Having just begun The Sense of an Ending by Julian Barnes, I wanted to share a wonderful excerpt. While this student is commenting on the origins of the First World War, his comments take us far beyond.
“Indeed, isn’t the whole business of ascribing responsibility a kind of cop-out? We want to blame an individual so that everyone else is exculpated. Or we blame a historical process as a way of exonerating individuals. Or it’s all anarchic chaos, with the same consequence. It seems to me that there is–was–a chain of individual responsibilities, all of which were necessary, but not so long a chain that everybody can simply blame everyone else. But of course, my desire to ascribe responsibility might be more a reflection of my own cast of mind than a fair analysis of what happened. That’s one of the central problems of history, isn’t it, sir? The question of subjective versus objective interpretation, the fact that we need to know the history of the historian in order to understand the version that is being put in front of us.”
Can’t we substitute economist for historian in the excerpt? And might this student’s comments about “ascribing responsibility” refer also to our recent financial crisis?
Sources and Resources: The excerpt is from p. 13 in the paperback edition of The Sense of an Ending, winner of the 2011 Man Booker Prize. You might also enjoy this econtalk podcast on “Truth, Science and Academic Incentives” and this one on “Science, Replication and Journalism.” Both podcasts take you to academic bias and relate to Daniel Kahneman’s discussion of confirmation bias in Thinking Fast and Slow, p. 80-81.
Posted by: adminEcon
Tags: belief, causation, confirmation bias, Daniel Kahneman, economists, financial crisis, First World War, great recession, historians, Julian Barnes, The Sense of an Ending
Having experienced an economic calamity, don’t we just need to figure out how to prevent it from happening again?
Yes…but that might be impossible.
MIT economist Andrew Lo read 21 books on the financial crisis. 11 were from academics, 10 from journalists and one was written by former Treasury Secretary Henry Paulson. Comparing the dates, the problems, the solutions that deal with the events of 2006-2009, here is what Dr. Lo learned:
There is disagreement about when the crisis began:
- Mid-2006 when the housing bubble crested?
- Late-2007 with the liquidity crunch in the shadow banking system?
- September 2008 with the Lehman Brothers bankruptcy and “breaking the buck” by the Reserve Primary Fund?
People disagree about the protagonists and the focus of the financial crisis:
- a housing bubble?
- concentration of power with financial elites?
- financial innovation and deregulation?
- subprime mortgage crisis?
- regulatory shortcoming?
- misaligned financial incentives?
- disproportionate emphasis on shareholder wealth?
- too big to fail?
- income inequality which led to political decisions about housing and easy credit?
- failure of the market system?
- “animal spirits?”
- international contagion of investment products?
Depending on how the problems were defined, the solutions differ:
- diminish inequality
- government subsidies for those who cannot afford financial advisors
- government monitoring of financial products, creating safer financial products
- greater transparency
- price risk higher
- capital requirements
- separate investment and commercial banking
At the end of his 36 page analysis, Dr. Lo suggests that we need a “black box” of indisputable facts rather similar to the data from a plane crash. However, Dr. Lo warns us that the complexity of the crisis and of human behavior may preclude us from ever getting satisfactory analysis.
Dr. Lo’s paper returns me to Dodd-Frank. Isn’t it a solution to a problem we have not clearly identified?
A draft of Dr. Lo’s paper can be read here while the work of the Financial Crisis Inquiry Commission is here and here in econlife and here is their report.
If you were asked today to plan next week’s snacks, would you select fruit or chocolate? In a 1998 study, 74% of those surveyed said fruit. However, when the same people had to decide between fruit and chocolate for today’s snack, 70% chose chocolate.
As explained by behavioral economists, those who chose chocolate for today’s snack were ”overvaluing” current gratification and “undervaluing” the future benefits from fruit. Behavioral economists also believe that people tend to choose the status quo instead of other choices that require active decision-making.
