Friday, January 9, 2009

Whose Fault is All This?

As reports roll in about unemployment reaching levels last seen in the Great Depression (this is not yet true on a percentage basis, but that does not stop the press from reporting such things), and as scandals such as the Madoff affair unfold, our collective national psyche is searching for villains to blame.

There are quite a few to choose from: Stan O’Neal of Merrill Lynch, Franklin Raines of Fannie Mae, Madoff himself. Others would like to paint the entirety of Wall Street itself (as distinct from “Main Street”) as the villain. Still others have found even more specific grievances to air: Deborah Spar, President of Barnard College, has recently pointed out in a Washington Post Op Ed that most of the guilty parties identified so far are men, and wonders whether there isn’t some innate difference between the sexes which accounts for the more testosterone-enhanced among us being more prone to the types of excess which led to the current financial collapse.

While there may be something to Ms. Spar’s thesis, I can’t help but wonder whether all of these thousands or hundreds of thousands of people (some of whom I know, by the way) can all be truly evil (or even just stupid).

I suspect not.

Taking the argument one step further, why do we suppose that, while the great things that make our economy dynamic and lead to ever greater standards of living are somehow widespread and universal, the opposite, those which cause financial distress and cause decreasing standards of living, are somehow always the result of individual turpitude?

As most of us know, Adam Smith described the former as the “invisible hand.” This is the principle that hundreds, thousands, perhaps even millions of individuals, each pursuing their own particular utility, will collectively result in the betterment of mankind.

But is it not possible that the invisible hand is also responsible for economic turmoil? I think it was Benjamin Graham who, when asked what was going to happen in the stock market, said it was going to go up and it was going to go down. Is it not possible that there is some equivalent with regard to the economy in general? Is it not possible that the invisible hand moves economies down as much as it moves them up (although inexorably, over longer periods of time, mostly up)? Is it not also possible, therefore, that these downward economic dislocations are simply the result of hundreds, thousands, perhaps even millions of people, each pursuing their own particular utility?

I suspect so.

The implication of this theory is that some people are going to be frustrated very soon. One class of people will be frustrated because their search for villains will prove more elusive than hoped. They will look deeply into the actions of the purported villains only to find, surprisingly, that each of these people acted somewhat in accordance with accepted strategies and procedures, and further, that they probably behaved rationally given the information available to them.

Another class of people, for whom I have the deepest empathy, will be crucified, notwithstanding that they acted rationally and in accordance with generally accepted strategies and procedures. Stan O’Neal particularly comes to mind. He’s probably a decent fellow, and when things were going well, boy, they were going really well. But now that they’re not going so well, nobody really remembers the circumstances under which he made his decisions. The assumption is that he was complicit in some great theft from the masses, rather than just a CEO trying to make the most money for his corporation, and generally unaware of the financial disaster looming ahead. Frankly, nobody saw this coming. I listen to Chief Economists all the time, and not one of them gave us a whisper of what was to come.

And now it’s all Stan O’Neal’s fault?

There are people who will go to jail because of this unquenchable thirst of ours for fault-finding. The Bernie Madoffs of the world certainly deserve to go to jail, and for a long time. But I will guarantee you that more than just a few Stan O’Neals will go to jail, too, just to satisfy a weird craving humans all have to blame someone when something goes wrong. And that’s a shame.


Hermagoras said...

This is a really interesting post. From my wholly amateur perspective, you represent the situation very well: there are in fact fewer villains than one might hope for, and the issues are largely systemic. But I'm left with two broad questions: first, what is the appropriate role of regulation to mitigate some of the systemic shifts; and second, what are the roles of asymmetric information in causing some of the last few months, and how might these asymmetries be dealt with? I tend to imagine that these are related, but I'm worse than an amateur: I'm a reader of columns. I'm like a prisoner with access to a few law books who files handwritten appeals. (This is David K, by the way, your step-brother-in-law.)

mfinlay said...


I am tempted to write a whole blog post in response, but I don't really have good enough answers.

My sense is that regulation could have reduced the severity of the cycle, but not by much. Furthermore, the kind of regulation which might have helped (and which might have been even imagined) would have been politically infeasible (i.e. regulations to stop institutions from writing mortgages for people who could not afford them - many of whom happen to be the most disadvantaged among us).

There's lots of possible regulation which was simply unimaginable a few years ago. Regulating the structure of the securities industry, for instance, and the leverage it employs (especially with regard to derivatives), and the use of complex collateralized obligations, is an issue so complex I am convinced that there's not a person in the world who truly understands the issues involved. I think senior management at the various institutions were truly acting in good faith, and believed their risk models were appropriate.

On the role of the asymmetry of information, I don't profess to know a thing. I know there's lots of scholarly data about asymmetry of information, but I haven't read anything about it and this particular cycle.

With regard to your last point, I'd bet that a good portion of the prisoners who file handwritten appeals are pretty astute, even if a bit crazy. And I'd bet that you probably fit that mold, except for the crazy part...

Anyway, if you read anything interesting on these topics please send along a note.