[25 January 2010]
I was entranced by the Hayekian story of how markets aggregate and communicate widely dispersed information. I also found it fascinating that markets achieve legitimacy by disguising human choices, sometimes good and sometimes bad, as facts of nature.
I began a serious study of financial markets, first just by reading textbooks, then by going through the CFA curriculum and now grad school…. I was struck by how much real financial markets differed from the kind of markets one would invent (and that people like Robin Hanson do invent) if you took the Hayekian story seriously. Real market institutions seem designed to hide information and shift consequences rather than reveal outcomes and allocate costs and rewards. I quickly shed a libertarian prejudice in favor of what is “emergent” or “natural”, and became a critic of a financial system ill-equipped to serve the purpose to which it is addressed.
Without effective regulation, market actors will have incentive to direct their efforts at information destruction, because in such situations, it is often easier to try to make money by finding a bigger fool rather than performing the necessary due diligence to find socially useful investment projects. Chapter 12 of Keynes’s General Theory is all about this problem; the Epicurean Dealmaker has an interesting exposition of it here that’s well worth reading too. His post connects the bad incentives of the financial sector directly to the recent economic crisis:
Arguably a leading reason why the mortgage and credit markets imploded in 2007 and 2008 is because newfound liquidity enabled the separation of ownership from management of the underlying assets. (Sound familiar?) Lenders (investors) no longer had to own or even manage (service) the loans they originated. Banks no longer had to underwrite and screen mortgages or corporate loans as if they planned to hold them to maturity, as they once did: they bundled them up and sold them off instead. A passel of morons in Mayfair wrote billions of dollars worth of naked puts on CDOs they didn’t understand because the markets and their counterparties made it look like free money. Hedge funds who took a negative view on a company could purchase credit default swaps in amounts which dwarfed not only the company’s entire outstanding debt but also its entire enterprise value. Everybody outsourced credit analysis and credit judgment to the ratings agencies, which were more than happy to take a fee for telling everybody what they wanted to hear. Aggregate market liquidity went up, and aggregate investor knowledge went down. Everyone became a market maker. (That, at the margin, is what a speculator is.)
Naturally investment banks swelled like a tick on a dog in this environment. Increased liquidity begat increased volume, which begat more investment bankers earning more money for moving value from one pocket of the global economy to another. (Productivity in terms of volume of deals per banker always lags overall market growth.) It didn’t matter to them where the money was going, or if it was doing anything truly productive on the way. That wasn’t their job to worry about. They just had to make sure the moolah got from column A to column B intact and on time.
The sense that this is no way for a financial sector to behave is perhaps leading to more “strategic thinking” on the part of those walking away from underwater mortgages—a move Waldman has endorsed. (If it’s good enough for Tishman Speyer, isn’t it good enough for the rest of us?) Mark Thoma theorizes that norms regarding mortgages are changing as people come to believe the system was rigged against them:
The change in norm will occur when people begin to believe that they weren’t just unlucky, but instead were duped or treated unfairly in some other way. If [buying a house during the bubble] wasn’t just a bad bet, the kind you reluctantly pay when you lose, but was instead caused by some unfair factor that only becomes evident ex-post, then the norm begins to change as people begin to realize what really happened to them. They don’t want to believe or admit to themselves that they were fooled into a loss rather than the victim of a fair bet, but that changes as the losses and resentment mount, and as the evidence that things weren’t what they seemed comes into focus. And that does seem to be happening.
The disappearance of those norms—the idea that obligations have a moral component, that life is not merely a series of mutable contracts in which we seek to take advantage of one another if possible—would be very bad. That would move us that much closer to the purely techno-rational Machiavellian world that critics of capitalism have always feared. Waldman is eloquent about this:
I thought it was the challenge of our day, and the grand project of modern economics, to build a system in which people pursuing their own self-interest would provide all social goods, in which the benevolent invisible hand would rule all and we’d have no need to rely upon ideas as shifty and manipulable as “virtue”. I have done a full 180 on this question. Economic self-interest and formal legal frameworks are simply insufficient to regulate a decent society.
With regard to walking away from mortgages, Waldman argues that what looks like strategic amoral behavior in borrowers is actually moral retribution for unethical lending: “People in the financial industry earned huge sums making loans that shouldn’t have been made, offering “affordability products”, Orwellian slang for means of selling homes at unreasonable prices that buyers could not afford. They failed to perform the core social duty of creditors, which is to make prudent judgments about whether loans are likely to be in the mutual interest of borrower and lender over the full term of the debt.” For borrowers to uphold their half of a bad bargain is “to reward the cynical immorality of others, which serves no social good.”
That seems right to me. The asymmetrical morality in which banks are held to a Machiavellian standard while individuals are held to the code of honorable friendship seems unsustainable; it’s part of the capitalist ideology that justifies dramatic inequality and boundless accumulation, creating institutional scapegoats (evil banks and corporations) for the unfair deals foisted on more or less powerless individuals, who can nurse their pride with the idea of how they struggled to preserve their financial virtue in the face of nameless, implacable forces of bad fate. We can’t do anything about corporations but we can do something about the governmentin a democracy, as Waldman explains—“Congress finds excuses to tolerate predation by private banks, but would have a hard time doing nothing when it is the government perpetrating the abuse and constituents are angry about it.” But if the government maintains a hands-off approach to corporate governance, if it refuses to regulate, but some crazy twist of nonlogic, it can’t be blamed for anything. Americans currently can’t seem to process dissatisfaction with government in any other way than to make an effort to reduce or destroy it. (Maybe the Tea Party people will succeed in getting rid of democracy altogether.)
Waldman argues that “in a sane financial system, credit would be extended far more conservatively than it has been. Credit contraction is consistent with growth, but only if it is offset by broad-based income expansion that would permit middle-class consumers to live well without borrowing.” Instead we have a system in which more and more people are brought into a kind of credit-based indentured servitude as the price to remain middle class. The standards of middle-classdom are revised ever upwards while wages stagnate, prompting ever more borrowing on terms that favor the lending classes. It’s a perpetuation of an economic arrangement that funnels wealth up, and obligations and consequences down.