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The financial markets are deregulated, banks are “too big to fail”, interest rates were kept low by Alan Greenspan etc…are these the only issues that caused the financial crisis?
Malcolm Gladwell has a very interesting article suggesting overconfidence played a role in causing the bubble that eventually burst. The main protagonist in the story is Jimmy Cayne, former C.E.O. of Bear Stearns. The man was sometimes confident and perhaps over confident:
The high-water mark for Bear Stearns was 2003. The dollar was falling. A wave of scandals had just swept through the financial industry. The stock market was in a swoon. But Bear Stearns was an exception. In the first quarter of that year, its earnings jumped fifty-five per cent. Its return on equity was the highest on Wall Street. The firm’s mortgage business was booming. Since Bear Stearns’s founding, in 1923, it had always been a kind of also-ran to its more blue-chip counterparts, like Goldman Sachs and Morgan Stanley. But that year Fortune named it the best financial company to work for. “We are hitting on all 99 cylinders,’’ Jimmy Cayne told a reporter for the Times, in the spring of that year, “so you have to ask yourself, What can we do better? And I just can’t decide what that might be.’’ He went on, “Everyone says that when the markets turn around, we will suffer. But let me tell you, we are going to surprise some people this time around. Bear Stearns is a great place to be.’’
Gladwell connects overconfidence to success at some games people play in nature and refers to work by biological anthropologists. This all seems quite interesting and I can see chasing it up for fun. But he then goes on to try to connect Cayne’s overconfidence to his success at bridge – appreantly he is an excellent player and it helped him get his job at Bear Stearns. This is a disconnect. Bridge is a zero-sum game. Behavioral biases such as overconfidence lead people to make mistakes and hence lose out more than people who judge hands correctly. If Cayne is good at bridge, he must judge probabilities accurately rather than exaggerating his odds of success. This then implies that he is less likely to be overconfident than others working in finance who are perhaps bad at bridge and poker as they are overaggressive.
So, while Gladwell may have a point to make, he does not do it convincingly as his main example concerns a protagonist who is less likely to be overconfident as he is good at zero-sum games.
Goldman Sachs and JP Morgan have quickly returned the money they got from the government. The CEO Of JP Morgan sees it as a badge of honor:
Amid the surge, Jamie Dimon, JPMorgan’s chief executive, has cemented his status as one of America’s most powerful and outspoken bankers. He has vocally distanced himself from the government’s financial support, calling the $25 billion in taxpayer money the bank received in December a “scarlet letter” and pushing with Goldman Sachs, Morgan Stanley and others to repay the money swiftly. Those three banks repaid the money last month.
Whether a bank returns the money quickly and even if they never got any of it, the bank gained from the intervention. Why? Because if AIG, to name the key firm, had gone down, the chain of interlinked insurance contracts that it sold would have been worth nothing. This would impact the whole financial system, including Goldman Sachs etc. That’s why credit was coming to a halt as no-one knew the value of the insurance contracts that were supposedly providing a safety net.
So, taxpayers bailing out AIG helped all these banks, even those who did not participate in the government program. (It’s a classic free-rider problem in public good provision.) So, where’s my Goldman bonus since I helped to save the financial system?
A Slate article reports that in surveys the proportion of people who say they voted for Obama over McCain does not match the results of the election. Of course this panders to my inner economist. I’m interested in how much of the difference can be attributed to outright lying versus self-deception. An outright liar knows he is lying while credible self-deception involves some chance you actually believe the story you tell yourself.
It would be cool to have an experiment that distinguished between the two. Maybe it’s already out there?
Greg Mankiw thinks B-School economists are “practical” and “empirical” while Econ Dept economists are free to be abstract and theoretical.
I don’t think this is true for the research done by economists differs across these two types of schools but it is true that the teaching is different. The MEDS Dept at Kellogg where I work is somewhat different from other business schools as it has always been very theory focused. The Econ group at Stanford GSB is similar. Some of the best work in game theory, contract theory and decision theory came out of these departments.
It is the case, as Mankiw says, that teaching has to be practical and useful in a B School. Whether that drives research or not depends on the philosophy of the school. I have never felt any pressure for my research to be practical.
