Economics and Ethics

The Resurrection of Finance?

Jonathan B. Wight

Via John Davis comes a link to Dan Berrett's recent article in The Chronicle about Robert Shiller's new book, Finance and the Good Society (Princeton University Press, 2012). The book seeks to resurrect the field of finance from the ashes of the great collapse of 2008—and the strong perception that the field is guided solely by greedy ones who have brought the rest of us down.

Shiller argues in his new book that financial innovation is a leading force for economic growth and should be encouraged. Moreover, he argues that young people should not be discouraged from entering the field by the Occupy Wall Street protestors. Instead, Shiller says that finance offers a world-improving career for idealist.

Resurrecting the moral image of the people in finance may be a very good thing, but real moral improvement is unlikely to happen: there is probably too much of a self-selection bias. And, there appears to be a huge culture of entitlement, as evidenced by the vicious attacks that ensued when a tax increase on the wealthiest was proposed that would raise the marginal tax rate by only about 3%. If internal self-controls are lacking, then external ones are needed, such as we had in place with Glass-Steagall Act and other restraints that limited excessive risk-taking. Incidentally, this was exactly the kind of excessive risk-taking that Adam Smith opposed in The Wealth of Nations.

Here is the U.S. growth rate by decade. It should be abundantly clear that we did not need fancy financial instruments to grow rapidly in the 1950s and 1960s. All the BRICK countries today (Brazil, Russia, India, China, and South Korea) are booming and none of these is known for financial innovation. U.S. growth rates actually slowed down after financial market liberalization began in the early 1980. Of course there are lots of confounding events.

When I think of the best financial innovation of the last half-century it is micro-lending, which was not invented by Wall Street but an entrepreneur in Bangladesh. When I think of the U.S.'s innovation lead over many other countries it is because of the venture capital in Silicon Valley, not so much the investment banking of Wall Street. Of course there are interconnections and synergies to consider. But on the face of it, I am not convinced that the financial innovation Shiller touts is necessary for economic growth. However, having a well-working financial system is necessary—but I mean a plain vanilla variety that works consistently well, costs a whole lot less, and is less likely to break down than the one Shiller extols.

Here's an analogy: is a Ferrari 458 that gets a top speed of 201 mph needed to commute from home to work? Or, would a Ford Focus get you there with greater fuel economy and safety? If society is expected always to "pick up the pieces" after fabulous wrecks, I know how I want my tax dollars to work—I'll help build the roads for Fords, but not racetracks for Ferraris. The same goes for the financial system.

Note to readers: Berrett's article also quotes our own Mark White, who advises graduates to enter the field and change it from within.

Consequences of Economic Downturn -- Part IV: Borrowing & personal responsibility

Martha A. Starr

Today’s topic is one on which Mark has much to say: personal responsibility. Looking back at the years before the financial crisis, a big question is why households were increasingly borrowing via ‘exotic’ mortgages and other high-cost methods, even though such borrowing was pushing their debt burdens towards all-time highs. Accumulating evidence from behavioral economics suggests they may not have understood what they were doing: because people’s financial choices seem to be very sensitive to how options are presented, perhaps lenders were tilting them into products that maximized their profits, but saddled consumers with exorbitant debt costs.

Enter U. Chicago scholars Cass Sunstein and Richard Thaler, who argue that a good way around this problem is to “nudge” consumers towards good decisions -- by making “good” choices the default option and “bad” choices available by special order only. Some view this idea as nicely balancing consumer protection and personal freedom. But if this idea of “libertarian paternalism” rubs you the wrong way, you’ll love Mark’s chapter in Consequences of Economic Downturn, which eloquently slams it on several accounts. For one, “nudging” assumes the government can effectively identify what’s best for consumers, despite  great variations in their circumstances and the fact that government’s expectations for the future have no special claim to accuracy over those of consumers. For another, it ignores realities of government policy-making, whereby powerful institutions lobby Congress in favor of rules and regulations that best protect their interests. Finally, by taking responsibility for decision-making away from people, nudging actually cements any tendencies towards “cognitive flaws” they may have, and disregards fundamental concerns about building social environments that promote people’s agency, dignity and autonomy. {What do you say, Mark: Should Mr. Burns take the donuts out of the break room at the nuclear power plant?}

