I Am Not Now, nor Have I Ever Been, a Monkey Psychologist

In response to my observation that he had put little emphasis on the real estate and other malinvestments that kicked off our financial turmoil, Bradford DeLong writes:

That there are “malinvestments… wealth-squandering mistakes” … is simply not news.

I understand that Professor DeLong’s main interest lies elsewhere, in the question of what has made the global decline in measured financial wealth so much larger than in earlier crises.  Nevertheless — news or not — I think the opening phase of the crisis calls for explanation.

DeLong caricatures my account as follows:

White’s theory seems to be that our current crisis is deserved and inevitable retribution for financial fecklessness. … White’s position is, I think, a normal reaction derived from monkey psychology — the band of monkeys hangs together better if monkeys fear that they will be punished if they transgress the rules. But I don’t think it helps us understand what is going on very much.

In fact, I think economic reasoning about cause and effect (not monkey psychology) helps us to understand what is going on.  Economic reasoning does not require the use of, nor have I used, normatively loaded terms like “deserved” or “retribution” or “fecklessness.”  To repeat what I wrote on my blog in September: 

This isn’t a morality play. What we’re seeing are the consequences of monetary-policy distortions of interest rates and regulatory distortions of incentives, amplified in some degree by private imprudence, not the consequences of blackheartedness.

Nor, I would add, need we appeal to “fecklessness,” if that implies some additional moral failing beyond imprudence and miscalculation.

I myself don’t think that Professor DeLong’s “utilitarian’s dream” helps us to understand what is going on very much.  This appears to be a normative yardstick according to which there would be more risk-spreading, more intermediation, and more investment in an ideal world (of zero transactions costs, complete markets, and perfect information?) than in our real world.  By such a standard, “financial markets do not do a good job.” Here we seem to have a variety of what Harold Demsetz used to call the “Nirvana fallacy.”  The real never measures up to the imaginary ideal.

DeLong concludes that there isn’t a lot of sense in talking about “overinvestment” in the real-world economy, apparently because the  ideal world would always have more investment than we have even at the peak of an investment boom.  In my view, by contrast, it is perfectly sensible and useful to talk about whether investment in the real-world economy has been expanded beyond voluntary saving in the real-world economy.  It is sensible and useful to talk about whether investment was misallocated, in particular whether real-estate investment was unsustainably large. 

Professor DeLong writes that “the proper public policy response to every situation that White would characterize as one of ‘overinvestment’ is, I think, one in which the government takes steps to mobilize more of society’s risk-bearing capacity rather than letting asset prices collapse and create massive unemployment.”  But does any decline in asset prices from their level at the peak of the boom constitute a “collapse”?  Does DeLong believe that it is never proper policy to let unsustainably high asset prices return to equilibrium, and to let misemployed capital goods and labor be reallocated to better uses, provided that we take care to avoid a collapse in nominal aggregate demand and thereby the deep depression and massive unemployment that nobody wants?   

Also from This Issue

Lead Essay

  • What Really Happened? by Lawrence H. White

    In the first of this month’s four accounts of the causes of the financial crisis, Lawrence H. White, the F.A. Hayek Professor of Economic History at the University of Missouri, St. Louis, makes his case. White argues that the housing boom and bust, and the resulting meltdown of financial markets, cannot have been the result of a laissez-faire monetary and financial system, since we never had one. Nor can deregulation have been the cause, since the most recent relevant deregulation has probably helped contain the turmoil. While admitting that “private miscalculation and imprudence made matters worse,” White argues that “to explain industry-wide errors we need to identify policy distortions capable of having industry-wide effects.” He points to two such distorting sets of policies: the overexpansion of the money supply by the Fed, and government mandates and subsidies to write riskier mortgages.

Response Essays

  • Adam Smith Was Right about Corporate CEOs’ Incentives absent Effective Regulation by William K. Black

    In our second anatomy of the financial crisis, William K. Black, associate professor of economics and law at the University of Missouri, Kansas City, says that key to the crisis was perverse compensation schemes that put the incentives of executives at odds with the interests of creditors and shareholders. Drawing on his concept of “control fraud,” Black argues that a failure of regulation encouraged executives to meet short-term earnings goals and to capture large bonuses by encouraging fraudulent mortgages – even when it could be foreseen that this might lead to the destruction of the firm. “When we do not regulate or supervise financial markets we, de facto, decriminalize control fraud. The regulators are the cops on the beat against control fraud – and control fraud causes greater financial losses than all other forms of property crime combined,” Black writes. Fannie and Freddie cannot have been the culprits, Black argues, because they were guilty of less mortgage control fraud than their fully private counterparts. “ ‘Modern finance’ has failed the market test,” Black concludes. “Its policies optimize the environment for control fraud and create perverse dynamics that create recurrent financial crises.”

  • Fundamental Origins of the Housing Boom and Bust by Casey B. Mulligan

    The housing boom and bust stands behind the financial turmoil of 2008. Therefore, in our third analysis of the financial crisis, University of Chicago economist Casey B. Mulligan explores various hypotheses about its underlying causes. Was it changes in tastes and technology? Public policy? Investor “exuberance”? Mulligan describes some of the empirical tests that would be needed to settle the question, and argues that at least part of the answer is already clear. Most of the housing boom, Mulligan finds, was based in expectations about the future, rather than in demand, supply, or subsidies during the boom. Mulligan says that additional empirical tests – especially about the aggregate wealth effects of the boom and bust – would help us form a more educated guess about whether boom expectations were based more to changes in tastes, changes in technology, or exuberance. But those tests have not been done, and therefore, Mulligan concludes we cannot yet reliably predict the future economic damage from the housing boom and bust, or formulate beneficial financial industry regulation.

  • Liquidity, Default, Risk by J. Bradford DeLong

    Our fourth and final anatomist, J. Bradford DeLong, notes that “in the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion,” and lays out five reasons why this value might fluctuate. “Savings has not fallen through the floor. We have had no little or no bad news about resource constraints, technological opportunities, or political arrangements.” Therefore, DeLong says, we’re left with changes in the discounts for liquidity, default, and risk. The housing crash has increased default risk significantly, but central banks have actually pumped up liquidity. Almost the entire drop of the value of global capital, DeLong argues, comes from an “increase in the perceived riskiness … of income from capital.” The problem, DeLong says, is that “our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level that has led to ten times the total losses in financial wealth of the impulse.” However, DeLong is confident that Larry White’s story – focusing on the money supply and government policy to encourage bad home loans – cannot be the right one.

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