The Bright Side

Throughout the unfolding financial meltdown, I keep finding myself thinking that there might be one small, positive effect to come out of this: namely, a much-needed dose of realism and humility for market advocates. Because, really, after reading this Steven Teles post:

All through the financial crisis, governments have failed to act in a powerful, concerted way when markets were susceptible to a signal of a major shift in direction. The nature of market panics is that they don't necessarily find their bottom when they reach some measures of the "fundamentals"--they reach their bottom when everyone thinks that everyone else believes the bottom has been hit. That is often when some set of governmental actors make what markets actors plausibly believe that other market actors will think is decisive action. In the absence of such a focusing event, things keep spiraling downward.

If I never hear another goddamn libertoonian holding forth on the "wisdom of crowds" and the superiority of markets to governments in all things, it will be too God damn soon. The financial system is in free fall because a bunch of brain surgeons on Wall Street managed to convince themselves that they could get rich by making bad loans to people with no ability to pay them back, and that there was nothing that could possibly go wrong with this plan. And now that the scheme has failed in an entirely predictable manner, these same geniuses are going into a hysterical panic like a bad caricature of a 1950's tv housewife, because the government isn't acting decisively enough to bail them out.

The next time some financial genius pipes up to tell me how we ought to run colleges more like businesses, it's going to be very hard for me to keep from slapping him silly.

Matthew Yglesias suggests another possible bright spot, but I'd settle for a little quiet from the market maniacs.

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a bunch of brain surgeons on Wall Street managed to convince themselves that they could get rich by making bad loans to people with no ability to pay them back, and that there was nothing that could possibly go wrong with this plan

For many of them the plan was successful because they did, in fact, get rich. What, you were expecting glibertarians to care what happens to everybody else?

The next time some financial genius pipes up to tell me how we ought to run colleges more like businesses, it's going to be very hard for me to keep from slapping him silly.

Ditto government. One of the handful of promises that Bush has kept was that he would run government like a business. The businesses in question turned out to be Enron, Bear Sterns, etc. In New Hampshire, we've learned that lesson: our last Republican governor, whose previous experience was running a tech company during the dot com bubble, did so badly that he was unelected after a single two-year term.

And don't get me started about MBAs, a degree which IMO is worth almost as much as the paper it's printed on. (Remember, Bush has an MBA from Harvard.)

By Eric Lund (not verified) on 13 Oct 2008 #permalink

a much-needed dose of realism and humility for market advocates.

I knew you were an optimist, Chad, but...*grin*

Personally, I think it more likely that market advocates won't be able to convince people that they're right as easily as they could, but I'm skeptical that they'll actually be able to eat that much crow...

By Will "scifanta… (not verified) on 13 Oct 2008 #permalink

"I keep finding myself thinking that there might be one small, positive effect to come out of this: namely, a much-needed dose of realism and humility for market advocates."

Didn't you hear? The financial crisis was caused by excessive government interference with the market! It's true, because the libertarians tell me so, and also, if it weren't, markets wouldn't be perfect - and as we all know, they really are.

By konrad_arflane (not verified) on 13 Oct 2008 #permalink

Personally, I think it more likely that market advocates won't be able to convince people that they're right as easily as they could, but I'm skeptical that they'll actually be able to eat that much crow...

It depends on what you mean by "advocates." And for that matter, "free market."

There are certainly people out there who are such strong market advocates that they were still, last week, claiming that market intervention is just wrong and that the whole system should just be allowed to crash as hard as it can can. They may still be making those claims-- I haven't spoken to any of them at work for a few days. And these are people who should actually have some knowledge of what credit crunches and liquidity crises mean in practical terms, e.g., people with real business degrees.

That's free market advocacy of a sort, but it's less advocacy than sheer ideology, and it's a particularly extreme form of free market thought to begin with. Painting all market based thought with that brush is rather dimwitted, and requires its own form of mental gymnastics and cherry picking.

If by free market and advocacy, you mean that there will still be a sizeable group of people who think that market based systems are still in general good, and still in general function better with minimal interference-- with the definition of "minimal" certainly not being "zero" or even being exactly the same in all circumstances-- well, then, yes. Yes, there will be people trying to figure out what is the correct and minimal level of interference to apply once the whole mess is contained.

Here are two reasons why:

First, no one looked at the great electrical grid and power system crises of a few years ago, or of the 70s, and said, "Well, that's fucked up. Looks like we should abandon the whole thing, and start from scratch on a different guiding princple, like DC transmission!" No one serious, anyway. You can replace with many different examples, and see that in some cases, we have made that decision, e.g., with nuclear power, only to decide that, gee, maybe we shouldn't have been so hasty.

