This is the second in my new occasional series of reflections on some of the root causes of the global economic crisis. As is probably evident from the first one, I’m not going to try to identify the cause of the crisis, or even render particularly analytical judgments about the relative importance of various contributing factors. Instead, I’m more just presenting and thinking about some of the forces that were at work.
One of the singular features of the last decade was the U.S. housing bubble (replicated elsewhere, such as the U.K. and Spain, but nowhere on such a grand scale), which was accompanied by a broader though not quite as frothy bubble in asset prices overall, including the stock market. One of the standard explanations is that bubbles are created when greed takes over from fear: people see prices rising, and at first their fear of getting burned keeps them on the sidelines, but as the bubble continues and other people get rich their own greed increases until it wins out over fear, and they buy into the bubble as well. As a result, some say, we are bound to have bubbles periodically, especially when new investors (young people), who have never experienced a crash, come into the market.
There is psychological research that not only backs all of this up, but goes even further and says that bubbles are a virtual certainty. Virginia Postrel has an article in The Atlantic that centers on experimental economics research by people such as Vernon Smith and Charles Noussair. In one experiment, investors trade a security that pays a dividend in each of 15 periods and then vanishes; the dividend in each period will be 0, 8, 28, or 60 cents with equal probability, so the expected dividend is 24 cents, and there is no time value of money (the whole experiment takes an hour). Despite the fact that the fundamental value of the security is absolutely, completely, easily knowable, bubbles develop in these markets . . . 90% of the time. When the same people repeat the same experiment, the bubbles get gradually smaller; but simply change the spread of dividends and the scarcity of the asset, and the bubbles come back with full force (so much for experienced investors).
The implication is that if you put people in front of a market that is behaving a certain way, you are going to get a bubble. It’s not simply a question of not understanding the fundamentals, or getting suckered by real estate brokers, or trying to keep up with the Jones’s new McMansion (although all of these can help amplify the bubble); people are just wired to create asset price bubbles. The fact that we have so few of them is probably a reflection of the size of asset markets (it takes longer to get millions of investors bought into a bubble than a few dozen) more than anything else.
Certainly there are things that we (or policymakers, rather) can do about bubbles. If they see a bubble building, they can try to talk it down, or try to make money more expensive, or start selling lots of the thing that is appreciating quickly. But this hinges on two things: the ability to spot the bubble, and the will to do something about it. It’s not helpful to have a belief on principle that asset prices are always rational, because then you will never do anything about them. (As an aside, perhaps one solution would be to have some form of market intervention that is automatically triggered when some class of assets accelerates beyond a predetermined threshold – precisely to eliminate the ability of policymakers to convince themselves that “things are different this time.”)
But the broader point, I think, is that it’s not that useful to say the bubble happened because people were stupid, or greedy, or irresponsible. Yes, people can be stupid, greedy, and irresponsible, but you have to take people the way they are; mass psychological reeducation is not an option. And even if you could reeducate them to the point where they all fully understood the assets they were trading, there would still be bubbles. The issue to focus on is what regulatory policies or systemic changes can limit the incidence and cost of bubbles. (There’s an argument to be made that individuals should not be managing their own investments, since on average they just destroy value. But in an individualist, free-market society like ours, that argument will never fly.)
Besides the greed of the common man, though, much more has been made of the greed of the Wall Street banker. One argument, heard often around the time of the voting on the initial bailout bill, was that the financial crisis was caused by greedy bankers (and mortgage brokers, and hedge fund managers, and anyone else involved in the securitization chain) who created exotic new financial instruments and took on excessive risks in order to make lots of money for themselves. This has never satisfied me as an explanation. As I read somewhere, greed is like gravity. (I tried to look that phrase up to see whom to attribute it to, but apparently it’s a commonplace with no known source.) Blaming a financial crisis on greed is like blaming an airplane crash on gravity. Sure, there may be some correlation between greediness and working in certain parts of the financial services industry. But take people randomly off of Main Street and put them in that position – where most of your compensation is in a year-end bonus, and your bonus depends on the volume of business you do that year, not on the long-term profitability of that business, or on the success and satisfaction of your customers, and no one can take that bonus away from you in the future – and I wouldn’t bet that they would behave any differently.
