Financial reform

Zywicki and Smith examine the effect of behavioral law-and-economics on consumer financial protection

Mark D. White

Courtesy of the Mercatus Center at George Mason University, Todd Zywicki and Adam C. Smith have a new paper titled "Behavior, Paternalism, and Policy: Evaluating Consumer Finance Protection," in which they critique the impact of behavioral law-and-economics on the creation and operation of the Consumer Financial Protection Bureau:

This paper examines the relationship between behavioral law and economics (BLE) as a policy
prescription platform and its influence on the regulations emerging from the Consumer Financial Protection Bureau (CFPB). We show how these regulations are inconsistent with the intent and purpose of improving consumer choices. We further demonstrate that the selective modeling of behavioral bias in the BLE framework causes an overestimation of the ability of regulators, who in actuality use inefficient, heavy-handed rules based on little if any real empirical findings of “consumer irrationality.” Accordingly, the broader lesson on the misapplication of behavioral economics goes beyond the ill-considered policies emerging from the CFPB.

Near the end of the introduction (on p. 7), they detail their issues with this approach to consumer protection:

1. Political realities belie the attempts of behavioral theorists to construct policy corrections.
2. Actual political decision-making is susceptible to a number of distorting influences, most importantly bureaucratic overreach, behavioral bias on the part of the policymaker, and lack of appropriate information regarding consumer choices.
3. Bureaucrats do not hold the same preferences about political outcomes as behavioral theorists do. They are affected by self-interest like anyone else, which can cause deviations from prescribed policy measures.
4. Regulations based on behavioral findings tend to lean toward heavier forms of intervention that eliminate viable, alternative forms of exchange, thus impeding innovation and creativity in the marketplace. This in turn limits the overall amount of market activity (in this case consumer credit).
5. Policymakers are unlikely to incorporate evidence-based analysis into their decisionmaking in a manner consistent with the scientific method. Instead, policymakers are susceptible to “confirmation bias” in evaluating evidence.

I emphasize #2 and #5 and the CFPB itself in The Manipulation of Choice—in particular the last point in #2 about information—but Zywicki and Smith delve much more deeply and broadly into problems with the CFPB itself, contributing a much needed public choice perspective to the issue and concluding with recommendations to improve the operation of the CFPB. This is an essential read for anyone interested in behavioral law-and-economics or "nudges," regulation, or paternalism in general, as well as the CFPB in particular.

Ferrari Capitalism

By Jonathan B. Wight

Via Krugman we learn that Mankiw comes to the defense of the beleaguered mega-millionaires in finance, who have been getting a bad press: 

“Those who work in banking, venture capital and other financial firms are in charge of allocating the economy’s investment resources…. It makes sense that a nation would allocate many of its most talented and thus highly compensated individuals to the task.”

 It is very true that investment bankers and venture capitalists play a vital part of our dynamic adjustment to a changing world.  They should be amply rewarded for the risks they actually incur with their own money.  

In 1979 the share of income going to the top 0.1 percent of individuals was 2.83%, of which financial professionals garnered 0.34%.  By 2005 the share of income going to the top 0.1 percent had risen to 7.34%, of which financial professionals garnered 1.45%--an increase of more than 300%.  Hence, the share of income in the top 0.1 percent going to financial professionals rose from 12% to 20%. 

But Mankiw’s version of events implies that the extra income going to the financial sector over the past thirty years was somehow the result of greater productivity.  Of course, it likely was not.  It was likely a redistribution of the gains of economic activity. After 1980 a lot of smart people figured out how to rig the financial system so that the rewards of risk-taking were privatized while the added risks were socialized (through bailouts of financial companies “too big to fail”).  The major investment banks put their own people in the Treasury and other agencies.  

Between 1950 and 1980 the U.S. had a “Plain Chevy” financial system that was solid, safe, and reliable: it got you where you needed to go without any big accidents or breakdowns. Financial markets were heavily regulated to prevent risk from spreading uncontrollably.  Financial reserves Chevy and low leverage gave financial managers the incentive to use care.  The economy grew faster during the 1950s and 1960s, evidence that our economy was not being held back by capital allocation.

After 1980 we succumbed to the notion that “greed was good,” and that avarice would lead financial markets to regulate themselves.  The result was a “Ferrari” financial system filled with fast products, faster computers, and greater risks.  The economy itself did not grow noticeably faster because of these slick innovations. 


Of course, not all else is being held constant so it is difficult to say how fast the economy would have grown without these financial changes.  But the initial presumption that innovation always leads to productivity growth needs to be questioned. 

A better highway system can get more people to work faster and lead to overall productivity growth.  But allowing  people to race Ferraris on those highways can lead to pile-ups and innocent people hurt, as happened in the great crash of 2008. 

To my mind the increase in rewards to financial professionals over the period 1979 to 2005 can hardly be justified by economic performance, at least not at the aggregate level.   We rewarded financial professionals for shifting risk onto the public sector, something Adam Smith strongly discouraged through his plan for financial regulations in The Wealth of Nations

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

Conseq 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.

Homer 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)

Conseq 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 …

Conseq 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

Conseq 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)...

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"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.

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