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.