How do we teach this?

15/02/2013 § 10 Comments

Reading through the post-mortems of the financial crisis, I’ve been struck by something. The behaviour of the finance sector doesn’t fit the standard economics model, the Samuelson textbook depiction, or the Heckscher–Ohlin model of trade, or the Solow model, or any of the other bog-standard depictions of the economic system that we like to teach.

A key idea is that capital is a factor of production, like labour, land, and maybe entrepreneurship, management, natural resources, human capital, or any of the other factors people like to add. Two things about this capital:

  • capital gets a return for its use, which accrues to the owner of said capital, and
  • owners (capitalists, entrepreneurs, whatever) receive a return commensurate with the risk they take: higher returns are required to entice people to take greater risks (and thereby promote innovation).

But, but, but…that’s not what’s happened.

If you read the accounts of the financial crisis, two things are clear:

1. The people administering the mortgage-backed securities (MBSs) are having a hard time proving they own the mortgaged they say they do. To quote Adam Levitin:

The mortgage foreclosure process is beset by a variety of problems.  These range from procedural defects (including, but not limited to robosigning) to outright counterfeiting of documents to questions about the validity of private-label mortgage securitizations that could mean that these mortgage-backed securities are not actually backed by any mortgages whatsoever.  While the extent of these problems is unknown at present, the evidence is mounting that it is not limited to one-off cases, but that there may be pervasive defects throughout the foreclosure and securitization processes.

That is, these folks aren’t sure of what they own, and yet they are selling derivatives based on what they think they might have. More frighteningly, banks are taking or selling houses they don’t own.

2. Risk and reward are now de-coupled. Companies in the finance sector took gambles on the housing market, and things didn’t go their way. That happens. An evolutionary account of the market economy is that success should be rewarded and failure should lead to extinction. AIG, just to name one company, took massive risk onto its books by insuring the value of MBSs. Their clients claimed against the policies, which was going to drive AIG into bankruptcy. AIG got bailed out, as did a number of other financial firms. So, for finance firms, success is rewarded but so was failure.

Thomas Baxter, Jr., New York Fed:

In the months leading up to early November 2008, AIG had been actively engaged in efforts to negotiate tear-ups of its CDS contracts with its counterparties. AIG was completely unsuccessful. The need for the tear-ups was real; AIG was effectively hemorrhaging cash.

But what happened? Wall Street posted record profits in 2009 and had its fourth-most-profitable year in 2010, after it ‘benefited from a series of federal bailouts as well as low interest rates’.

Why aren’t more economists having a crisis of faith? The story and the models that we use to talk about the economy appear flawed in a fundamental way. It isn’t about innovation and efficiency, the supply side responding to signals from the demand side. Instead, fraud, crime, and collusion seem to be the path to riches.

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§ 10 Responses to How do we teach this?

  • I’m a Virginia Political Economy grad. This is exactly what I expect, so why should I be having any crisis of faith? Of course politically connected firms will seek bailouts, and they’ll often get them.

    • Bill says:

      Fair enough. But there are plenty of economists basing their work on a theory that doesn’t hold, given the new data.

      I also wonder — wouldn’t Political Economy collapse into a theory of power? In which case (given, for example, that ownership depends on who asserts it, not the law), what’s wrong with nationalising an industry? Or, why shouldn’t assets remain in state ownership?

      • Matt Nolan says:

        This all sounds like a typical incentive problem in the face of asymmetric information, so I wouldn’t expect it to cause economists a crisis of faith – outside of the law and economics discipline.

        Microeconomists would hardly be suprised, and macroeconomists probably feel let down that issues of asymmetric information and corruption were allowed to dominate in an area where state government and financial regulation were supposed to help.

      • Bill says:

        I’m not sure it’s asymmetric information. That doesn’t capture the idea of power, which is what is at play. I guess it’s rent-seeking, and I have to go read all that literature. Suggestions, anyone?

      • Actually, Seamus and I put forward that kind of argument for not privatising the power companies, figuring that the high profits in dry years needed to make the system sustainable wouldn’t be politically sustainable in a private system, and so it would wind up in bailouts and messes.

      • Bill says:

        I didn’t see that argument — it sounds like there may be something to it.

      • Matt Nolan says:

        Isn’t asymmetric information inherently related to rent seeking in the financial industry? Institutional arrangements that were meant to improve transparency and reduce risk were actually used as vehicles to manipulate information to reduce costs and try to increase margins – by misrepresenting asset quality.

      • Bill says:

        Asymmetric information describes part of what was going on before the crisis — investment companies selling defective products and then shorting them. But also, the investment companies themselves do not appear to have understood the full extent of the risk. That’s less about asymmetric information about more about ‘surprises’ (Shackle) or ‘black swans’ (Taleb). Also, the bailing out of powerful, connected firms was not about information but power or rent-seeking.

      • Matt Nolan says:

        “Also, the bailing out of powerful, connected firms was not about information but power or rent-seeking.”

        Bailouts were justified no the basis of systemic risk issues – which we may not accept. If we do accept them, then there should be a counterveiling costs … if financial firms are implicitly insured, they should have to pay for the insurance. This is the direction a lot of the economic literature was going both before the crisis (the Basel accords) and post-crisis.

        Your concern is very much about the fact that this isn’t taking place, and that there are strong interest groups in the US that are extracting rents. This is a damned fair concern, and I agree with you.

        However, I wouldn’t blame economists for this – I’d blame corruption and the institutional failure that is going on. This is disappointing, but I’m not sure why it would cause economists to have a crisis of faith. As a group we are incredibly cynical about the functionings of large institutions by default.

        Perhaps your point is that instead of studying the workings of DSGE models, more economists should be explicitly modeling and commenting on rent seeking behaviour – a good point. I’d just point out that as a discipline we follow the incentives laid out for us, I’m not sure exactly why our discipline has a “special role” for fighting corruption.

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