Posts by Martha A. Starr

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.

Consequences of Economic Downturn -- Part I

Martha A. Starr

Thanks, Mark, for your invitation and warm and enthusiastic welcome! And also for your support and persistence in "nudging" us to get this book project done.  ;)

Conseq The central idea of Consequences of Economic Downturn: Beyond the Usual Economics is to discuss issues that usually get left out of discussions of the 2008 financial crisis and the "Great Recession" that accompanied it –- which threw one in 10 members of the labor force out of work. Such discussions usually emphasize specifically economic dimensions of the financial crisis: What role did mortgage securitization play in causing the crisis? Was it Greenspan’s fault for leaving monetary policy too lax for too long? What is wrong with incentive structures in financial institutions and markets that cause people to take on too much risk? Not that these questions are not important, but they’re only part of the picture. A much wider range of factors led to the crisis and downturn -- social, ethical, political, cultural, educational -- and this wider range needs to be discussed if we are to have any hope of bolstering the economic and financial system’s resilience against convulsions like this.

So over the next few weeks, I’m going to lay out some of the core ideas of the book -– beginning today with those of someone whose ideas Mark has already discussed, George DeMartino of the University of Denver, whose book The Economist's Oath: On the Need for and Content of Professional Economic Ethics has attracted attention on a global scale.

George’s chapter addresses the question of whether knowledge practices in economics may have contributed to the crisis and downturn. Unlike just about every other academic profession (statisticians, mathematicians, physicists, sociologists, and more), economists have always resisted adopting a code of conduct or ethical code spelling out how they are expected to act –- as matters of keeping the profession’s members from using their specialized knowledge in ways that could advantage them but harm others, and/or that could cast doubt on the value, integrity and competence of the profession’s work. George doesn’t actually advocate such a code, because he thinks it would oversimplify the thickly tangled ethical questions here. Rather he calls for the establishment of a field of professional economic ethics which, like the field of medical ethics, would seriously study how economists should tackle specific problems that come up in the course of their work.

Important here, for example, is the principle widely found across the professions that people should avoid courses of action that could do harm to others (like the physician’s oath). George argues that reasonable concern for the wellbeing of others –- especially vulnerable groups lacking the wherewithal to deal with a period of significant economic and financial distress -- would have impelled economists to think more squarely about the risks inherent in the constellation of developments in the years before the financial crisis (the housing price bubble, rise of subprime lending, proliferation of collateralized debt obligations, and so forth). This, in turn, would have clarified their social responsibility to try to stop practices that were contributing to these risks, and/or advocate policies that would tamp them down.

Personally, I think the economics profession does need a code of ethics because, as Deirdre McCloskey says, “words matter,” and a well-done code could go a long way towards making people think twice before (say) taking $135,000 speaker's fees from Goldman Sachs, then giving them privileged access to the White House. But George’s argument against oversimplifying is powerful and thought-provoking.

Up next: Robert Prasch’s chapter on policies and institutions that shift risk away from wealthy and powerful institutions onto folks like average taxpayers.