Mankiw writes his post to answer David Brooks’s query about why B School economists are giving him better answers about the current state of the economy. As finance is a B School specialty, it very natural that B schools profs may know more about what a CDS is without having to look it up on Wikipedia! But again, finance economists are not more “practical” or “empirical” than econ dept economists. I bet Doug Diamond and Milt Harris at Chicago GSB have really perceptive things to say about the financial crisis as has Oliver Hart at Harvard Econ. They will use simple, clear models (hopefully!), to explain their ideas about how to fix incentives in the financial sector. And then maybe somone will give a little theory a chance as much as data analysis!
James Joyce’s Ulysses? The Great Gatsby? Something challenging by Thomas Pynchon? Something whimsical by P.G. Wodehouse?
No, the smart vote goes to Isaac Asimov’s Foundations Trilogy.
The latest fan to come out in public is Hal Varian. In a Wired interview, he says:
“In Isaac Asimov’s first Foundation Trilogy, there was a character who basically constructed mathematical models of society, and I thought this was a really exciting idea. When I went to college, I looked around for that subject. It turned out to be economics.”
The first time I saw a reference to the books was in an interview with Roger Myerson in 2002. And he repeated the fact that he was influenced by Foundation in an answer to a question after he got the Nobel Prize in 2007. And finally, Paul Krugman also credits the books with inspiring him to become an economist. A distinguished trio of endorsements!
Asimov’s stories revolve around the plan of Hari Seldon a “psychohistorian” to influence the political and economic course of the universe. Seldon uses mathematical methodology to predict the end of the current Empire. He sets up two “Foundations” or colonies of knowledge to reduce the length of the dark age that will follow the end of empire. The first Foundation is defeated by a weird mutant called the Mule. But the Mule fails to locate and kill the Second Foundation. So, Seldon manages to preserve human knowledge and perhaps even predicted the Mule using psychohistory. Seldon also has a keen sense of portfolio diversification – two Foundations rather than one – and also the law of large numbers – psychohistory is good at predicting events involving a large number of agents but not at forecasting individual actions.
As the above discussion reveals, I did take a stab at reading these books after I saw the Myerson inteview (though I admit I used Wikipedia liberally to jog my memory for this post!). And you can also see how Myerson’s “mechanism design” theory might have come out reading Asimov. I enjoyed reading the first book in the trilogy and it’s clear how it might excite a teenage boy with an aptitude for maths. The next two books are much worse. I struggled through them just to find out how it all ended. Perhaps I read them when I was too old to appreciate them.
The Lord of the Rings is probably wooden to someone who reads it in their forties. It still sparkles for me.
I’m sipping my morning coffee and glancing at the Sunday New York Times when my 8-year old son asks “What is stillborn?”. I choke on my coffee a bit and open my eyes wider to see a photo of several women in Tanzania burying a tiny stillborn baby on the front page of the paper. After a quick answer that doesn’t invite much discussion I flip the paper over so that the distressing photo is no longer in view. Only to see another photo — this one of a college student feeding a lamb with a bottle in upstate New York — that makes the first photo even more depressing. Apparently in the U.S. we have a surfeit of college educated young people to care for newborn lambs, while in Tanzania (and in distressingly many other places throughout the developing world) mothers and their babies die because there are too few people with the requisite skills to care for them.
The credit card companies are claiming they will have to charge annual fees and cut reward programs for customers who always pay on time because they are being forced to stop ripping off confused customers who incur late fees and sudden doubling of their interest rates. Ed Yingling, President of the American bankers’ association warns:
“It will be a different business,” said Edward L. Yingling, the chief executive of the American Bankers Association, which has been lobbying Congress for more lenient legislation on behalf of the nation’s biggest banks. “Those that manage their credit well will in some degree subsidize those that have credit problems.”
The idea seems to be that since the price is being cut for the people with credit problem, it will have to be increased for those with good credit.
I claim this is does not make any sense and is not going to happen. There are two reasons for this.
To understand the first reason, we must consider why credit card companies charge different prices to different consumers in the first place. This is a form of price discrimination. To people with lots of outside options, you have to give a good deal – this is the rationale for reward programs for good risks. For people with few options, you can afford to raise the price – this is the rationale for high interest rates for the high risk consumers. To implement price discrimination you have to be able to identify people in the two groups. The credit card companies have access to both internal and shared data to do this. You make profits in both markets, with higher profits presumably in the high risk market if you manage the risk correctly. If you cannot price-discriminate because you do not have the information or are not allowed to do so by law, you set a uniform price, hiking up the price to the low risk and lowering it for the high risk. This is the idea Yingling is suggesting. For a monopolist, uniform pricing makes less profit that price discrimination as it is less targeted to cnsumers’ willingness to pay.
