Financial reform

"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

Crisis-recovery 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."

The ethical dimensions of the financial crisis and rationality – by Ricardo Crespo and Irene van Staveren

The meaning of the term “crisis” in the economic literature is not without ambiguity. As a general feature, macroeconomic crises are events marked by “broken promises” that shatter the expectations that many agents had entertained about their economic prospects and wealth positions. The large change in the economic (and possibly also, social and political) environment naturally leads to reappraisals of the views of the world upon which agents had based their expectations, plans and decisions, and to a reconsideration of theories and models on the part of analysts. Crises are “memorable” events with potentially long-lasting consequences on attitudes and beliefs. They require a reinterpretation of past experiences and a re-statement of propositions concerning the way in which the relevant systems are assumed to work.

                Concern for the study and the understanding of crises is actually older than macroeconomics as an established discipline and it has operated historically as a strong motivation to investigate in the field. Modern macroeconomic theory, on its side, has increasingly become committed to a set of analytical and procedural presumptions, which lead to look for representations of macroeconomic behavior as the result of well coordinated (except for some noise which acts as an additional constraint) optimal decisions of agents, equipped with rational expectations, that is with knowledge of the probability distributions relevant for their plans. These research criteria, sometimes elevated to the rank of methodological prescriptions, can be seen as the outcome of past debates on the theory of macroeconomic fluctuations and inflation, which generated dissatisfaction with earlier theories. At the same time, their application to the study of crises, as if they could claim a universal range of validity, has been subject to paradoxes and problems in the interpretation of salient facts, which seem to call for new searches. The crisis has been the acid proof leading to discard these theories. If the expectations were rational we would not have had a crisis. Then, the analysts begin to discern other kinds of reasons embedded in the process:

                (i) An excessive liberalization of the banking rules and the financial sector regulation (lower capital requirements, no limits to joint ventures and mergers and acquisitions leading to banks with extremely large assets on their balance sheets) facilitate irresponsible loans, mortgages and investments.

                (ii) The Central Banks’ controls fail, partly due to lack of knowledge of new financial products (securities), partly due to limited international cooperation, and partly due to too close connections with banks.

(iii) The provision of wrong incentives through disproportionately high bonuses to bankers, traders and managers of the financial sector based on short run profits, ignoring high risk and long run viability of financial institutions, clients, and whole economies; as well as through golden handshakes even in cases of bad performance.

                (iv) The moral hazard role of government which tends to save big banks and firms because they are too big to let them fall: bankers and entrepreneurs know this and they therefore take excessive risks.

                (v) Technical problems such as difficulties in understanding the technicalities of mortgages operations, or systems of financial evaluations.

                (vi) A tendency to hide risky positions in the accounting proceedings. This, for example, was the case for Lehman Brothers, which was factually bankrupt half a year before its fall, thanks to accounting tricks.

                (vii) Failing rating agencies that provided too rosy assessments of banks.

                (viii) A monetary and fiscal policy that foster consumerism through low interest rates and taxes, in particular for the rich. For some analysts the monetary excess is the main cause of the crisis, leading to over-liquidity, while others emphasize how more inequality in income distribution was driving the over-liquidity.

                This list entails reasons that are beyond narrow economic rationality: within them we can find psychological, sociological and moral reasons. According to Max Weber’s classical classification, we can distinguish four types of rationalities guiding social actions: instrumental, value-rational, affective and traditional. Instrumentally rational is the action aiming at allocating means for the attainment of the actor’s ends. When this allocation is the best possible we have a specific kind of it: maximizing instrumental rationality. Value-rational actions are determined by conscious beliefs in the intrinsic value of some behaviour: they follow moral criteria. Affective are the actions guided by the actor’s affects and feelings, i.e., psychological springs. Traditional actions are determined by ingrained habituation, by mainly sociological reasons. Economic rationality is an instrumental maximizing rationality. However, Weber argued that, although one specific form of rationality might prevail in a specific action, rather all human actions are oriented by various types of rationality. This is thus the case of economic actions and instrumental maximizing rationality: this rationality prevails in economic events, but it often goes jointly with other forms of rationality. As all social phenomena, economic phenomena are complex and we may analyze them from all four Weber’s perspectives of rationality: instrumental, moral, psychological, and sociological.

