Gambling with Other People’s Money

RUSS-final-1Dr. Russell Roberts at George Mason University (the finest economic hub in the country) has written a delightful piece on the real causes of the financial crisis.  The observation that greed and stupidity do not help to explain the crisis since greed and stupidity have always been with us (and always will be with us, by the way), is an important one.  Roberts argues that “public-policy decisions perverted the incentives that create stability in financial markets and the market for housing”. Like all economists who understand Hayek, Roberts understands how important price discovery is to a free economy.  Essentially, what Roberts is stating is this: A toxic mix of bad meddling (monetary and fiscal) damaged the price discovery process, encouraged unwise investments, and generally led to the mess that was 2008.  He offers us a prescription to avoid these things in the future: a system of natural incentives for profit and loss.  Well, imagine that.

It is perhaps the best piece I have read thus far on the root causes of the crisis, and it blends a deep and mature understanding of financial economics with a macro philosophical approach that is impressive and cogent.  Roberts does not seek to vindicate Wall Street; in fact, he slams them.  But he does not slam them according to the status quo script; rather, he goes after them for “crony capitalism” – not for exploiting the system of risks and rewards that came to be, but rather for their role in manipulating to get that system of risk and rewards.  It is an important distinction.

Everything I have said thus far is well and good in theory, but in what practical sense did incentives get “perverted”?  His example of an investor backing a poker player is brilliant and very useful: the untold mystery of the 2008 crisis is not in the absurd risks folks with equity took, but rather how the creditors of those risk-taking equity guys could have ever allowed it (with no share in the upside).  Without re-writing his thesis for him, Roberts lucidly explains how our generational coddling of creditors led to a morally hazardous financial culture in which creditors were willing to finance all kinds of highly risky activity with all kinds of excessive leverage, believing they would not be made to deal with the pain of their losses if push ever came to shove. 

It was the leverage of 2008 that elevated it from run-of-the-mill bubble burst to full-blown financial armageddon.  Roberts documents case after case that caused creditors to feel that they had an accomplice in Uncle Sam.  Quick trivia: what do the cases of Continental Illinois, Long Term Capital Management, the country of Mexico, Bear Stears, Fannie Mae, Freddie Mac, and AIG have in common?  Creditors/bondholders were essentially made whole 100 cents on the dollar …  (The one exception throughout this mess seems to be Lehman Brothers).  He goes after Michael Lewis’s theory that the conversion of Wall Street firms from partnerships to publicly-held corporations cause the crisis, suggesting that the theory begs the question:  The more important consideration is why the partnerships would have wanted to be public corporations to begin with.  For Roberts (and me), the issue even then was the complete lack of fear of anything bad ever happening to creditors.  Wall Street set its structure around this paradigm; this paradigm didn’t come about because of the structure.

Roberts’ explanation on the role Fannie and Freddie played in the big picture of the crisis is choice, and extremely comprehensible for any reader.  He transcends political rhetoric and actually gives us the nitty-gritty.

It is hard to draw any conclusion when evaluating the legacy of Fannie and Freddie other than this: The government’s intervention into the marketplace is inevitably deceptive, politicized, and damaging to the cause of maintaining accurate risk and reward incentive structures.  Government intervention is damaging to the cause of price discovery.  And Russell Roberts has eloquently established what the incomparable F.A. Hayek did a generation ago: When we see one thing wrongly, we will see everything else wrongly too; and nothing is more likely to create damage than actions taken as a result of seeing things wrongly …