The new legislation is limiting the firms’ ability to impose terms on the high risk consumers. So, they will make less money in that segment. But the key point is – legislation is not outlawing their ability to price discriminate. There is no incentive for them to do uniform pricing as they still have the information, ability and incentive to price discriminate. As long as the different segments have different patterns of willingness to pay for credit card services, the rationale for price discrimination is present.
Moreover, there is second reason why fees will not go up – competition. The low risk consumers are profitable as they generate merchant fees because they use their cards frequently. Suppose all the credit card companies cut rewards and/or impose annual fees. Then, one company or another has an incentive to cut the fee or increase rewards to steal customers from another. In fact, this is the most fundamental force keeping fees down and rewards high – the low risk, high volume consumers of credit card services generate revenue. To entice them to get your card, you have to give them rewards up front. The legislation does not change this competitive logic.
So, look forward to more points that help keep up the constant upgrading of your iPod.
(Hat tips: Kellogg MBA students – Aneesha Banerjee, Ondrej Dusek, and Steven Jackson)
My old post about A-Rod colluding with the opposition to massage his stats was drawn from a New York Times article. It suggested that in blow-out games when a few extra runs here or there would not affect the outcome, A Rod would collude with friends on the other side to raise improve their stats and his.
Now a follow-on article in the NYT says a data analysis suggests this did not occur. I personally think A Rod is getting a bad rap and did not cheat. But the statistical analysis does not make a convincing proof of this hunch.
The data say that in low stakes situations A Rod had many fewer runs than in high stakes situations. This leads the NYT to conclude that either there was “no tipping going on or it was pathetically ineffective.”
This when a little game theory is useful. When the game is close, you have the most incentive to exert effort to win. When it is not close, even the likely winner slacks off as there is no reason to work hard. This is the game theory analysis of R and D races for example (though the details are quite intricate and can sometimes be surprising).
This logic meant A Rod would naturally, given the dynamics of the game, have played hard when the game is close. The collusion has a countervailing effect when the game is not close. But this effect may not be large enogh to counteract the natural incentives of competition. So the data do not prove anything. But I still think A Rod did not cheat.
(Another Hat Tip: Pablo Montagnes)
I’m almost beginning to feel sorry for Alex Rodriguez. Everyone is picking on him. The latest strike against him is that he is being accused of collusion. He has an enviable batting record but now it seems the figures may be inflated. Alex is accused of pitch-tipping. Pitch-tipping involves somehow signaling the oncoming pitch to the hitter of the opposing team. According to an op-ed in NYT:
So, according to the latest story, Alex is connected to some pitch-tipping scheme in which he relayed signs to the opposing hitter (if he was a friend) or for someone who would return the favor when he was hitting. This was supposedly done in one-sided games where, in theory, one team had no chance of catching up. Alex was said to be in cahoots with a lot of middle infielders. Allegedly, there was some sign he would relay to the hitter — a movement with his glove or his feet — to let the hitter know what type of pitch was coming and where.
That is, there was “I scratch your back and you scratch mine” equilibrium. No contract is in place to enforce this so it would have to be enforced implicitly over multiple rounds as a repeated game equilibrium. It’s pretty cunning and companies have been known to do it. Alex didn’t need a M.B.A. to be taught it. He learned it in the game of hard strikes.
(Hat tip: Pablo Montagnes, PhD student).
The main logic of torture is to inflict so much pain that the victim reveals all his information to make the pain stop. Incentives for truth-telling in this situation are eerily similar to those in the bank stress tests.
All banks want to report that they are healthy. To distinguish the lying sick banks from the healthy ones there has to be some verifiable information. Healthy ones have this information (e.g. they passed the stress test) and the sick ones do not. The healthy banks have to have the incentive to reveal the information. This is all too clear for the healthy banks: by revealing their results they can avoid bank runs, get liquid, start lending etc.