Henry Blodget – yes, that Henry Blodget – has a variant of this argument in an article also in The Atlantic (yes, I’m a subscriber, and I finally found a few minutes to look at the latest issue). After the usual explanation of bubbles, he looks at things from the Wall Street perspective.
Professional fund managers are paid to manage money for their clients. Most managers succeed or fail based not on how much money they make or lose but on how much they make or lose relative to the market and other fund managers. . . .
In the money-management business, therefore, investment risk is the risk that your bets will cost your clients money. Career or business risk, meanwhile, is the risk that your bets will cost you or your firm money or clients.
The tension between investment risk and business risk often leads fund managers to make decisions that, to outsiders, seem bizarre. From the fund managers’ perspective, however, they’re perfectly rational.
This is similar to my earlier theory about why banks won’t lend. It’s also similar to Andrew Lo’s explanation of why chief risk officers didn’t clamp down during the bubble. Basically, the incentives are such that it is more valuable to you or your company to be doing roughly what everyone else is doing than to do what you think is right (not in the moral sense, but in the profit-maximizing sense). We thnk the capitalist system is wonderful because all firms act to maximize their profits (and I do think that capitalism is the best economic system around, if that phrase even means anything), but the fact is that firms are made up of people, and the connection between the interests of those people and the interests of their firms is indirect at best. OK, I’ll cut off the tangent there; the rest of that thought will have to wait for another post.
In any case, the question isn’t how to make bankers less greedy, but how to create incentives that better align their personal greed with the interests of their firms and their clients. And how to do it without doing things that are possibly unconstitutional – like simply banning certain forms of compensation – or that have all sorts of unanticipated consequences. Maybe strict limits on executive compensation would do the trick. I know the argument that this will deter talented people from entering the industry, but – and the business world is one place where I do have a lot of experience – the difference in “talent” between CEOs and people one or two levels down is minimal if not negative. (Rakesh Khurana has a book on the distorted market for CEOs, and either he or Jim Collins – can’t remember which – has evidence that companies would be better off promoting people (who have never been CEOs) from within than shopping on the CEO market.) Put another way, I think there are plenty of hardworking, bright, experienced people in banks today who would be happy to be senior executives for a mere $1 million per year.
In the end, this is all probably pretty obvious: don’t blame people for being the way they are, and instead try to create structures and incentives that will protect them (in general) from themselves (in particular). More on that another time.
The Baseline Scenario 
Greed, herd mentality, and easy money all seem to be ingredients of a bubble. Yet, not all bubbles are the same.
For one, most bubbles, when they burst, do not threaten to bring the entire American financial system to its knees, as the current housing crisis has done. What about the housing bubble caused it to have such a devastating impact on the financial system?
It seems the entities losing the most money are the commercial and investment banks which originated the securities at the root of the problem. Yet, these are the very institutions which should have understood the enormous risk inherent in these securities.
The basis of the problem securities are subprime mortgages. Someone who gets a subprime mortgage has a poor credit record, puts little or no money down, pays a large portion of his or her income towards the mortgage, and has an interest rate which adjusts upward after a period of time, thus almost guaranteeing default. How can securities based on subprime mortgages ever be rated Aaa, even at the top tranche of the mortgage pool? How could bankers, who are supposedly experts in housing and mortgages, not understand what is now so obvious to everyone?
Well, ya gotta keep dancing while the music’s playing, I guess. Somehow that doesn’t quite explain it.
What is even harder to comprehend is that the institutions which were responsible for rating these securities totally failed in that job. Moodys, Fitch, and S&P blew it big time.
I believe that if these three companies had done their jobs by objectively analyzing these securities, there never would have been this financial crisis. An objective analysis of the subprime securities would have thrown cold water on the subprime market long before it really got going.
