Thank God for Anonymous Readers!

I’m back from Utrecht and eager to rejoin the discussion, which has been aided greatly by the contributions of an anonymous reader who has obviously been in the tranches.  Let me first respond to the specific questions my colleagues have posed to me. 

Do I argue that agency problems in the private sector are both an important cause of the crises and exacerbated those crises?  Yes.  My prior essays and long reply explain why, though I will amplify the answer in my next post.

Do I, Larry White asks, agree with Gerard Caprio, Jr., Aslı Demirgüç-Kunt, and Edward J. Kane (CDK)? “[W]hat prompted the overleveraging and excess risk-taking in the first place? CDK argue that an important contributor was ‘safety-net subsidies,’ i.e., moral hazard from implicit or explicit financial guarantees.” 

No.  First, CDK do not provide an explanation of why regulators permitted these activities.  One needs to explain why economists’ endorsement of non-regulation and deregulation led to non-regulation and deregulation.  One also needs to examine the ideology of those who appoint the regulators and those appointed as the top regulators.  As I discussed, when you appoint individuals who believe that regulation cannot succeed, they will prove themselves correct.  You get exactly what we have experienced — desupervision. 

Second, the great bulk of the crisis was not “excess risk-taking.”  Again, my prior pieces provide substantial analysis and data explaining these points.  Mortgage fraud (by lenders) is a “sure thing” (Akerlof & Romer 1993; Black 2005) — it is (in combination with rapid growth, high leverage, and minimal loss reserves) mathematically certain to produce extremely high short-term “profits.”  It is also certain to produce failure — the only question is how soon.  Note that control fraud (rather than “excess risk-taking”) also played the dominant role in prior crises such as the S&L debacle, Enron/WorldCom and their ilk, Russian privatization, and the travails of the “the Washington Consensus” in Latin America.

Third, unregulated (or almost entirely unregulated) lenders committed the great bulk of the mortgage.  These lenders were not covered by deposit insurance.  If CDK were correct then they should have been subject to far more stringent “private market discipline.”  Private market discipline (under their theories) is supposed to ensure adequate capitalization — which is (under their theories) supposed to minimize “moral hazard.”  Thus, the predictive strength of their model has been tested by the subprime crisis — and falsified by it for mortgage fraud (or, if the reader is still in denial about fraud despite the data I provided, which my colleagues don’t even attempt to refute, the “excess risk taking”) was significantly more common in the sector that under their theories had the least moral hazard.   

The Enron/WorldCom, et al., scandals had already shown that accounting control fraud did not require explicit or implicit governmental guarantees.  Fourth, moral hazard theory (as interpreted by CDK) did not explain the S&L debacle even though it took place in an industry with explicit governmental guarantees. They (implicitly) interpret the theory as excluding control fraud.  This is an incorrect interpretation of moral hazard theory, which arose in the insurance context and has long recognized that moral hazard can lead to either excessive risk-taking or fraud by the insured.  For the sake of testing their argument, however, I assume their definition that argues that S&L owners, made insolvent by the interest rate shock of 1979-82, responded by “gambling for resurrection.”  These were honest gambles that would only pay off for the CEO or shareholders if the investments succeeded.  The troubles with this theory include (1) the purported “rational” strategy (as interpreted by economists) was virtually certain to fail, (2) all of the purported “gamblers” economists asserted followed this strategy (the “high fliers”) first reported exceptional profits and then failed, (3) as the national commission (NCFIRRE) found, “fraud was invariably present” at the “typical large failure,” (4) the business practices that the purported gamblers followed were profoundly irrational if they were honest, but were optimal as accounting control frauds, and (5) in fact, there were honest gamblers but they (A) did not act in a manner that economists predicted and (B) they won their bets and substantially reduced the cost of the debacle.

Point 1:  economists assert that the optimal “excess risk-taking” strategy for insured banks that are inadequately capitalized or insolvent is to maximize the value of the put option. [1] The means by which one maximizes the put is to take ultra high risk.  The optimization is straightforward — the greater the risk, the greater the expected value of the put.  The obvious (except to most economists) problem with this concept is that the way to optimize is to take a bet that is so risky that it is virtually certain to fail.  Even economists should be able to understand that financial suicide is an unattractive and oxymoronic form of “optimization.” 

Point 2:  The concept of “optimization” I have just explained could explain part of the pattern of outcomes of the “high fliers” and lenders that specialized in nonprime mortgage loans, i.e., universal failure.  Why S&L subordinated debt holders and other creditors that are not protected from loss by deposit insurance never blocked these suicidal strategies by the “high fliers” is, however, inexplicable under neoclassical economic theory.  (Subordinated debt holders, who economists predicted would be the optimal agents of private market discipline because they had large amounts of at-risk funds and were financially sophisticated, also failed to block control fraud — or “excess risk-taking” — at banks, investment banks, and insurance companies.) 