                We can detect the presence of these rationalities in phenomena by the ordinary discourse used to describe them. Descriptions are rarely pure descriptions. They frequently bear connotations going beyond mere description. We can find some of these connotations in the list of reasons for the crisis. Although we are not able to evaluate the exact impact of the moral aspects of the crisis it seems that many moral terms are intermingled in the list.

                In effect, the list includes terms with moral resonances. For example, “to hide risky situations”, “excessive liberalization”, “extremely high bonuses”, “irresponsible loans.”” failing control”,  “wrong incentives” , “moral hazard”, “too rosy assessments” and “consumerism” add  qualifications to the economic facts including but also going beyond economic analysis.  It was remarked that during the crisis, we had cases of fraud or greed; but most often, we have had laziness, a tendency to close the eyes when performing risky actions and to irresponsibly go on without reflection when something wrong was hinted. It is clear that in this crisis there was much mediocrity, work badly done, disregard for others, and complicity with egoist or pragmatic concerns. Moral decline influences people’s psychology: when the crisis was triggered, partially due to inadequate ethical conduct, people lost trust in the economic sector’s modes of operating and its financial systems.

                Economic rationality only considers the best way of achieving preferences, regardless of their specific content. The characteristics of the conducts assessed above –e.g., that are hiding, that the liberalization is excessive, that the bonuses are extremely high, the loans irresponsible, the incentives wrong, that we are falling in consumerism or that we are lazy, egoistic or pragmatic– are traits of preferences that are irrelevant for economic analysis. However, as John Stuart Mill has highlighted, although the highly abstract character of political economy helps to understand economic affairs, given that life is complex, it often has little empirical relevance. Mill actually maintains that we have to consider other motives if we want to know the motives of real world facts. The description of the facts of the crisis indicates that we have to consider the moral dimension.

Strategic mortgage default and efficient contract breach

Mark D. White

Following up on Jonathan's post on rules, norms, and contracts from July, I just came across (thanks to ContractsProf Blog) a paper titled "Strategic Default: The Popularization of a Debate Among Contract Scholars" by Meredith R. Miller of Touro College - Jacob D. Fuchsberg Law Center, forthcoming in Cornell Real Estate Journal. I have yet to read it in its entirety, but in it Miller seems to discuss well the conflict between morality'promise and efficiency in interpreting contractual agreements, especially as this debate was conducted in the public sphere as well as the academic. From the abstract:

A June 2010 report estimates that roughly 20% of mortgage defaults in the first half of 2009 were “strategic.” “Strategic default” describes the situation where a home borrower has the financial ability to continue to pay her mortgage but chooses not to pay and walks away. The ubiquity of strategic default has lead to innumerable newspaper articles, blog posts, website comments and editorial musings on the morality of homeowners who can afford to pay but choose, instead, to walk away. This Article centers on the current public discourse concerning strategic default, which mirrors a continuing debate among scholars regarding whether the willful breach of a contract has a moral element.

For those scholars that maintain that it is possible to describe and prescribe contract law with a general, unifying theory, the debate is primarily one between promise-based theories and economic theory. This debate between promissory and economic theory reflects a perpetual volley concerning whether contract law should reflect the primacy of morality or efficiency.

The argument of those that support strategic default reads like a case for efficient breach. Many of these commentators argue that the mortgage contract simply presents home borrowers with a choice: pay or surrender the property in foreclosure. If a homeowner is deep underwater, she is better off defaulting and the lender is no worse off relative to the bargain (after all, the lender agreed to foreclosure as a remedy). However, those who argue in favor of strategic default are counteracting a prevailing social norm that it is fundamentally immoral to willfully breach a contract. Many of the blog comments and even newspaper editorials have reflected a general sense that the homeowners who strategically default are acting shamefully.