In the torture analogy, a healthy bank is an informed terrorist with real information of an attack and a sick bank is someone, say an uninformed terrorist, with no information. The assumption of the pro-torture people is that the informed terrorist will have the incentive to report his information to avoid pain. But an uninformed terrorist has the same incentive. To tell one from the other, the informed terrorist’s information has to be verifiable. For example, there has to be “chatter” on Al Qaeda websites that can be used to cross-check the veracity of the torture victim’s confession. If this information is out there anyway, one might ask why torture was necessary in the first place. Presumably, the information is vague or ambiguous. The torture victim’s information brings some clarity.
This process seems heavily error-prone. False confessions may also cross-check by accident. The information is so noisy that a lead that is very weak may be thought to be strong. The more noise there is, the more the victim’s report is uninformative cheap talk – it contains no true information as informed and uninformed terrorists all give information, false and true and impossible to distinguish.
There is a second problem. Once a healthy bank releases the stress test information, the game is over – the market has the information and responds correspondingly. A torture victim faces further torture. There is no way for the interrogator to commit to stop torturing. If the victim knows this beforehand, the victim lies in the first place as there is no way to stop the torture. If the victim finds this out between episodes of water-boarding, the victim might start lying to contradict their earlier true confessions.
The efficacy of torture relies on verifiability of information and the ability of the torturer to commit to stop if good information is revealed. Both properties are hard if not impossible to satisfy in practice.
The federal government owns preferred stock in many of the banks it has bailed out. According to the NYT, it is thinking about converting this preferred stock to common stock. The article also claims that this reduces the need for a further capital infusion and hence the need to go back to a feisty Congress for more money.
How could that be? Isn’t the re-labeling of stocks going to leave banks with exactly the same amount of capital and not change anything? This is just rearranging chairs on the Titanic.
The key sentence is the article is:
The administration said in January that it would alter its arrangement with Citigroup by converting up to $25 billion of preferred stock, which is like a loan, to common stock, which represents equity.
Preferred stock used to recapitalize banks does not come with voting rights but does come with a compulsory dividend. It is 5% now and rises to 9% after five years. In that sense, the preferred stock are more like debt that equity. There is a risk that a bank defaults on this in the same way it could default to other debt holders. Converting it to common stock implies the government gets voting rights but gives up the dividend. This reduces the payments the bank has to make on a regular basis and hence makes it more liquid. This appears to be the main idea. It is good for the banks as their debt obligations are reduced. It makes it more likely they survive.
What about taxpayers? They are taking on more risk as their stake is more junior than before. There are two countervailing effects. First, maybe the probability of bankruptcy goes down as a result of this so the risk goes down. Second, the initial decision to acquire preferred stock may have been politically expedient in which case it did not maximize shareholder/taxpayer value. There is the perception of a big political cost of being seen to nationalize banks. The initial plan reflected this political constraint. This plan is a move to pay this cost to avoid the new political constraint, the cost of going to Congress. So, maybe the Congress constraint is helping Obama to move to the economic optimum from the constrained political optimum as one political constraint cancels out the other.
Continuing to make bold moves in the first 100 days of his administration, Obama will announce this week two blockbuster appointments to senior positions at the Department of Treasury.
Freakonomist
Sure to raise eyebrows will be the appointment of University of Chicago economist Steve Levitt to Tim Geithner’s team. Rarely venturing into the realm of policy, the author of Freakonomics is better known –and often derided– for research focusing more on cute trivialities like cheating by Sumo wrestlers.
Ironically, his foray into Sumo-economics appears to be exactly why he is getting the call. As readers of Freakonomics know, Levitt made headlines when he used the same statistical analysis to expose widespread cheating by teachers in the Chicago Public Schools. How does this help the Department of Treasury you ask? Stress Tests. The big headline of Geithner’s first announcement as Treasury Secretary was the promise to screen out banks doomed to fail. Strangely, Treasury has since been mum on the results from the stress tests. Now we know the reason: it turns out all the banks are getting passing marks and the suspicious Treasury Secretary is calling on Levitt to bring his Sumo-scrutiny to bear on the banks.
Colleagues at the University of Chicago economics department are cheering the move. “I could not think of a better choice than Steve Levitt to move to Washington and help the Obama team” says Nobel Laureate James Heckman, adding that he expects the job to occupy Levitt for two full Obama administration terms. “We will miss him, but he has an important job to do.”