Second, at least of some of those advocates have a passing familiarity with history and are aware that there have been crashes and panics in the past, and are therefore reconciled to that fact of life. Some have even noted that the crash-and-rescue phenomenon has happened before: The S&L crisis followed this model in (very) broad outlines, and in the same proportion to the GDP at the time.

By John Novak (not verified) on 13 Oct 2008 #permalink

Dr. George Hockney told me yesterday that the good news was that Canada was granting $50,000,000 to the University of Waterloo for Quantum Computing research.

He suggested that if governments gave out more money for basic physics research, those people getting the money would be less tempted to be "quants" in the Finance industry making up bizarre and incomprehensible derivatives and other securities.

Physics helped get us into this mess; Physics can help to get us out...

"The financial system is in free fall because a bunch of brain surgeons on Wall Street managed to convince themselves that they could get rich by making bad loans to people with no ability to pay them back, and that there was nothing that could possibly go wrong with this plan."

In part. But that is just the beginning. From top to bottom the low interest rates, often negative in real terms, meant that you could borrow money and easily assume that virtually anything would be profitable. If the interest rate is below the rate of inflation and well below any conservative estimate of profit in any number of investments then it, according to typical business school thinking, would be crazy not to take out a loan.

this, of course, becomes a self reinforcing system when all the other financial geniuses draw the same conclusion.

ie: Lets say your running a small business making cubical bowling balls. They don't really work very well for bowing and tend to jam the machines. So your market is rather small. You sell a few to friends, relatives and people who buy novelties. You have never shown a profit.

But one day the interest rates effectively go below inflation and a tipping point is crossed. Suddenly tens of thousands of business types, geniuses all, rush out and get loans to invest because they know they can't lose. After all the sound investment choices are taken people start dropping into your cubic bowling ball business.

Overnight your business has investors. Funny thing is that even though you have never shown a profit selling these balls (cubes) people see others buying your stock and start making offers to buy more stock. Soon the original investors are able to sell their stock to the next wave of buyers. Everyone is making money. Your stock holdings, as founder, are worth millions. People see others making money buying your stock and feel the need to buy.

Seeing a good thing and wishing to leverage it people start taking out loans to buy more. And as people buy more stock prices rise and the whole thing reinforces itself as higher prices mean higher profits and the profits prove that you can borrow money and invest in virtually anything, even square bowling balls, and make a huge profit.

Of course it wasn't stocks. The locus of error was real estate. But it doesn't matter what it was. It could have been tulip bulbs. Or cubic bowling balls.

And it wasn't community reinvestment in poor folks promoted by Washington. Many more of the faults came from relatively rich people. Often who were investing in second and fourth homes. And it wasn't simple leveraging.

There were 'liar loans' but even 'legitimate' loans were obtained by services that set up a hidden, of the books, loan that allows you to take a few hundred dollars and insert, for a time, thousands into your bank account. this then is proof for getting a loan or closing on a mortgage. Made all the more palatable because many mortgages were set up on a 'no recourse' basis.

This 'win big if you win but lose nothing if you lose' logic was mirrored in institutional investing. The head of an investment bank can make a killing if the investment pans out. But the same guy is protected from loss by corporate rules and a golden parachute if the investment craters.

Up and down the system the combination of the price of money being below any reasonable estimate of return on anything at all and the perverse incentives of a 'I win big or lose nothing' system worked together to inflate the market into a froth of hollow promises and 'no loose' situations based on smoke and self-deception.

Which, in a nutshell, is how we got here.

But don't assume these financial geniuses will learn anything of laws will change to eliminate this method of failure. Already the myth that it was the federal government that forced the otherwise prudent and conservative bankers to make loans to poor people has become a durable meme.

No, it wasn't well off people looking to make a killing. It wasn't greedy investment banker. it wasn't people making a killing assembling mortgages they knew would explode. it wasn't investment banks who bought huge bundles of these mortgages and loans and then turned around and took out 'insurance' by buying credit default swaps from friends that were backed by other bundles of equally empty pieces of paper.

No, it was those poor black folks who forced their way into the banks and used the heavy hand of unjust government to force these otherwise incorruptible bankers to give them a loan.

When all else fails blame the government, the poor, the people who don't look like we do. Ready made scapegoats for this whole debacle. And a really handy way to avoid any responsibility, future regulation and ability to learn from the mistakes.

We might see some regulations to knock the worse of the rough edges of abuse off but I don't hold out much hope that the roots of the problem: easy money, perverse incentives, and financial institutions too interlocked and huge to be allowed to fail will be addressed in any meaningful way. Count of seeing this problem again in a decade or two.