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.