Deb Figart’s chapter takes a swing at a different proposed solution for curbing ‘imprudent’ borrowing: “financial literacy” programs, which have been rolled out by all sorts of government agencies, financial institutions, and nonprofits since the crisis. Most claim to aim to help consumers understand how to scrutinize financial products, identify those with low costs and risks that best meet their needs, and structure their spending, saving and borrowing patterns to minimize chances of financial distress. Yet as Deb points out, many do not actually focus on helping people become fully participating agents in control of their own economic and financial lives. Rather many aim to make them into orderly consumers, still taking for granted that the dominant work-and-spend lifestyle is the proper one and that ‘responsible’ use of borrowing products is fine. As with Mark’s view of ‘nudging’, Deb is skeptical as to whether these kinds of financial literacy programs actually respect people’s agency and enhance their capabilities. But whereas Mark thinks more can and should be expected of the individual, Deb objects to the assumption behind financial literacy programs that it’s up to the individual to make good financial decisions, avoid unscrupulous actors, attain financial security, etc., assuming that government and financial institutions do not also share responsibility for maintaining an orderly financial system that enables people to conduct their financial affairs without needing to constantly be on guard against risks of financial ruin. Thoughts, Mark?

Consequences of Economic Downturn -- Part III: More of the rich getting richer?

Martha A. Starr

Since the early days of the financial crisis, claims have been made that it was somehow caused by rising inequality. A big dose of suggestive evidence comes from statistics on income inequality: as the chart shows, on the eve of the 2008 crisis, inequality had risen to levels not seen since 1929.

 
Data for the U.S. from the Top Incomes database (accessed 4/12/2011)

But how exactly are inequality and financial crisis related? The chapter in Consequences of Economic Downturn by Jon Wisman and Bart Baker of American University takes on this question, identifying three dynamics implicated in both the 1929 stock market crash and the 2008 financial crisis. First, both crises came after years when real incomes rose for households at the high end of the income distribution, but stayed flat or slipped for others. Drawing on Veblen’s ideas about conspicuous consumption, they argue that this led average people to rely increasingly on borrowing to “keep up with the Joneses”, building ever more risk into the financial system. Second, with the consumption of the rich already very high (how many Audis, ski vacations, homes in the Hamptons, etc., does one actually need?), they tended to channel their rising incomes and wealth into financial investments, which kept interest rates low and encouraged the creation of new credit instruments with poorly-understood risk properties. Third, with rising economic clout, the rich gained increasing control over politics and ideology, shifting the government and public into a mentality of laissez les bons temps rouler. They conclude that, because these dynamics reflect structural economic problems –- spending levels above purchasing power, loanable funds above productive investment opportunities – we can’t expect measures to repair flaws in the financial system alone to put the economy back on secure footing.

While there is much to be said for this argument, I have small nagging doubts about it. For one, as popular as the “keeping up with the Joneses” story is, careful empirical research shows that people tend to emulate relatively successful people in their own social segments, not so much the rich. Sure, one can argue that pervasive media influence has widened our perceived social circles, so that we increasingly understand ourselves as peers of Donald Trump. But most people's spending is concentrated in everyday things like the rent or mortgage, food, utilities, transportation, health insurance, etc., not silk ties and mobile champagne coolers. For another, data on household finances show that, in the years before the crisis, high-income households were accumulating non-financial assets (residential properties, business interests), not increasingly risky financial assets; rather, it was financial institutions that were gobbling up the MBSs, CDOs, etc. So as much as interested readers will find this paper rich and nuanced in its historical arguments, I’m not sure we’ve yet got the story fully nailed down.

Consequences of Economic Downturn -- Part II: Who gets stuck holding the bag when financial markets implode?

