Thoughts on a crisis

This is just an attempt to systematize my thinking about the causes of the financial crash and subsequent recession of 2007-8. As I understand it, the core of the problem was the way moral hazard interacted with the principal agent problem. To clarify those technical terms, moral hazard is the concept that if an individual or group is assured that if they collapse or otherwise fail they will be protected from the fallout this assurance will disincentive trying especially hard to prevent failure. The principal-agent problem is the issue arising from a situation in which an agent – say a CEO – has different incentives than their principal – say the owners of that company. In this case, the CEO wants to maximize his returns in the short run, while the owners want to maintain the long term value of the company. This may cause the agent to pursue goals different from or even contrary to the principal’s.

In the decades preceding the crisis, the federal government began sending strong signals to the market that the failure of huge institutions wouldn’t be tolerated – that is to say, those that had lent money to those institutions would be secure. Russ Roberts does a good job covering the history of bailouts, beginning with the protection of the creditors of Continental Illinois through the Savings and Loans Crisis and finally to the bailout in 1998 of Long Term Capital Management. The cumulative effect of these bailouts was to tell creditors that if they wanted to lend to large financial institutions, those bets would be safe because they were in essence going to be backed by the US government. This allowed banks to borrow large amounts of money for very low interest rates, which in turn allowed them to take highly leveraged bets (that is, making bets with borrowed money).

At the same time, the payment structure of these banks encouraged leverage in several ways. One was that compensation was geared towards huge rewards when leveraged bets paid off and small downsides when they failed. Bonuses and other incentivized pay skyrocketed when a bet paid off; if it failed limited liability shielded the trader from having to pay the downside. Likewise, because executives were often paid in stock, they were encouraged to run up the stock price in the short run rather than nurse the long term value of the company. Given the enormous access to capital that these banks had – because the capital was essentially subsidized through implicit government backing – the executives were able to make catastrophically leveraged investments which, when they went well, paid off hugely and when they went bust they were able to walk away from (this is chillingly similar to the American mortgage market, where regulation allowed borrowers to simply walk away from mortgages they were unable or unwilling to pay).

And there’s an even greater structural problem. As Tyler Cowen points out, the returns from finance are so vast on an individual level that the downside doesn’t compensate.  As he puts it, “we don’t know how to punish people in a manner consistent with the rising size of absolute rewards.” Russ Roberts in the piece above says that capitalism is a system of profit and loss, and that the government protection of downside is removing the element of loss, thereby fundamentally destabilizing capitalism.  As the above analysis indicates, that’s right, but it may not be the whole problem. When a manager at an investment bank can expect millions of dollars of compensation in an average year, if they play their cards right, then the downside of losing their job just isn’t enough to make them very cautious. This causes them to, in Cowen’s phrase, short volatility – that is, make giant bets that what we would normally expect to happen happens. In an average year they’ll win the bet and reap huge returns. In a bad year, the bet explodes and possibly the company goes bankrupt, but the investor made so much money in the good years that the downside just doesn’t hurt that much.

Of course, all of these factors work together. The creditor bailout provides easy money to people who for all the factors mentioned above have strong incentives to place absurdly leveraged bets on the status quo continuing – the stock market will go up, the Pirates won’t win the World Series, etc. In our case, in the 2000s the market bet hugely and dangerously that real estate prices would go up. One year, they fell, and the financial system fell with them.

This leaves the question – where do these root causes stem from, and what could we possibly think about doing about them? I’ll try to write about those in a future post.

Also: See Scott Sumner on moral hazard and why finance does deserve big rewards; See here for a more technical explanation of a lot of what I said above.

Picture: My photo, available under CC licence.

(Thanks to Sam and Gabe for useful conversations on the topic. Also for conversations with my dad, but I don’t want to make this sound like a book dedication or anything.)

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6 Responses to Thoughts on a crisis

  1. atymins13 says:

    I completely agree with this post. I have felt for a long time that the rapid decrease in personal responsibility in business has been a great detriment to success in the short and long term. I still am not sure how this issue can be fixed, because regulatory institutions (i.e. the federal government) will have an extremely difficult time getting to the root of all this. The adaptation of executive stock options was supposed to fix this problem, but if anything, it has exacerbated it.

    http://southpawreport.wordpress.com/

  2. Good Post.
    You ask about root causes and I’m not sure what you mean.

    I will say that if you look at financial crisis historically they often come after an asset price bubble. Further often the “smart money” i.e. hedge funds / insiders get out before the crash and reap huge profits from doing so. There are many academic papers on this occurring in different crisis, for example here is one on the Dot-Com bubble: Brunnermeier and Nagel – Hedge Funds and the Technology Bubble

    Also things like “golden parachutes” (which we saw deployed so wonderfully after TARP) ensure that CEO’s suffer from a moral hazard. In fact even if they didn’t get such wonderful severance packages all that would be necessary for a moral-hazard would be that they don’t suffer negative losses on their bets/business decisions. If a stock tanks, you may loose everything but CEO gets his take home pay and will only see the upside. This hyper-encourages risk taking, because you can basically gamble with other people’s money.

    Well, hope some of that was helpful.
    floodingupeconomics.wordpress.com

    • Morton says:

      I’ll have to look into that paper. As far as asset bubbles go, Scott Sumner has a good point about bubbles: what do we mean by a bubble, and why is it that
      no one gets credit for long decrying undervaluing? It’s only predicting overvaluing that has this heroic predictor role attached to it, and that should make us wonder about what a bubble actually is. The price is in a certain sense what the market assigns to it, and if this price persists long enough despite claims that the price is too high, in what way is there a bubble? (his post: http://www.themoneyillusion.com/?p=8063).

      What I meant by root causes was this. Why, despite the fact that it’s been long known that moral hazard can cause issues, did the government persist in this dangerous habit? And the principal agent problem is also known. Why didn’t stockowners address the problem with executive compensation? In fact, it seems that this problem hasn’t been at all dealt with since the crisis, and will only grow worse because if anything moral hazard to creditors should be stronger.

      • Regarding root causes, I think you’re right. Most people who follow finance know that there have been little substantial changes in the way business is done on Wall Street. The reason is everyone wants to get in make their money and get out. Stock-owners have very little real rights, and don’t use the ones they have. Its all about who the board of directors is, and if you’ve ever looked at a public company’s proxy 14A you’ll know they’re all friends with the executives and basically the same people. The board makes decisions, shareholders don’t.

        As to why the government behaves the way it does…its the same. Just look at who is in government. The lobbyists and economic advisers all shape the decisions in the end, and they’re all from Wall Street.

        Regarding Bubbles, yes it is always nebulous to describe what actually constitutes a financial bubble. In economics the general consensus is an asset becomes a bubble when holders are no longer purchasing based one “underlying value” but instead are simply purchasing based on the belief the price will rise and they can hold the asset to catch this upside, so its about intent… but its certainly not a perfect definition on many fronts. Regarding the opposite of bubbles (there should be a name for this?), undervaluing, if something is truly undervalued the people who notice should not “get credit”, they should be keeping their mouth shut, investing, and making a profit… but I’m guessing that’s not exactly the type of undervaluing you were talking about, so I’d probably need an example

  3. Just to note: What I described above is pretty much the principle agent problem run amok

  4. Pingback: Economics Headlines for the Week: 1/10/2011 « floodingupeconomics

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