Apparently the problem was a conflict of interest. The rating agencies were payed by the very organizations whose securities they were rating. The NYTs article, “Debt Watchdogs: Tamed or Caught Napping?”, gives a pretty good overview of the situation. See http://www.nytimes.com/2008/12/07/business/07rating.html?scp=2&sq=moodys&st=cse.
Conclusion: The financial system needs a securities rating system where there is no conflict of interest. Moodys, Fitch, and S&P need to be reimbursed for their ratings in a different manner.
Based on the research described in the article, the rating agencies only did what should be expected of them given their incentives, which is the same sort of behaviour exhibited by mortgage brokers, wholesales, bankers, investment dealers and anyone else in the long chain of sub-prime mortgages, CDOs,CDSs etc. It seems quite logical that the vast majority of people would respond to their incentives which is, of course, the whole reason why they are designed as “incentive” systems in the first place. The challenge is to design incentive systems that reward the appropriate and desired behaviour and, since no incentive can do it all, to complement them with other systems of regulation, accountability, values and measurement that temper the extremes of behaviour that might otherwise result. The key challenges are related to the effectiveness of an integrated set of regulatory, governance, and incentive systems supported by a flexible, pragmative approach to markets that is not restricted by a dogmatic adherence to some percieved “the free market will correct all” perspective
In the final analysis, its the regulators that failed us. It is the job of capital market regulators to protect society against systematic risk, to constrain economic agents (who are by definition greedy, selfish and self-serving) from taking actions which might, either jointly or individually, sink the whole economy, just as the captain of a ship must prevent passengers and cargo from all amassing on one side of a ship. In the final analysis, all of the regulators sold their souls to Wall St.
Wow. Have economists finally succumbed to the ‘post-modern’ belief that our perceptions as individuals are interdependent, that ‘truth’ is defined socially and depends on the context?
Otherwise nothing new here.
Bubbles occur when a group overestimates its ability (and morality), and closes its mind to contradictory information in order to maintain conformity (see Janis Groupthink: Psychological Studies of Policy Decisions and Fiascoes, 1982) or when a group makes a collective decision that is riskier than any member would have taken individually (see Stoner Risky and Cautious Shifts in Group Decisions: The Influence of Widely Held Views, 1968).
But I think it too fatalistic to conclude that bubbles are inevitable. To counter conformist tendencies you need an environment that encourages the expression of dissimilar views (a Yala), and organizational Ghostbusters to play the role of devil’s advocate, looking out for missing information, doubtful assumptions and flawed reasoning.
… “But I think it too fatalistic to conclude that bubbles are inevitable”
.. mate what are you on about? bubbles have repeated throughout the last 500 years, this is just another.
… “But I think it too fatalistic to conclude that bubbles are inevitable”
.. Geoffey what are you on about? Asset bubbles have repeated throughout history, this is just another. At the peak of the tulip bubble people were swapping their houses for flower bulbs.. there will be plenty more to come.
Read Kindelberger manias panics, crashes.
The fact that changing attributes of the same asset results in a “new” bubble and therefore the experienced people behave the same. Since this attribute of human behavior has now been clarified, (which leads to the fact that the bubble is an inevitable entity), we should put it in the same category as “natural disaster”. I mean you cannot predict it, it wreaks havoc, and the next one does the same. The conclusion is that business schools should not be teaching about “Oh, that was a bubble and its causes”, but a course on “How to ReBound After a Bubble”, similar to “How to Build Your House After a Typhoon.”
Well, to take the analogy further, you can still track hurricanes, forecast where they are going to land, build structures that can withstand hurricanes, make people who build in hurricane zones pay appropriate insurance premiums, evacuate people to safety when necessary, etc.
There were housing bubbles elsewhere, including Spain and UK, and even perhaps of larger magnitude, but it seems the US housing market had specific characteristics (legal, fiscal, regulatory, market organization…) that lead to the crash, as explained in The Housing Market Meltdown: why did it happen in the US (http://www.bis.org/publ/work259.htm)
Here’s a question: those countries or situations where there WASN’T a bubble… why did that happen? I have my own theory (it’s all down to austerity and morals) but it’s an interesting observation, don’t you think?
