Thursday, May 19, 2011

Economic Experts

Generally speaking trusting experts is a wise move. I do it often. But when it comes to economics I think the evidence is that many so called experts are in prominent positions not because their theories accurately describe the world, but because they espouse views that serve the interests of power and privilege.

We recently learned that the billionaire liberterian and activist Koch brothers have granted Florida State monies on the condition that they have a say in the hiring of faculty in the economics department. What do you expect the impact will be on the ideology of the economics faculty? Don't these ideologues have a vested interest in the policies that this economics faculty would advocate? Are our experts being corrupted?

Or for that matter are they already corrupted? How many of these experts saw the financial crisis coming? What kind of policies did they advocate in the lead up to the crash? Would it matter if the very people that advocated for the destructive policies in fact were on the payroll of the corporations that profited so immensely from these same destructive policies?

Glenn Hubbard is dean of the Colombia Business School. In November of 2004 he co-authored a paper, along with Goldman Sachs Chief Economist William C Dudley, entitled How Capital Markets Enhance Economic Performance and Facilitate Growth. The Executive Summary is worth reading. Capital markets have improved the allocation of risk, stabilized banking, produced more jobs and higher wages for the average American, reduced unemployment and volatility in the economy, and made recessions more mild and less frequent.

The general consensus is that this is precisely wrong. The exact opposite is the truth.

Here's a basic understanding of what caused the financial crisis of 2008 as described in the movie Inside Job. A financial tool, known as Collateralized Debt Obligations (CDO's) was developed in the late 80's. Prior to these when a bank offered a loan on a mortgage they were very interested in knowing if the borrower was capable of repaying the loan. What CDO's did was they allowed lenders to sell loans to a third party. They were variously grouped and sold to investors. Ratings agencies evaluated their risk. AAA is the highest ratings grade, equivalent to US Treasury Bonds. Ratings agencies had a financial incentive to rate CDO's high and had no penalties if the ratings proved to be wrong.

This is a rather perverse system. Effective capitalism relies on good information. Yet the information is coming from those that have an incentive to lie in the case when the product is junk. This would appear to be risky.

In addition another product was developed. Credit Default Swaps. These are effectively an insurance policy on an investment. That's not such a bad thing in itself. There's nothing wrong with covering your risk by buying an insurance policy.

But here's where it became a problem. In normal insurance you can only take out one policy on a product. So for instance I own my home and I purchase insurance for it in case of a fire. Only one person can do that. I can't have 6 of my neighbors likewise buying insurance protection against my home in case of a fire. The reason is obvious. If lots of people have an incentive to see my house burn, that's a perverted incentive structure.

Brooksley Born was appointed to the Commodity Futures Trading Commission and she realized that this was perverted and regulation was required. So she started to take steps to bring in oversight. She was immediately resisted by free market ideologues. They argued that regulations stifle innovation.

Fine. Maybe they do. And maybe that's good. What if the innovations being developed in fact make some people really rich while risking the entire financial system? That's exactly what we were dealing with. But the free market ideologues won the day. The result was the Commodity Futures Modernization Act of 2000. These prevented any regulation on these products.

So companies like Goldman Sachs not only sold products they knew were junk. They then went out and bought multiple insurance policies on that junk. They stood to make enormous gains if borrowers started defaulting. Holding the bag was large banks and insurance companies, like AIG.

Normally GS wouldn't collect all of their gains because their insurers would go out of business. But these insurance companies and banks are so large that their failure meant a total credit freeze. So those of us not involved in these transactions just going to work 9-5 find ourselves in trouble. The credit crunch means our employers can't pay us, we can't pay for services, and everything grinds to a halt. Government is required to bail out the mess created by the free market.

But a lot of the experts didn't see it that way leading up to the crisis. Here's Frederic Mishkin. Deregulation came to Iceland and it likewise caused a bubble that made certain people very rich. Mishkin, like Hubbard, thought this was really a great turn of events.

What he doesn't mention is that he was paid $140K by the Icelandic Chamber of Commerce to write this report extolling the virtues of unregulated financial markets. Then the whole thing collapses, requiring a state bail out.

You've got Martin Feldstein at Harvard. He's a professor of economics. He was a Reagan adviser and architect of his deregulation. He served on the board of AIG from 1988 to 2009. Larry Summers, a member of Clinton's financial team, was a major architect of the legislation that blocked regulation on derivatives and CDO's. He's now president of Harvard. Ruth Simmons is president of Brown University and makes $300K/yr on the board of directors at Goldman Sachs. Personally I don't think these are evil people. They probably honestly believe what they say. But they don't recognize how much incentives shape what it is that they find persuasive.

I think we should consider what the views are of the people that we can look back on and see understood the issues at the time. Charles Morris wrote a book, written in 2007 but published in early 2008, that very accurately described the financial conditions that we underwent and today are dealing with. In the movie "Inside Job" he shares his belief that the economics departments at the various universities are part of the problem. In my view Morris has earned some credibility. He may be quite right once again.

