high income levels.

To put this another way: I would guess that when you see someone driving a really expensive car, most of the time they will be people who benefitted from the upside of the bubble. And are now leaving you (and your kids) to deal with the downside.

Too pessimistic? Maybe, but I'd love to see the data.

Black swan takedown

Via Andrew Gelman's wonderful blog, a link to an excellent review of Taleb's Black Swan by legendary Bayesian statistician Dennis Lindley (you don't have to be a mathematician to follow this):

http://www3.interscience.wiley.com/cgi-bin/fulltext/119424936/PDFSTART?CRETRY=1&SRETRY=0

My feeling from reading Taleb and seeing him speak is that although he thinks he has found some huge flaw in probability (his hubris really is breathtaking), his real beef is not with probability or statistics but with finance. His critique is really one of conflicts of interest, perverse incentives and so on: he is talking about political economy, not mathematics.

And from that perspective, he's quite right. Building bogus models and making nonsense predictions pays pretty well (and continues to do so), so it's really just another case for that Upton Sinclair quote I use too much: "It is difficult to get a man to understand something when his job depends on not understanding it.

What De Long might call the London Times Death Spiral Watch

From a piece in today's London Times on bonuses:

It would be surprising if Brown did not meddle in this politically charged vote winner, but I suspect he’ll bungle it. These are migrant international workers and if Brown were to block pay-outs they would take their skills to other financial centres — if not now, then when the next upturn comes. ... Excessive interference would damage London’s status as a financial centre and stop financial innovation.

What planet does this guy live on? Note the language - "meddle" for the possibility of government acting for it's citizens against an oligarchy that has brought the entire nation to its knees. London's status as a financial centre is gone, my friend. And that "financial innovation" is leading us into what is now certainly the worst downturn since the Great Depression.

This is why the UK may be affected even more than the US: here the rot has set even deeper, an entire generation has internalized the nonsense spouted by the banking sector.

The compensation these people have received in the last few years was (i) out of all proportion to their contribution and (ii) a direct cause of behaviour that led to the crisis. The crisis will get even worse before it gets better, and if at the end of the day we end up with a utility-like financial system (see Canada), and a better balanced economy, so much the better. If at that point - after many trillions of dollars of losses worldwide and enormous distress - some people still want compensation of the kind that was available during the bubble and some country is enough of a financiers' oligarchy to offer such compensation, then it surely would be a good thing if these rapacious characters left our shores.

Bankers playing us for chumps

Watch this interview with Simon Johnson. Now.

http://www.pbs.org/moyers/journal/02132009/watch.html

Johnson was formerly Chief Economist at the IMF and is currently a Professor at MIT's Sloan School of Management, so he's not exactly a leftie. Which it makes it all the more worrying that he chooses to phrase his case this way: "The bankers think we're chumps."

Should economists be apologizing too?

As a natural scientist, my perception is that a lot of my peers feel less than entirely happy with economics, and its role in the current crisis, especially in the English-speaking world. Here are some initial thoughts:

• It's not simply the case that the crisis was caused by rapacious bankers. This is true, of course, at one level, but it was important that the game they were playing appeared to have some sort of intellectual foundation. This was tacitly (and sometimes quite explicitly) provided by economics.

• I realize that it's not as though there was ever a theorem which said that what was happening (e.g. wages, impacts on the wider labour market) was in some sense optimal, at least under real-world conditions, but the impression was often given that there was.Countless WSJ and FT comment pieces from the boom years have this tone, sometimes pretty explicitly. This was an intellectual deception, which I think played a key role in getting us to where we are today.

• I realise that economists, if asked about this point blank, would always be equivocal, but my impression is that during those years the bulk of the profession was happy to go along with the story. Why? Well, it didn't hurt the profession as a whole to be so closely associated with an industry sector raking in 30-40% of all corporate profits. I'm not talking about direct benefits like endowments and speaking fees, but more the intellectual glow of feeling that your work provides the theoretical edifice on which what seemed a hugely profitable sector was based.

• Again, there were dissenting voices, but my impression is that these people (for example Dean Baker and Steve Keen; quite often Krugman and Stiglitz) were viewed as academically minor-league (DB, SK) or politically motivated (PK, JS) and therefore not entirely in tune with the academic mainstream in the profession, at least on these issues.
  

• To take one example: most people outside economics always thought that salaries in finance were somehow wrong. This was a widely shared perception. Yet economists mostly seemed to support the notion that these wages reflected value added (perhaps this is the wrong term, but you know what I mean), or least didn't appear to question what were huge changes in the labour market. It is now clear that lay people were broadly correct.

• It's perfectly alright to be wrong about something, especially when the subject of study is something as complicated as the economy. I do not pretend natural science has the answers, and I hugely respect economics for taking on the challenge of at least trying to understand these things. But when the profession as a whole was wrong, or at least seen to be supportive of positions that were wrong, I think it's time to explicitly refute some of the intellectual claims of the bubble era.

• Surfing the econ blogs, I see a lot of technical discussion about the crisis but little by way of apology, contrition or even just a "hey we were really wrong about this".
  

Peanuts

Scientific research is feeling the pinch too. From a piece in Nature Biotechnology:

...even before the economic slowdown, the UK Engineering and Physical Sciences Research Council had planned to reduce its grants portfolio for physics from £137 million ($206 million) for 2006–2007 to £97 million for 2008–2009, according to council reports.

I'm struck by the numbers here: the amount spent on physics research in the UK is tiny in absolute terms (and just got smaller). Less than 100 million UKP is the national budget for the the only research which will give us long term solutions to our energy woes (and much, much more)? The long-term ROI on this spend must be huge: economists, what's going on, why is this stuff so woefully under-funded?

Do I need new glasses?

Am I reading this graph (from WSJ) right?