The public discussion further mirrors the academic debate about whether encouraging efficient breach enables the greatest public good or, instead, undermines the very convention of contracting. On the one hand, strategic default serves as an example of how encouragement of breach of contract may lead to a breakdown of confidence in the marketplace and, in turn, could inhibit market activity. On the other, it is difficult to muster sympathy for lenders, whose imprudent loans are a large piece of the systemic problems that precipitated the housing crisis.

In the end, to the extent that questions of morality are nuanced and contextual, the example of strategic default elucidates the futility of either morality or efficiency as a unifying descriptive or normative theory of contract law. Indeed, it suggests that instead of focusing on individual contracts between borrowers and lenders, a more fruitful public discourse should be reframed to focus on appropriate systemic reforms to prevent the practices that played a part in devastating outcomes for the housing industry, families and communities. Because the concerns about strategic default – neighborhood depreciation and market collapse – are systemic, the solutions should be driven by those concerns, rather than shaming individual borrowers who decide to walk away.

Elizabeth Warren, simplification in lending, and competition

Mark D. White

Harvard law professor Elizabeth Warren, special adviser to the secretary of the Treasury for the Consumer Financial Protection Bureau, has an op-ed in the Wall Street Journal this morning (subscription may be required), in which she argues that simpifying consumer credit products will please both consumers and lenders and will promote competition. After describing meeting with a variety of lenders, she writes:

The very early feedback I've received indicates that the industry is eager for simplification. Some bankers have told me that a short, easy-to-read agreement is exactly what they want. And many others have expressed their interest in working with the new agency to advance a robust market for consumer credit—one that produces real competition that benefits millions of Americans.

If in fact "the industry is eager for simplification," what exactly is stopping them from achieving it? If consumers want simplification, why aren't lenders bending over backwards to give it to them? Is there some Prisoners' Dilemma in the industry that is preventing these win-win situations? It is difficult to see how: if consumers respond positively to simplified products, then lenders have a clear incentive to provide them, especially if other lenders don't. Government action is rarely needed to promote competition; why is it needed in this case, especially in the absence of Prisoners' Dilemma-type problems?

Perhaps she's arguing that simplification must be an industry-wide effort, e.g. to standardize the presentation of key terms and provisions on common lending products, which was already done to some extent by previous legislation. (If you've received a credit card offer recently, you've seen the effects.) But even if consumers want more standardization and simplification, there are ways to achieve it without a new government bureaucracy: for instance, entrepreneurs are free to launch magazines or websites (like Consumer Reports) which focus on lending products. (In fact, there are many: just search Google for "credit card comparison site," for instance.) If this service is important enough to consumers to warrant government action, it should be important enough for them to support such a private concern as well.

(For more on Professor Warren, financial reform, and libertarian paternalism, see this previous post and the paper linked within.)


Jonathan B. Wight

Kant is a strong defender of the viewpoint that people deserve to be treated with respect, as autonomous and dignified individuals.  I say “Bravo!” There is a dangerous and slippery slope from portraying others as incompetent to taking over their lives “for their own good.”

Yet... some staunch defenders of liberty have also walked that slippery slope.  Adam Smith, for example, chronicled the irrational foibles of humanity, and suggested policies for accommodating it.  Unlike Mark White, I am willing to consider the walk. 

People are gullible.  It’s an indelible feature of human experience.  People are gullible amount money, about war, and about love.

I’ve been listening to Rufus’ The Wisdom of History.  Time after time people have gone to war believing—dreaming or imagining—that the conflict will be over quickly and with minimal casualties.  Rufus takes us back to the Peloponnesian War between Athens and Sparta, with the same distressing and repetitive theme as the American Civil War, World War I, and to the “Mission Accomplished” speech on Iraq in 2003.  People always believe irrationally that this time it will be different.  It’s the gambler’s curse and the alcoholic’s refrain.

Is there anything we can or should do about gullibility?  The option to “let people learn from their mistakes” is a good one—and accords them dignity and freedom.  At the same time, some choices may be irreversible and catastrophic.  Some aspects of finance have become so specialized that the average consumer will never master its intricacies, no matter how many disasters befall them. 