Most of this info is via Charles Ferguson's movie "Inside Job" BTW.


Chad said...

I tried to read this with an open mind, but this is rubbish of the highest order. The Private sector was following the game plan put forth by the Dems and the Social progressive agenda. Jon wants all the evil profit seekers burned at the stake and forgot to mention how it all started. Here is a an article that explains it better than I and is a bit more accurate as to the root cause.

In September 2003 the Bush administration launched a measure to bring Fannie Mae and Freddie Mac under stricter regulatory control, after a report by outside investigators established that they were not adequately hedging against risks and that Fannie Mae in particular had scandalously mis-stated its accounts. In 2006, it was revealed that Fannie Mae had overstated its earnings – to which its senior executives' bonuses were linked – by a stunning $9.3billion. Between 1998 and 2003, Fannie Mae's executive chairman, Franklin Raines, picked up over $90m in bonuses and stock options.

Yet Barney Frank and his chums blocked all Bush's attempts to put a rein on Raines. During the House Financial Services Committee hearing following Bush's initiative, Frank declared: "The more people exaggerate a threat of safety and soundness [at Freddie Mac and Fannie Mae], the more people conjure up the possibility of serious financial losses to the Treasury which I do not see. I think we see entities that are fundamentally sound financially." His colleague on the committee, the California Democrat Maxine Walters, said: "There were nearly a dozen hearings where we were trying to fix something that wasn't broke. Mr Chairman, we do not have a crisis at Freddie Mac and particularly at Fannie Mae under the outstanding leadership of Mr Franklin Raines."

When Mr Raines himself was challenged by the Republican Christopher Shays, to the effect that his ratio of capital to assets (that is, mortgages) of 3 per cent was dangerously low, the Fannie Mae boss retorted that "our assets are so riskless, we could have a capital ratio of under 2 per cent".

Maxine Walters' complaint about previous attempts to bring the great state-sponsored housing finance bodies under stricter control was partly a reference to Bill Clinton's efforts. Last week the former President acknowledged that "responsibility" for the absence of proper regulation rested "with Democrats who were resisting any efforts of Republicans in Congress, and earlier when I was President and tried to impose tighter standards on Fannie Mae and Freddie Mac". Then, as now, members of his own party saw all such initiatives as unwonted attacks on the chances for low-earners, and particularly African-Americans, to own their own homes.

From its inception in 1938 Fannie Mae (and later Freddie Mac) was designed to make housing finance available to "ordinary Americans". This was a noble aim. In the 1970s another Democrat President, Jimmy Carter, introduced legislation which demanded that such bodies enhance their lending to minorities. Again, this was based on a noble idea: to stamp out racism in the mortgage market. Thus by 1998 you had the Federal Reserve Bank of Boston producing a document entitled "Closing the Gap: a Guide to Equal Opportunities Lending", which instructed banks that an applicant's "lack of credit history should not be seen as a negative factor" in obtaining a mortgage. As Stephen Malanga of the Manhatta *Institute notes: "Of course the new federal standards couldn't just apply to minorities. If they could pay back loans under these terms, then so could the majority of loan applicants. Quickly, these became the new standards in the industry. As the housing market boomed, banks embraced these new standards with a vengeance. Between 2004 and 2007, Fannie Mae and Freddie Mac became the biggest purchasers of subprime mortgages from all kinds of applicants, white and minority, and most of these loans were based on lending standards promoted by the Government."

Chad said...

One of the few journalists to see where this would lead was Jeff Jacoby, of the Boston Globe. Last week he reminded his readers what he had written in 1995: "Our banks are knowingly approving risky loans to get the feds and the activists off their backs... When the coming wave of foreclosures rolls through the inner city, which of today's self-congratulating bankers, politicians and regulators plans to take the credit?". Jacoby adds now: "Barney Frank doesn't. But his fingerprints are all over this fiasco."

It's true that the improvident lending was not initiated by Fannie and Freddie: their role in this was to buy these loans and sell them on – but then the music stopped. Cynical students of the American political system will note that the biggest recipient of campaign contributions from the munificent duo of Fannie and Freddie over the past 20 years was one Christopher Dodd, Democrat Chairman of the Senate's Banking Committee.

Rather surprisingly, given that he has only been in the Senate for four of those years, the second biggest beneficiary was Barack Obama. In August the Washington Post reported that Obama's presidential campaign team had sought the advice of Franklin Raines "on mortgage and housing policy matters". Perhaps Mr Obama's team just wanted to know where all the bodies are buried – there are rather a lot of them.

The saddest outcome of all this within America – apart from the crippling cost to the nation's taxpayers – is that the very people the Democrats had intended to help will be the biggest victims: for many years to come banks will demand the most stringent terms for mortgages to the least well off.