The concept of optimization, however, cannot explain the first aspect of the pattern of outcomes – uniform high, initial profitability.  There is no reason why hundreds of S&Ls and scores of nonprime lending specialists (A) should have all specialized in the same small number of activities, and (B) should all have been highly profitable while purportedly engaging in ultra high-risk investments. [2]

What does fit the pattern of outcomes is accounting control fraud.  It is a “sure thing.”  It produces certain profits in initial years.  Unless the fraudulent CEO exercises restraint presumably because the company is well-capitalized and likely to generate long-term profits — which was not the case for any S&L in this era — the optimal strategy was “looting” (Akerlof & Romer 1993).  Looting is fatal and typically causes catastrophic losses.  I term the exercise of restraint in converting firm funds to the CEO’s personal use through accounting fraud “grazing.”

Points 3 and 4:  NCFIRRE (1993) found that (A) there was a distinctive pattern to the high fliers’ business practices, (B) the pattern was irrational if they were engaged in honest gambles, (3) the pattern optimized accounting fraud, and, (4) that fraud was “invariably” present at the “typical large failure.”  The nonprime lenders meet those four characteristics, as do Enron and its ilk.

Point 5:  “Traditional” S&Ls did “gamble for resurrection” in 1981-83 by maintaining much of their interest rate risk exposure.  This was not consistent with economists’ beliefs about moral hazard theory.  Every traditional S&L was insolvent on a market value basis in 1982.  Very few of their CEOs (roughly 100 of around 3000) engaged in reactive control fraud due to moral hazard.  This restraint is the most significant reason why the debacle did not grow to catastrophic proportions.  (Roughly 200 “opportunistic” control frauds entered the S&L industry in 1982-84 through changes of control or opening de novo institutions.  The typical opportunist was a real estate developer.  He had large conflicts of interest and no ties of loyalty to the S&L or its shareholders, customers, or employees.  He was more willing to loot than was the typical traditional CEO that had come up through the ranks over the course of two decades.

Moral hazard theory (as taught by neoclassical economists) predicts that traditional S&Ls would dramatically increase their risk exposure through honest gambling in 1982-84.  Instead, traditional S&Ls made modest increases in credit risk and modest-to-moderate reductions in their interest rate risk exposure.  This behavior was inconsistent with the predictions of moral hazard theory.  It was risky.  If interest rates had continued to increase throughout 1982 and beyond the overall industry insolvency (on a market value basis) of $150 billion would have increased.  Instead, the traditional S&Ls were lucky on interest rates after mid-1982, as rates fell significantly and fairly steadily.  Because traditional S&Ls only partially reduced their exposure to interest rate risk, their “underwater” mortgages regained most of their (unrealized) market-value losses.  As a result, “only” about $25 billion of that $150 billion was ultimately “realized.”  (NCFIRRE 1993).  If economists wish to define insolvent S&Ls continuing to take serious, but modestly less, risk as “moral hazard,” then they can conclude that moral hazard significantly reduced the cost of resolving the S&L debacle.

Ultimately, CDK’s logic (if not their conclusions) strongly supports the themes I have developed during this discussion.  Deregulation and desupervision in the financial sphere can have the unintended consequence of optimizing a “criminogenic environment.”  The extension of implicit federal guarantees to every large corporation operating in the United States can exacerbate the problem of control fraud.

Casey reminds me that he has GDP data (emphasis in the original) that, he argues, demonstrate that there is no “crisis” for the “average” American.  Casey is aware that I (and our readers) have data too, and that (unlike lagging GDP numbers) they demonstrate a crisis greater than any of us have experienced in our lifetimes (except for readers who are very long-lived and knew the Great Depression).  We know that there have been unprecedented failures of hundreds of markets — globally.  We know that but for unprecedented intervention by the Fed, Treasury and other central banks it is the considered judgment of the economic powers that be (here and abroad) there situation would have become catastrophic.  We see unprecedented socialism in the United States for our more elite institutions.  We see the failure (or “but for” intervention failures) of many of our most elite financial institutions.  Now, granted, I was born in Detroit and grew up in Dearborn, so the auto industry probably has lubricants running in my veins, but the “but for” collapse of the entire domestic auto industry is a kind of a big deal.  All of this happened not in some “perfect storm” but during the “great moderation.”  It is also getting worse, commercial real estate, the PBGC, SIPC and other shoes are waiting to drop.  All of these facts are data.  They are simply vastly more important data.

Brad argues that:

Thus practically every risky asset, all the time, sells for much less than its fundamental value — and does so because financial markets do not do a good job of mobilizing the risk-bearing capacity of society. I don’t think we have any prospect of living in a world in which financial markets do their job of risk-tolerance-mobilization well — nobody should trade or invest in anticipation of such a world. But I don’t think that the idea of “overinvestment” makes a lot of sense: 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. 