It seems disingenuous to say, “Let’s let thousands of people fall off the financial cliff—eventually those that survive will learn.” 

A greater concern for people’s dignity and autonomy might lead us to ask:  “What common standards and terms for loans would allow people to successfully complete a contract without losing their financial independence?”  Accomplishing this might require that businesses report information—as in the Truth in Lending Act 1969—which required lenders to disclose the annual percentage rate of interest.  It might also restrict certain types of products.

Some paternalism would make it illegal for lenders to prey on our known gullibility.  Adam Smith directly addressed this issue when he argued for restricting bank note issues to larger than 5 pounds.  The reason is because he didn’t want to give the poor the “choice” to destroy themselves by speculating on bank notes.  Any loss for the poor would be catastrophic.  Smith was being pragmatic about what would ultimately allow the poor to live dignified lives. 

Is paternalism a dangerous, slippery slope?  Absolutely.  But that does not mean we walk on only flat and dry land.  We have good hiking boots and ice crampons and other tools for helping navigate.  It helps to have a good guide (e.g., Kant) who can warn us of excessive slopes.  But it seems excessive to banish society from visiting any slope at all. 

Elizabeth Warren, financial reform, and Nudge

Mark D. White

Since the nomination of Harvard law professor Elizabeth Warren to head the Consumer Financial Protection Bureau is currently making headlines (though not as much as if she were a disgruntled flight attendent), I thought it was a good time to share a recent paper of mine, "We've Been Nudged: The Effects of the Downturn on Dignity and Responsibility," which I wrote for Martha Starr's upcoming edited volume, Consequences of Economic Downturn: Beyond the Usual Economics, forthcoming next year from the Palgrave series "Perspectives from Social Economics." Here's the abstract/introduction:

The economic downtown that began in 2008 has had tremendous consequences in the United States (and abroad), including declines in traditional economic variables such as gross domestic product, the stock indices, and employment, as well as the broader measures of well-being detailed in other chapters in this book. Scholars will argue for years to come over the true causes of the downturn - how much was due to imprudent practices on the part of business (chiefly, financial concerns), irresponsible behavior on the part of consumers and borrowers, and ill-designed regulation and intervention by the government - as well as the effects of various aspects of the government response.

Regardless of the relative validity of these factors, the common perception seems to be that private institutions - the market in general and the financial sector in particular - failed, and government intervention is necessary to serve the functions that private institutions used to provide. As a result of this perception, the American people may be more open to increased regulation of economic and financial activity, including state intervention in personal decisionmaking, as typified by the “libertarian paternalism” made popular by the book Nudge and incorporated into proposed federal legislation to enact broad reform of the financial sector. I argue below that we should not be too hasty to surrender choice over personal decisions to the state, based on criticism of libertarian paternalism and its academic basis in behavioral law and economics from the viewpoint of dignity and autonomy as described by 18th century philosopher Immanuel Kant. I discuss the specific work in the area that inspired the most recent attempt at financial regulatory overhaul, and show how its features are consistent with the broader literature from which it derives, and also how it suffers from the same flaws epistemic and ethical shortcomings. Ultimately, I argue that the perception of the failure of the market that has led us to question our own choices results from a misunderstanding of the role of the market in society, and an improved understanding of the market will serve to reassert the importance of individual choice and dignity over the supposed benefits of government decisionmaking on the behalf of consumers.

In this section on financial reform I discuss a bit of Professor Warren's work, mainly her 2008 paper "Making Credit Safer" with Oren Bar-Gill from the University of Pennsylvania Law Review. As I explain in my paper (with many quotes from Bar-Gill and Warren, plus others), these scholars share the same attitude toward consumers as Richard Thaler and Cass Sunstein do in their academic and popular work on libertarian paternalism, which is ultimately based on incredibly simplistic and reductive understandings of human motivations and behavior (which is ironic, coming from behavioral economists), and a refusal to consider the autonomy and dignity of the consumers they presume to be helping.