This takes me to a question. If we tend to overvalue current gratification and stick with the status quo, then how can we make wise decisions about health care insurance, retirement planning, and mortgages? In a recent column, New Yorker columnist James Surowiecki suggests “choice architecture” through which optimal choices are the default option. For example, a fixed rate, self amortizing 30 year mortgage would be the default rather than a more risky loan. Another possibility is just having a brief explicit disclosure that buyers have to sign. For example, when getting a risky mortgage, they would have to indicate that they knew that, ” You could lose your home.” (Researchers have found that this works.) Surowiecki also recommends that government protect us and that schools mandate financial literacy courses.
The Economic Lesson
Behavioral economics offers some insight that legislators should recognize. Still though, we have the convergence of the profit seeking sell side and the buy side with a plethora of exploitable tendencies. Add to that congressmen with reelection concerns and you start to wonder how 2300 pages of financial reform can reflect our collective wisdom.
In many ways, the recent financial crisis was (and is) really about seesaws. A seesaw is a lever that lets you do a lot with a little. Using a seesaw, a person weighing 100 pounds can lift someone at the other end who is much larger.
As purchasers of mortgages from financial institutions, Fannie Mae and Freddie Mac had rules about the size of down payments for home loans. Lowered to 3% in 1998, new down payment rules meant that consumers needed a lot less money to get a mortgage. In 2001, the rules again shifted when buyers could use other people’s money and loans for a down payment. Leverage? Yes. It became possible to spend a lot on a home with very little money. According to 2002 Congressional testimony from the CEO of Fannie Mae, financing for low down payment loans (5% or less) grew from $109 million in 1993 to $17 billion in 2002. The number of Fannie and Freddie loans requiring less than a 5% down payment soared to 608,581 in 2007 from 75,694 in 1998. In a paper on the financial crisis, George Mason economist Russell Roberts details the leverage that people enjoyed.
Investment bankers also had their own seesaw. When businesses can borrow at a low interest rate and then earn a higher return on that money, their profits multiply. Between 2003 and 2007, investment banking firms started to increase their leverage ratio from 21x to 30x. The leverage ratio compares money borrowed to a firm’s total assets. The change was the result of more lenient borrowing parameters from the SEC during 2004. Interest rates trending downward since 2000 then incentivized further borrowing. Leverage? Yes! Investment banking firms could use a little to borrow and then invest a lot. A paper from University of Maryland associate law professor Robert J. Rhee describes the leverage employed by the major investment banking firms.
Pondering Greece, I realized that they too had their own seesaw. With debt totaling 113% of G.D.P., they too were spending a lot when they had a little.
The Economic Lesson
Hoping to use other people’s money to grow their own assets, in a market economy, individuals, business firms, and governments borrow money. Then, when you have a sufficient return on the investment, you can pay it back. Problems only develop when leverage works in reverse. If the returns do not materialize, then you owe more than you can pay back.
In an October NY Times op-ed, Calvin Trillin describes a (hypothetical) conversation in a midtown bar about the financial crisis. “The financial system nearly collapsed because smart guys had started working on Wall Street.” By contrast, decades ago, a top student became a federal judge or a professor. Meanwhile, the bottom third went to Wall Street. More recently though, “Smart guys started going to Wall Street.” and invented derivatives and credit default swaps. ”But who was running the firms they worked for? Our guys! The lower third of the class. Guys who didn’t have the foggiest notion of what a credit default swap was…!”
I only remembered Trillin’s column because of yesterday’s Financial Crisis Inquiry Commission (FCIC) testimony from Chuck Prince, former head of Citigroup and Bob Rubin, Citigroup “senior counselor” and former Secretary of the Treasury.
Please do read Trillin’s column and then listen to yesterday’s testimony. Your opinion? Also, check this baseline scenario comment on Alan Greenspan’s testimony.
The Economic Lesson
The FCIC is being compared to the Pecora Commission. Between 1932 and 1934, the Pecora Commission investigated “stock exchange practices and their effect on American commerce, the national banking system, and the government securities market. They also addressed issues of tax evasion and avoidance.” Their impact is reflected by the content of the Banking Act of 1933 (Glass-Steagall), the Securities Act of 1933, and the Securities Exchange Act of 1934. A St. Louis Fed paper has the documents.