Martha A. Starr

More from Consequences of Economic Downturn on why economists missed the systemic risks that were accumulating in plain view before the financial crisis …

Bob Prasch of Middlebury College, points out how standard economic theories of the relationship between risk and return contributed to "blind spots" in economists’ judgments.

A core tenet of financial economics is that above-average returns cannot be had from safe investments; if you want to earn above-average returns, you have to invest in risky assets, which ought to pay you a premium to compensate for the uncertainty in your expected earnings. This leads to the kind of reasoning that got former Fed Chairman Alan Greenspan into trouble: He assumed that financial-market participants would not have been investing in new financial products (like securities backed by subprime mortgages), unless they judged the risks they were taking to be reasonably small, relative to the returns they could expect to earn. Thus, if all those shrewd, smart investors aiming to maximize their risk-adjusted returns saw no reason to worry about the riskiness of subprime mortgages, neither should he.

Trouble is: as Prasch argues, risk and return are not actually very closely linked in contemporary U.S. capitalism, especially for large businesses and financial institutions. A variety of laws, practices, policies, and institutions enable the wealthy and powerful to shift downside risks off themselves and onto others -- especially the unsuspecting taxpayer. Important here is the concept of ‘limited liability’, which keeps corporate shareholders and executives from having to bear the full costs of negative business outcomes. Limited liability is intended to promote socially-beneficial risk-taking, because people could be reluctant to invest in new businesses if they could be forced to sell their homes and liquidate their life savings to cover the business’s losses. But this creates a screen behind which people can squirrel returns while they are accumulating, and they don’t have to fork them back over if their bets eventually go bad. Thus, if a bank, or hedge fund, or insurance company becomes insolvent, its creditors can demand that its assets be sold to pay down its liabilities -- but except in cases of gross negligence or illegal activity, any wealth accumulated by the firm’s principals as a result of their past bad actions (e.g., outsized bonuses, realized capital gains) can remain safely in their bank accounts.

So who ends up holding the bag? In the case of the 2008 financial crisis, the federal government stepped in and "managed" the giant losses that eventually showed up on investors’ books, on the grounds that they had to in order to keep the financial system afloat. Financial executives could hang on to the outsized bonuses they earned during the boom years, no problem. Instead, the financial bailout shifted the downside risks onto average taxpayers, who had not agreed to take them on and had not benefited from the outsized gains; on the contrary, they also disproportionately bore the costs of the downturn, via lost jobs, homes, home equity, and retirement savings. (Stay tuned for future posts on this). To be sure, banking economists had warned for years of the incentive problems of "moral hazard" and "too big to fail." What Bob Prasch points out is that these are just manifestations of a broader problem of “divorce of risk and return” that runs rampant through American capitalism, whereby the "big guys" earn the returns and use their privileged command of access to power to get the "little guys" bear the risks.

Welcome Martha A. Starr to the Economics and Ethics blog!

Mark D. White

It is both a pleasure and an honor to introduce Martha A. Starr (American University) as our first guest-blogger here at Economics and Ethics! Over the coming weeks (and maybe longer, hint hint), Martha will blog about her new edited book, Consequences of Economic Downturn: Beyond the Usual Economics, the second release in the Perspectives from Social Economics series from Palgrave Macmillan.

As the title indicates, the book discusses the effects that the current economic malaise has had on the real people behind the statistics and soundbites, so please join us as Martha takes us on a guided tour through the various chapters and topics in this extremely timely volume.

Inside Job now available to watch online for free (or not)

Mark D. White

Quick news update: The movie Inside Job, which Jonathan discussed previously on this blog, is now available to watch for free online, thanks to Open Culture (with tip o' the hat to Legal Nomads for passing along the news and link).

UPDATE (April 7): As some of you (like Jonathan) may have noticed, the film is not available at present. If you click on the link, you see this message: "Sorry folks, it looks like the Internet Archive (which hosted Inside Job), has now taken it offline. If it comes back, we will let you know."