When we finally reached Levitt, he was at McDonalds headquarters at Oak Brook, IL. Some of their franchises have been cheating by hiding Big Mac revenues that they have to share with McDonalds. Levitt has found a way to benchmark performance that can reveal suspiciously underperforming locations. “This is what economists call ‘moral hazard,’ ” Levitt said over a carton of Chicken McNuggets. “Look, economics is not rocket science. Think of the US Government as like McDonalds, a bank and a toxic asset are just like a franchisee and a Big Mac. Once you see it that way, its simple.”
Former Bushie
Joe Lieberman supported John McCain during the election, made a speech at the Republican Convention and said Obama was not ready for the Presidency. And yet Obama later forgave him because he knew Lieberman’s vote was going to be crucial in the Senate.
Now, Obama has shown the same pragmatic streak in inviting Greg Mankiw to join his administration. Mankiw was the head of Bush II’s Council of Economic Advisors. He has so far played a role on the sidelines, an informal referee of the contest between Obama and his right-wing critics. Mankiw is often skeptical of Obama’s plans but at the same time he does not fully endorse their antithesis. This ambiguity has suited Mankiw well, as he has been courted by both sides of the political spectrum. Finally, he has chosen his prom date and decided to join the Obama administration. He will serve alongside his old Harvard colleague Larry Summers as Co-Director of the National Economic Council.
Why did Obama choose Mankiw for this post?
Mankiw said, “Well, in all modesty, I must point out that I proposed something like the Geithner plan – of course, I call it the Mankiw plan (!) – last October. There are some differences in the details but the principles are the same. I’m looking forward to improving the plan and being involved in its implementation. Whenever you are asked to serve your country, I think you should do it, even if there are ideological differences with some of the people involved.”
The additional intellectual heft of having Mankiw on board will certainly help in the coming months. Mankiw is also quite familiar with the rump of the Republican party that is still left standing in Congress. He is one of the rare individuals who has a good relationship with both John Boehner and Mitch McConnell. McConnell and Mankiw were bridge partners and they have the camaraderie and preternatural ability to wordlessly communicate that comes from expertize at that genteel but vicious game. But Mankiw can also be a populist and is a great expositor of complex ideas, a fact that Obama hopes will help in persuading at least some House Republicans to occasionally vote for some of his economic plans.
There is another factor at play. True to predictions, Larry Summers has proved hard to control within the West Wing. Orzag and Geithner have not been able to do it. In any case, they are fantastically busy trying to implement Obama’s healthcare policies and manage the financial crisis. Furman and Goolsbee , who were both students in Cambridge, are in awe of their former teacher and find it hard to contradict him. Summers and Mankiw respect each other, or at least Mankiw respects Summers! Obama has watched Biden and Clinton argue over Afghanistan policy. As a lawyer, Obama has always favored the “team of rivals” approach and wants to replicate it in economic policy.
Only one thing stands in the way. Mankiw has amassed a huge fortune by selling economics textbooks all over the world. He is incorporated in Switzerland as a Verein for tax purposes. A verein is an association of independent businesses and each international textook is an independent “firm” within the Mankiw Verein. This has several tax advantages and seems to be all quite legal. But with the current furor over AIG bonuses the administration wants to tread carefully.
Jeff and Sandeep
A recent Slate article “The messy room dilemma: when to ignore behavior, when to change it” by tackles the important topic of when you should ignore your child’s undesirable behavior and when you should intervene. The authors use a series of intriguing percentages to suggest that many childhood behaviors will change on their own if you just wait long enough. Here’s an excerpt:
Many unwanted behaviors, including some that disturb parents, tend to drop out on their own, especially if you don’t overreact to them and reinforce them with a great deal of excited attention. Take thumb sucking, which is quite common up to age 5. At that point it drops off sharply and continues to decline. Unless the dentist tells you that you need to do something about it right now, you can probably let thumb sucking go. The same principle applies for most stuttering. Approximately 5 percent of all children stutter, usually at some point between ages 2 and 5. Parents get understandably nervous when their children stutter, but the vast majority of these children (approximately 80 percent) stop stuttering on their own by age 6. If stuttering persists past that point or lasts for a period extending more than six months, then it’s time to do something about it.