In the meantime, let us praise Congressman Artur Davis of Alabama, who confessed this week: "Like a lot of my Democrat colleagues I was too slow to appreciate the recklessness of Fannie and Freddie when in retrospect I should have heeded the concerns raised. I wish my Democrat colleagues would admit that we were wrong." I fear Congressman Davis will not go far with this attitude – but at least he will be able to look at himself in the mirror.

Jon said...

So your position is that unregulated CDO's and CDS's did not play a role in the financial crisis?

Chad said...

Absolutely they did 100%, but and here is the big but - but they were simply following the rules put in front of them. Money was to be made, opportunities opened and the groups like GS made stock holders very happy for a time - many of those people Democrats and Progressives who publicaly denounce evil profits and privately welcome the windfalls.

The progressive/socialist movement wanted the 47% not paying taxes to own the big houses on the corner in plush neighborhoods previously reserved for only the rich. They wanted to pull the lower class up to middle through home ownership and it failed so it is time to lay blame and the Left is so good at that.

HispanicPundit said...

While were on the topic of perverse incentives, lets also not forget that Jon has a strong incentive to find the economics departments biased and discredited - they fundamentally clash with most of his world paradigm.

Like the Christian fundamentalist with evolution, Jon is at a crossroad - he has to choose between two credible sources that conflict. And like Christian fundamentalists, he falls into the conspiracy theory of a full profession being out of synch with reality.

Not me - I take the consensus of professionals seriously. If it conflicts with my worldview, chances are, it's my worldview that needs to change.

Jon said...

That's absolutely right, Chad. They follow the rules put in front of them. And when it comes to CDO's and CDS's the rule is this. There are no rules. Do whatever it takes to profit even if it means collapsing the whole system. I'm not saying they broke the law. They followed the rules. But they rigged the rules.

A couple of points on your article. Jeff Jacoby in 1995 can't be predicting the housing crisis. Look at this plot of home prices. Why would people bying a home in 1995 or prior be defaulting? There's no bubble. The price they pay is rational. Even today if they can't pay they can sell their home for profit. So there's no crisis there. The bubble comes in just prior to 2000 and the proliferation of CDO's. You immediately get a push for regulation that is beaten back by the right wing ideologues. Yes, they were in the Clinton administration.

Second point. I've read somewhere that Fannie and Freddie were following the lead in sub prime, not in fact doing the leading. They saw the other companies making huge profits and sat idly by for a while, then couldn't resist the gravy train and jumped in. Whether that's true or not I need to check.

But it's not like they don't play a role. They do. But it's a combination of factors. The underlying problem is the bubble. I mean, what's wrong with buying a home with little down if prices accurately reflect the value? If you default you just sell and there's no problem. The problem of course was that the prices were being manipulated by financial agents that were given free reign to act in that way. Of course they would. Why wouldn't they exploit misplaced trust to make profits? Why wouldn't they threaten the entire financial framework, your salary and mine, in order to make profit? That's the nature of our system, but it's also why we need some regulation. The markets are not self correcting. It's a repeated phenomenon all over the world. Bring in deregulation, claim the market corrects for these things, crash the economy, bring in the taxpayer for bail out. Since the taxpayer is being asked to clean up the mess, and the taxpayer is also at risk due to financial transactions that involve parties that I'm not associated with, the public should be permitted to have a look at what is going on and stop risky deals that threaten the public.

Jon said...

We all have biases, HP. Does this mean we shouldn't disclose conflicts of interest in economics departments?

I really think you don't know what the word "conspiracy" means. If my employer tells me I shouldn't advocate that we use my wife's small business as a supplier what do you think they'd say if I objected by saying "Are you alleging some sort of conspiracy?" Maybe that response would make sense to you, but that just means you don't know what a conspiracy is.

HispanicPundit said...

Yes, by all means - disclose conflicts of interest in economics departments. But you've listed a few people here and there, then extrapolated based on that to implicate WHOLE departments. Its a HUGE stretch.

Listen to Rush Limbaugh, he does the same thing regarding Global Warming and climate scientists. Listen to Christians, they do the same thing regarding evolution. Its the same tired ol conspiracy theories, that these people really have an agenda outside science.

Sure, I am sure some people do here and there, but the median economist? I doubt it.

Let me give you a rule of thumb I use religiously: If your preciously held views clash fundamentally with those who spend their lives thinking about this stuff, chances are its your views that are wrong. :-)

Jon said...

You are the one that is stretching so as to concoct a straw man. Why not deal with my comments as stated? Where did I say that WHOLE departments are corrupted. I'm talking about "many so called experts are in prominent positions" not ALL experts.

Your caricature allows you to easily dismiss my statements. I think addressing what I actually say would be more interesting.

HispanicPundit said...

I'm not into personal politics - whether that is individual politicians, or individual economists.

So if your only point here is to call into question the objectivity of a couple individual economists, then fine. I'm not going to object (not because I agree, but because it doesn't interest me). I certainly misunderstood you, my bad.

My only point was to defend the profession as a whole. Which we both seem to agree should be the default view on matters of economics.

Carry on.