Does the financial crisis call for reflection on economic methodology?

Mark D. White

A minisymposium in the most recent issue of Journal of Economic Metholodogy (December 2010) asks that very question--it seems to be that reflection on methodology is always justified, and it is unfortunate that it took a crisis of this magnitude to spur it.

After a brief introduction from Kevin Hoover, the following three papers are featured (see below the fold for details)...

"Free to Choose" symposium on behavioral law and economics

Mark D. White

As I noted earlier, on December 6 and 7 the blog Truth on the Market hosted "Free to Choose?", an online symposium on behavioral law and economics, the contents of which appear below the fold, followed by an excerpt from Josh Wright's introductory comment.

"Inside Job" is a Provocative Movie

Jonathan B. Wight

 Inside Job (2010) is a new documentary that exposes the seamy underside of the financial bubble and its bust.

 What’s different here from other revelations of skullduggery is that academic economists take a lot of the heat—and a sharp jab is aimed at the alleged ethical misconduct of economists.  Aside from the usual suspect—the ubiquitous Larry Summers—this movie also castigates two big names:  Fred Mishkin and Glenn Hubbard, both at Columbia’s Business School (where Hubbard is Dean). 

 These are both highly admired economists who have served their country—Mishkin as a Fed governor and Hubbard as Council of Economic Advisors leader.  And both men could have made a lot more money on Wall Street had they desired.  Both did take consulting assignments from financial markets—and that’s where the movie kicks in. 

 According to the movie, Mishkin took over $100,000 in consulting fees to write a glowing report about the financial market takeoff in Iceland, including a statement about how well the banks were regulated.  Of course, in hindsight, we know that Iceland’s three major banks were grossly over-leveraged and took very big risky and soon came crashing down.  When confronted on screen, Mishkin had a completely lame answer: he said he simply “trusted” the central bank of Iceland.  He stammered horribly when he was asked why the information that he’d been paid by the government of Iceland was never disclosed in his report, so as to warn of potential conflicts of interest.

 In a similar vein, Hubbard was slowly roasted.  He took great offense at his personal integrity being questioned.  Indeed, it appears the movie producers hijacked the interview, hitting Hubbard with personal financial questions without forewarning.  I did feel sorry for these individuals, who as far as I know are, and have been, upstanding citizens.  But Hubbard has also lent his name and been paid in the hundreds of thousands of dollars to companies seeking help with financial deregulation. 

 The point raised in the movie is compelling:  have academic economists sold out?  Is there too much money to be made peddling the ideology of laissez-faire?  Are there adequate ethical ground rules in place?

 John Campbell, Harvard’s Chair of the Department of Economics, also stumbled badly when asked if there were any conflict of interest regulations regarding outside consulting fees and full disclosure. If a doctor were being paid hundreds of thousands of dollars by a drug company, should that information be disclosed to patients when the doctor prescribes that drug?  Hubbard was adamant about NOT disclosing his private consulting gigs, even when they are financial market related and he was an architect of Bush’s financial deregulation team. 

 Inside Game is beautifully filmed and raises troubling questions about the big elephant in the room: namely, should economists ascribe to an ethical code of conduct?

New book: Crisis and Recovery: Ethics, Economics and Justice

Mark D. White

In a case of excellent timing with Irene's recent post, as well as Martha Starr's upcoming book, Consequences of Economic Downturn: Beyond the Usual Economics, I just received a new book edited by Rowan Williams, Archbishop of Canterbury, and Larry Elliott titled Crisis and Recovery: Ethics, Economics and Justice (Palgrave, 2010).

The contributors seem to be drawn from a wide range of fields, from academics and politics to the non-profit sector and the church, all commenting (as do Irene and the contributors to Martha's book) on the moral aspects of the current downturn. Chapters which looks particularly intriguing to me upon first glance are Phillips Blond's "There Is No Wealth But Life," Andrew Whittaker's "Culture and the Crisis," and the Archbishop's own "Knowing Our Limits."