Monday, December 21, 2009

Moral Hazard?

Megan McCardle, yes that Megan McCardle, actually gets close to something important in a recent post about moral hazard in economic terms.
I go to a lot of pro-market think tank events where one speaker or another blames the financial crisis and the current recession on moral hazard, as well as basically everything else that has gone wrong in the last sixty years. I'm afraid I don't see it. The sticking point for me is twofold. The first is that we had crises before there was moral hazard--really, really dreadful crises, crises far worse than the one we're having now. I just don't see how you can look at the 1930s and name the FDIC as the decade's biggest financial problem. Or this decade's biggest financial problem. The closest our era came to a really devastating financial crash along the lines of the 1929-1933 period was in the total unguaranteed institutional money market funds.

Bingo! Nice job Megan. It's not often a bona fide Kool Aid Drinker manages to spit enough out of their grill to think outside their box. Keep going, you are almost there...
Nor do I find the central story of how the FDIC induced this moral hazard very compelling. Supposedly, ordinary depositors don't bother to check the soundness of their banks because they don't actually have skin in the game. Anyone making this argument cannot have met many ordinary depositors. If you stripped away my mother's FDIC protection, she wouldn't do any better of a job at evaluating Citigroup's finances. Moreover, this theory simply cannot explain the waves of bank failures that happened before 1934--failures in which the depositors neither expected, nor received, bailouts. Bankers still got overconfident, lent too much, and then went out of business. If you read contemporary accounts like the Benjamin Roth diary I recommended the other day, it's very clear that even when the shareholders and depositors were prominent local businesspeople with a lot of skin in the game and a pretty intimate knowledge of the bank's circumstances, they were still unable to foresee the trouble the banks got into.

She hits on an important idea that needs to be explored about what can we reasonably expect a regular citizen without a PhD in economics to understand about banks, markets, and what their best course of action in any given financial choice is, but we'll get back to that. This quote raises another important question, why didn't the bankers and regulators and everyone else figure out what was going to happen?

The central problem(s) we're dealing with right now seem to me to be, first, that asset/credit markets are sometimes subject to bad feedback loops which cause bubbles and crashes, and that the regulators cannot entirely forestall these, because the regulators are getting the same bad information from the feedback loop. And second, that to figure out what is going on in the banking system, we have to ask the bankers, who are going to tell us things that work to the advantage of the bankers. And third, that when new financial assets emerge, we don't fully understand the risks, and we tend to thereby get ourselves in trouble. Moral hazard seems like a distant fourth.

Good job Megan, I'll take it from here. What we might want to add to that paragraph is that one of the solutions to the problem of bad feedback loops that captures all the participants is to limit the systemic risk so that even if we make a bad call, we don't melt down our financial system. That is essentially what New Deal reforms to banking and markets did. As the Krugmanator put it, it made "Banking boring." Now, I don't think we can put that genie back in the bottle, but we can certainly put limits on the ability of lenders of all kinds to leverage themselves, force them to keep more capital in reserve, and make them disclose to regulators and investors all the relevant info. That's the minimum in my view, but its not hard to do. Megan, being the good University of Chicago graduate she is, will not be able to force such blasphemous thoughts through her keyboard onto the page, so I'm doing it for her.

This whole government intervention did it" argument stems in part from Milton Friedmans and Anna Scwartz's book "A Monetary History of the United States", where they argued that it was the Fed who monkeyfraked the economy in 1929-30 by raising rates and lowering the money supply. (true as far it goes) And that also the best way to deal with these downturns is to use monetary policy, which has been done since the 70's and seems to mostly work. Unfortunately, when you are already juicing the economy by keeping interest rates very low and one of these market blowups happen, you hit the zero bound pretty quick. Pulling out your Keynes playbook and blowing the dust off of it to run the Fiscal Policy Wildcat is what is really hard for many of these EMH fanatics to swallow.

Now, I think what Megan argues is true in that players in markets and the regulators get caught up on the feedback loop and don't see the apocalypse until the whole marketplace gets sucked into the abyss. Thomas Kuhn called this way of interpreting information a paradigm, and thus were a thousand awful business plan Power Point presentations born. But it is certainly true that once you buy into a conceptual framework, forever will it dominate your destiny until something drastic happens to shift the paradigm. Like, for example, a huge insurance company engaging in a global ponzi scheme and almost taking the entire financial system down with it.

I would go further and say that while Megan and people on the other side of the Great Divide like Tabbibi or academics like Krugman get close to portions of this, I think they miss the forest for the trees. I see the cause of the financial crash of 2008 as ideological. A free market ideology derived from the Efficient Market Hypothesis and a cultural brain tumor called Ayn Rand(insert your favorite cause here). And put in place and policed by a consortium of media, academic, business, and government group think that is almost Trotskyite in it's fervor to sell the beauty that are unregulated free markets and demonize anyone that wants to make them less insecure and destructive to regular people at the expense of quarterly profits and GDP.

So while I think its fair to point out the failures of the Obama economic squad, or to get worked up over banker salaries, I think that is ultimately spinning our wheels. We need to tear down the ideological construct and replace it with something that values economic growth, entrepreneurship and markets, but recognizes their limits, recognizes the role of the democratic institutions to intervene in markets, and remember that economic growth is only useful insofar as it elevates the human condition, not as fulfillment of biblical prophecy or to validate a particular economic thinker or school of thought.

Now I think Megan, at least in this piece, is sincere in her effort to grapple with what are uncomfortable questions for someone as far down the libertarian rabbit hole as she usually is. But the truth is that most of the people that are pimping the ideas that the Community Reinvestment Act is responsible for this horrible mess because of its liberal hippie meddling and forcing banks to lend white people money to non white people who then turned around and bought McMansions on credit and theen spent government money on guns, Malt liquor, and crack ho's they rented from Huggy bear the pimp are cynical douchebags who should not be taken seriously and probably should be frog marched into a rocket and launched into the Oort cloud to mine ice crystals and UnObtainum for the Trade Federation.

But I'm a DFH, so what do I know?

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