There are a lot more behaviors, running the range from annoying to unacceptable, in this category. Approximately 60 percent of 4- and 5-year-old boys can’t sit still as long as adults want them to, and approximately 50 percent of 4- and 5-year-old boys and girls whine to the extent that their parents consider it a significant problem. Both fidgeting and whining tend to decrease on their own with age, especially if you don’t reinforce these annoying behaviors by showing your child that they’re a surefire way to get your (exasperated) attention. Thirty to 40 percent of 10- and 11-year-old boys and girls lie in a way that their parents identify as a significant problem, but this age seems to be the peak, and the rate of problem lying tends to plummet thereafter and cease to be an issue. By adolescence, more than 50 percent of males and 20 percent to 35 percent of females have engaged in one delinquent behavior—typically theft or vandalism. For most children, it does not turn into a continuing problem.
The logic would seem to be don’t worry about the thumb sucking, the stuttering, the lying and so on. It will probably go away on its own and look there are many statistics to back this up … but this is a total fallacy. Suppose all of the statistics are completely accurate. It still doesn’t follow that they suggest you should just ignore behavior that you deem to be a problem.
I am guessing that most parents faced with unwanted behaviors like thumb sucking, stuttering, lying, and certainly, theft or vandalism intervene in some way, possibly many parents even “reinforce them with a great deal of excited attention.” The percentages reflect the impact of this intervention as well — 50% of adolescent boys do something delinquent, their parents justifiably freak out and only a small number do it again. This decidedly does not argue for doing nothing when you are concerned about your child’s behavior. We don’t know what fraction of young vandals would become repeat offenders if their parents ignored their behavior. All we know is that when the typical kid misbehaves and his or her parents react in a typical fashion, the behavior eventually goes away most of the time. The statistics are mute on whether this is because of, or in spite of, parental intervention.
The most painful decision in the publication game is the rejection that could easily have gone the other way. These are more heartbreaking that the clear rejections where you know you had no hope of getting in. Part of the pain comes from the fact that you now have to submit to a totally different journal and start all over again with new referees.
Well, now there is an idea whose time has finally come – the simultaneous submission to multiple journals. I must point out that this basic idea is at the heart of the BE Press Journal in Theoretical Economics, of which I am a Co-Editor. I can do this in all modesty as the idea came not from me but from Aaron Edlin and his fellow journal creators. Something like this has been adopted by the American Economic Review (AER), which now has five field journals (Econometrica will soon have two, including one currently Co-Edited by Jeff).
The procedure adopted by the AER is that if you submit to one of their field journals you can transfer your referee reports to the field journal. More importantly, you can ask to have your original referees’ cover letters to the original Editor also transferred. The cover letters presumably have an honest opinion of the paper that is very useful to the new Editor.
If this all works out, you avoid the problem of having to start over again. Plus, you save on total refereeing time as new sets of referees do not have to comment on the paper. (This is the other time-consuming part of academic life!)
But there is a missing market still. Referees may say: This paper is not appropriate for AER but may be appropriate for Econometrica. And they may be right. But you cannot transfer AER reports to Econometrica or vice-versa. This sort of transfer would also be huge in terms of increasing referee and author welfare. Jeff should work on it.
Suppose a bank is “too big to fail”. It’s got some bad assets that the government wants to buy so the bank becomes liquid again and people are willing to lend to it. But the assets come in different qualities and the government would like to buy them at different prices to minimize the loss to the taxpayer. It might want to pay a low price for the really bad stuff and a medium price for the medium bad stuff etc. If it knew the quality of the assets , no problem – you can just pay different prices for different qualities. But if the bank knows the quality it would try to palm off bad asset as a medium quality asset to get the better price. The standard solution to this is to use inefficiency to “screen” different types of assets. For example, the government says it is willing to buy a lot at the low price but less at the high price.
You have to set the quantity traded carefully so there is no incentive to sell the bad assets at the medium price as the amount the government would buy is too small to make it worth it.
All well and good it seems but remember this bank is “too big to fail”. So, here’s what can happen: The bank sells bad assets to the government pretending they are medium assets. It keeps the bad assets the government does not buy. If they tank, guess what, as it’s too big to fail, the bank can dump the assets on the government anyway. So, in the end, this scheme does not work, the government ends up buying medium and bad assets at the medium asset price.