I have a very different view.  Brad believes that financial markets are commonly made deeply inefficient by “lemons markets” problems in a manner that leads to a systematic undervaluing of asset values.  Many “risky assets” trade for much more than their “fundamental value” (assuming that this concept can be made meaningful.) That is precisely why we have epidemics of control fraud.  Spreads on nonprime mortgage loans during the last decade have always been grossly inadequate and spreads narrowed when they should have grown over the course of the decade.  Moreover, the entire concept of an “adequate spread” for this kind of lending was a misnomer because had the loans been properly priced the spread would have been so large that it would have sent the “adverse selection” problem through the roof (pun intended). 

It follows that we should not seek to initiate government action to inflate housing prices to the point that there were minimal credit losses on existing mortgages.  Doing so would misallocate resources further, reward fraud, and make the markets even more inefficient. 

Larry, responding to Brad, urges:

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.”

I will offer a different view.  There is nothing superior or scientific in avoiding the use of “normatively loaded terms” when such terms are accurate and important.  Readers will have discovered that economists have a profound unwillingness to use the “f” word — fraud — to discuss fraud.  You now see an effort to assert that this weakness is a virtue.  Even Brad’s euphemisms are too strong for Larry. 

The crisis we are discussing has its roots in a massive fraud, primarily by lenders.  Frauds this severe greatly extend and inflate financial bubbles.  This directly causes losses that measure in the trillions of dollars.  It indirectly causes systemic risk because (as the anonymous reader agreed) financial systems run on trust and there’s nothing like creating and then betraying trust (which is what fraud is) and causing enormous losses through that betrayal, to destroy trust.  This is the “transmission mechanism” Brad is searching for that produced the broader crisis.

Fraud has moral consequences, and morality is central, not peripheral to market efficiency.  Larry’s unwillingness to take fraud seriously, even after my data and analysis dump, is characteristic of what has gone wrong in economics. 

For the reasons shown in the earlier discussions, Larry’s claim that monetary policy caused or even contributed greatly to the housing bubble fails.  More to the point, if the “solution” were significantly higher short term interest rates the cure would have been far more expensive and harmful than appropriate micro/macro policies (i.e., regulatory restrictions on nonprime lending) that would have killed the bubble at much earlier time with far less collateral damage.

There was no “regulatory” distortion of incentives that caused or even contributed substantially to the bubble. The CEOs that funded these loans did it to create accounting profits.  It is naïve (and unsustainable) to claim they made the loans to comply with rules (that in fact did not require making or purchasing nonprime loans). 

There was, however, plenty of distortion of incentives by private parties.  They distorted those incentives to optimize accounting fraud.  They acted in a manner consistent with past control frauds. 

Economists love to talk about “unintended consequences” and they’re always in the context of social do-gooding gone wrong.  Here are two unintended consequences of non-regulation and/or desupervision.  (The consequences, of course, are intended by the private parties, but absent corruption, not by the legislators.)  First, when you don’t regulate financial activities you de facto decriminalize control fraud because the regulators are the “cops on the beat.”  Second, when you don’t regulate financial activities you make them opaque and you create a situation in which voluntary industry disclosures aren’t verified by a truly independent entity.

So, no it’s not a fictional medieval “morality play.”  It is the real-world economy, the study of which inherently requires trying to develop greater mastery of vital questions such as morals and fraud.  If you are saying that economics and economists are going to continue (1) not to develop a theory of fraud or become cognizant of the findings of other disciplines that specialize in the study of what causes markets to fail profoundly, (2) not to develop a methodology that does not praise accounting control frauds, (3) to recommend praxis that optimizes environments for epidemics of control fraud, (4) to refuse to analyze whether fraud is present, (5) to refuse to call a fraud “a fraud,” and (6) to think that this ignorance and addiction to euphemism is a virtue, then economists need to engage in a fundamental reconsideration of their profession, theories, methodologies, and policy recommendations. 

As constituted, the economics profession endangers the world economy. As even the triumphalist authors of Moral Markets concede (a book announcing the triumph and moral superiority of “free markets” that had the misfortune of being published this year), our business schools and economics programs too often continue to hold up homo economicus as the ideal — but homo economicus is, to quote that volume:  “a sociopath.”  The authors, in essence, charge that our business school and economics programs have become fraud academies.  Many students will have the moral strength to resist that training, but as economists emphasize, the concern is on the margins.    


[1] Note that this subtly removes the “moral” from “moral hazard” and turns an abusive behavior not simply into a neutral activity, but into a desirable activity.  This is dangerous because it helps “neutralize” abusive behavior, which increases abusive behavior.  As I am about to explain in my discussion of Point 5, “moral” constraints — a broad concept under “moral hazard” theory — can provide some of the most effective constraints against control fraud. 

[2] The markets offer far greater yields for honest risk-taking than honestly underwritten subprime loans or direct investments.  The reason that mortgage lenders specialized in subprime lending or that S&L specialized in “direct investments” or “ADC” loans has is that these types of investments are superb vehicles for accounting fraud, particularly during a “bubble,” not because the yield is spectacular.

Also from this issue

Lead Essay

  • 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

  • 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.”

  • 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.

  • 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.