I blame the economists. If we knew how economies work this never would have happened.
Also maybe we need additional incentives besides money. Economists work for Nobel Prizes, not for money.
Kondratiev (spelling varies) strikes again, possibly about ten years later than might have been expected on a stricter timetable.
Agreed with Simon almost on everything here. The interesting question is: how will a system that aligns personal greed with the greater good of the institutions they work in be put in place? Well, certainly you can’t have governments dictate how Wall Street firms pay their people. You would think that that role should be played by free market forces through shareholder. But interestingly, that does NOT happen. Look at the situation at Merrill Lynch. The guy who essentially sank the firm – Stan O’Neal is walking away with >$100mm. The person who was brought in to fix it (and who did a marvelous job at it) – John Thain will not be paid. AND this is overwhelmingly the sentiments of Merill’s shareholders. So a smart person working in the industry will draw the only logical conclusion – that it’s better to be Stan than to be John. The problem is a little bit more than alignment of interest, although that is probably the biggest one. The problem is also that in a highly complex system where transactions are built in with principal agency interactions, the agency problem has to be solved. It is particularly difficult with information asymmetry, lack of transparency and high costs associated with obtaining the information from which to make rational decisions.
I commented above: “But I think it too fatalistic to conclude that bubbles are inevitable”
Anonymous asks “.. mate what are you on about? bubbles have repeated throughout the last 500 years, this is just another” and so does mike “Geoffey what are you on about? Asset bubbles have repeated throughout history, this is just another. At the peak of the tulip bubble people were swapping their houses for flower bulbs.. there will be plenty more to come.”
OK, this is what I am on about. Of course there have been bubbles and there will be again. Sure people behave irrationally at times but merely to accept this is a counsel of despair. There are deep causes to the global economic crises and social psychology can aid economics, accounting and finance in helping us understand them, and the whole purpose of better understanding is to help us mitigate the risk of them happening again.
An accessible source of insight from this perspective is the excellent BBC series by Adam Curtis “The Century of the Self” , that you can download for free from the Internet Archive (www.archive.org search “century of the self”). If you missed it, watch it now. There are four programs of one-hour each. If you are only going to watch one, watch number four.
This last part describes how politicians took up “focus groups” and the consequences. It’s possible to argue that the global economic crisis is the result of governments’ indulgence of the view that everyone can be anything, do everything and have everything they want. Here is the conclusion to that series:
“Fundamentally, here we have two different views of human nature and of democracy.
“You have the view that people are irrational, that they are bundles of unconscious emotion. That comes directly out of Freud, and businesses are able to respond to that. That is what they have honed their skills doing. That is what marketing is really all about. What are the symbols, the images, the music, and the words that will appeal to these unconscious feelings?
“Politics must be more than that. Politics and leadership are about engaging the public in a rational discussion and deliberation about what is best, and treating people with respect in terms of their rational abilities to debate what is best.”
Two things have happened since that series was produced. First were the moves to encourage personal indebtedness – to keep the “dangerous crowd” hard at work and therefore more docile – that have culminated in the global economic crisis. Second came 9/11 which turned national security into a party-political issue, giving US and UK governments the pretext to vastly reduce the human rights of their people in the name of homeland security (see Naomi Klein’s provocative “The Shock Doctrine”).
When Christian Barnard was asked why, knowing the risks, he could contemplate pioneering heart-transplant surgery, he replied “because I’d rather put may faith in God than in the Devil”.
It’s true that people behave irrationally at times. But they can also behave rationally. It’s because I prefer to put my faith in people’s rational abilities that I am not so fatalistic, and that is why I have recommended books such as Weick and Sutcliffe’s most excellent “Managing the Unexpected: Assuring High Performance in an Age of Complexity” (2001) in earlier comments on this blog. It ought to be compulsory reading for all bankers and regulators, indeed for all managers who are have to cope in these disheartening times.