I haven’t worked this out, but it seems to be what when banks are too big to fail this is what’s going to happen whatever you try to do: you end up paying high prices for bad stuff and there’s nothing you can do about it. (Morally speaking, I’m replicating an old argument of Dewatripont and Maskin’s on the “soft budget constraint.”) The banks are happy as they get lots of surplus and the taxpayers pay a high price for liquidity. The fact that the government has a social motive, saving the financial system, makes it impossible to eliminate adverse selection.
One solution might be just to find out the quality of the stuff you’re buying directly by auditing the asset value carefully. Of course, you might have to rely on the bank for information and then they manipulate it and we’re back where we started.
What then is fair to taxpayers and saves the financial system? Some equity ownership in the banks for the taxpayer. Otherwise, all the surplus goes to the banks.
Why should we bail out big banks? Capitalism and Darwinism are closely related – only the strong survive. Bailing out the weak and unprofitable wastes resources and reduces efficiency, undermining the benefits of capitalism.
One response to this perspective is to get all lovey-dovey like David Brooks on one of his bohemian days. Embrace social Darwinism rather than the selfish gene. Bail out your fellow man as he is your fellow man.
But there is s a much simpler and standard explanation: externalities. If a small firm goes under there’s no problem. The depositors are insured and the main burden falls on the management and employees of the bank itself. They should not be rewarded for bad decisions. That would be bad for incentives and efficiency. Capital and labour flows to better uses.
If a big bank goes under, there is a ripple effect thoughout the economy and we start hurting good businesses who are not to blame for bad decisions by the big bank. This reduces output more than justified on efficiency grounds. And this justifies intervention. It has nothing to do with hurting for your fellow man – it is hard-headed economic calculation.
Unfortunately, this creates an additional incentive problem. If big banks know they are going to be bailed out, they have the incentive to take on risky projects that payoff big when they succeed as they get bailed out when they fail. They do not fully internalize the impact of their decisions. This is like the classic problem of the polluting factory that does not fully suffer the environmental impact of its pollution.
What is the solution? Eric Maskin and Roger Myerson (Nobels 2007) either hint or are explicit about their answers. Some kind of regulation is necessary. Banks might be forced to have larger reserve requirements as they become big. Or it might simply not to be allowed.
So, to summarise: we have to bail out big banks as their failure has large, external effects. Because of this, to prevent moral hazard, we either have to regulate to keep banks small or impose higher capital requirements so they grow responsibly.
This ideas are simple but it’s great to see Sheila Bair, head of the FDIC, embracing them. Maybe the ideas are in fact not that straightforward as they do not fall easily into the “markets are good” markets are bad” dichotomy. Free markets are sometimes bad is a more complex message. But I think it is the slightly right-of-centre philosophy that someone like David Brooks should embrace.
I had the privilege to introduce Larry Lessig at a Kellogg Distinguished Leader talk. He is famous as an exponent of “open source” software and websites, like Mozilla Firefox, UNIX, Wikipedia etc. These institutions work a bit like academia. Many things we do as academics, and even academic economists(!), involve free labor. Refereeing comes to mind first of course but editorial work is hugely onerous and often unpaid. People who do all this work for free seem to contradict the basic rational selfish actor model of economics. The rational actor is flexible enough that it can be “jazzed up” to make these facts consistent with selfishness. Maybe your papers get better refereeing if you referee well, publishing your papers in good journals leads to outside offers which leads to higher pay etc. etc.
But why employ a convoluted explanation when the obvious one is available? People do all this stuff for free because of the prestige, the power and the fulfillment from affecting the direction of research of entire fields of research. In our case, Jeff and I are doing this because we’re vain enough to think our random musing are interesting and useful. I’d be at the New York Times website as usual right now if I weren’t doing this so why not?
Similar motives underlie the development of open source software and websites. It’s got to be pretty cool to have been behind UNIX, LATEX etc. And the stuff that has huge positive impact on welfare in much the same way as academic science has had huge impact on knowledge. Both systems use a confusing mix of monetary and non-monetary incentives.
Larry Lessig made his mark initially by advocating looser copyright laws to facilitate this kind of free exchange of ideas. He helped to set up the Creative Commons project at Stanford. He worked on various cases to reduce extension of copyright laws. But he hit a roadblock. Special interests with an interest in protecting their monopoly power lobbied Congress, funded political campaigns and prevented his ideas being put into action. Even commonsensical ideas (e.g. promoting reduced sugar intake) were killed off. Larry realized the fault lay with our political system and has set out to reform it. He and Joe Trippi have joined up to advocate for campaigns being citizen-funded rather than funded by corporations – see Change Congress.
This was the content of his talk. I do not know if this scheme will work. First, it’s going to depend on how much money politicians raise from regular people versus special interests. Obama was very successful at energizing donations but other politicians are not. If they do rely on individual donations, then there is some leverage. But why do people may donations? There is a huge free-rider problem in voluntary donations so the be must be some non-economic factors at work. In my case, the one and only time I contributed, I felt as if I was paying to support my favorite sports’ team. Just like I might buy Bulls’ T-shirts, stickers and memorabilia, I bought Obama stuff even though I knew my contribution was minor and I could buy wine with it instead! I don’t think people like that are going to be dissuaded by Change Congress. But perhaps some people are driven by political philosophy when thye donate. If this is correlated with wanting to change congress this might Lessig-Trippi proposal might work. I hope so. Because Lessig’s main point is basic but fundamentally true.
Finally, I must turn to style. Larry’s talk is by far the best talk I have ever attended. I was blown away by Gore’s Inconvenient Truth presentation. As a B school prof I’m always impressed by Powerpoint slides! I never saw Gore’s talk live. Lessig I saw live and this is the best talk I have ever witnessed in person. To get a flavor, see here. I must sign off and work on my slides for next 1/4.
My first job after grad school was as a Research Fellow at King’s College, Cambridge. It was then that I first came across Wynne Godley. I was an undergraduate at St. John’s almost a decade earlier but I do not have any memory of him from that time. Wynne is a little like my imagined Lord Emsworth from the P G Wodehouse Blandings novels. Wynne was famous or infamous, depending on your point of view. Many rumours circulated about him and I will repeat some of them here.
My favorite is that the character of Tigger in Winnie the Pooh is based on Wynne Godley. It is claimed that Wynne went to school with Christopher Robin Milne. A A Milne is meant to have encountered him there and seen a little Tigger in his soul. Unfortunately, I don’t think this one is true because Wynne went to Rugby and Milne went to Stowe. Also, the Wynne I met was more like Eeyore than Tigger. I could be remembering the original story incorrectly and perhaps it is Eeyore that Milne saw in Godley. Anyway, I dearly, dearly hope this story is true. If not, let’s repeat it anyway so future generations believe it.
A second story is that the statue of St Michael outside Coventry Cathedral is based on Wynne Godley. Wynne was quite good-looking in his younger days. It is true that Godley married, Kitty, one of the daughters of Jacob Epstein, the sculptor. Epstein is responsible for the statue in question. And you can find the odd informed person to support this story.
The third and final story links it all back to Roubini. My Kevin Bacon number with respect to Roubini is two and I did meet him in person about ten years ago. I can report that he used to be a little bit Tigger-like himself. His current Dr Doom incarnation is more Eeyore-like. Jeff pointed out this story which suggests he still has a little tiger in him. The main connection between Godley and Roubini is macroeconomic forecasting. Godley spent his career trying to develop a macroeconomic forecasting model in the style of Lawrence Klein but built on old Keynesian ideas. Eventually, he had a column in some British weekly magazine (the New Statesman?). All of his forecasts were gloomy and he was often wrong. But there was a point where Godley’s model predicted slump, other models predicted boom and there was an actual slump! His name was made. When I met him, we was one of the “Six Wise Men” advising H.M. Treasury on their forecast. The Treasury was under attack because its forecasts were so often wrong. So, in a brilliant move they appointed six critics who had their own crazy forecasts. This allowed them to show how often these critics were wrong and the Treasury was right. Obama should do something like this. Get the guy from the Club for Growth, Mankiw, Roubini, Krugman, someone from Cato etc to join some official forecasting group. Have them nail their colors to the mast and screw up.
Let’s face it, this is not really a blog entry about forecasting but about a certain type f academic. I am impressed by what Roubini has built for himself and all the other successful econo-bloggers too. But they and I all lack the flair of a Wynne Godley. No “top five” publications to his name but quite a life. I think it”s possible to have both. Creativity certainly helps in doing top-shelf research. And I’m going to pretend to be Tigger for the rest of the day and try to get rid of my natural Eeyore.
Cheap Talk 