Wednesday, October 19, 2011

Comments on Inside Job

The film is a documentary, narrated by Matt Damon, about the cause of the financial crisis, which it puts squarely at the hands of the financial services industry and its cozy ties with the Federal government.  On the question, What happened?, including what temporally preceded the actual meltdown, I think the film is quite good.

Most of that is a matter of record.  I didn't know about some of the personal indiscretions of players on Wall Street.  That was new to me.  As I'm writing this during the week of the Educause national conference in Philadelphia, I should point out that most of the folks I knew professionally in Information Technology, though milder than the "type A" personalities depicted in the film, behave differently when at the conference, where the vendors want to wine and dine them, than they do when they are back on their campuses, when everything is paid for with their own nickel.  That dealing-with-vendors environment is omnipresent for folks who work on Wall Street.  So I found that less surprising.  That the behavior is financed by the investments of folks like you and me, surely that is infuriating, the entire film is meant to stroke our ire.  I used to rationalize some of the wining and dining as a way for the vendors and us to better understand each other, and there was some truth to that.  I suspect that if you did more investigation of the Wall Street types and asked them to defend some of these practices, they'd defend the practices similarly, even if some of the behavior is morally reprehensible.  In any event, that is symptom not cause, so I will push on.

On the question, Why did this happen?, I think the film is less good.  In a couple of places there were factual errors presented.  The film clearly had an agenda and therefore didn't spend nearly as much time as it might on presenting alternative views.  But mostly, I believe the problem is that it omitted events and practices that were relevant, in my view, and so the context for considering what happened is not set properly.  More on all of this below.

Deregulation (of natural monopoly) actually started under Carter, not Reagan, as it is stated in the film.  The first industry to be deregulated was the airlines, with the effort led by Alfred Kahn.  Had Carter won the election in 1980, surely telecommunications would have been next.  ATT eventually was split up, in 1984.  Given the state of air travel now, it is hard to offer a definitive conclusion that deregulation was a good thing.  But on telecommunications, that seems to me a no-brainer, in spite of issues that have emerged.

When Reagan became President the fervor for deregulation swept across the board. It wasn't just natural monopoly to be deregulated.   Environmental and safety regulations (regulation of externalties) were also taken to task.  Anyone who remembers Reagan's first Secretary of the Interior, James Watt, will understand the point implicitly.  An unfortunate rhetorical problem, in my view, is that the word "regulation" applies both to the natural monopoly case and the externality case.  That they might be different, both in kind and in degree, doesn't get discussed in typical media or political outlets.  So one doesn't usually hear that you can be for some regulation and against others.  That is too subtle for our discourse.  Instead, only the straw man argument is made - for or against regulation, in toto.  This puts the Democrats in the "for" camp and the Republicans in the "against" camp.

There is then the issue of regulation for financial services.  Is it a question of natural monopoly or externalities, or is it neither?  I note that with pollution, for example, you can measure the externality at the source.  With systematic financial risk, however, you can only measure that by looking at all sources simultaneously.  The exact same behavior can be of no consequence, in one instance, and of dreaded consequence, in another instance depending on what is going on elsewhere.  This makes it difficult to think of financial regulation as entirely within the externality family.  So I believe it should be its own separate category, in large part because Government will come to the rescue when there is a cataclysm.  An obvious question to ask then is whether the industry can be self-regulating, as Alan Greenspan believed it was before the meltdown.  It seems clear the industry was not.  Less clear is why.

The film does go as far as pointing out that there weren't deductibles, for example with mortgage loan origination.  Were there steep deductibles perhaps many of the excesses could have been avoided.

To me, much of the answer to that can be found in the leveraged buyout craze of the 1980s, which gets no mention in the movie whatsoever.  I believe that is a mistake in setting context.  As a defensive strategy against leveraged buyouts, CEOs and other high level executives got "golden parachutes."  The practice lingers although the problem it was aimed to address may no longer be an issue.  More important, however, is the following.  The film makes the point that outsiders: SEC regulators, the ratings agencies, and the accounting firms, have a tough time interpreting information that is on the firm's balance sheet.  (Sometimes this is fraud, but I believe much of this is simply not understanding the picture from the data they do observe, perhaps because the books are cooked to mask the problem, but also simply because of complexity.)  The film doesn't point out, however, that corporate boards are in the same boat.  Therefore it is extraordinarily difficult to measure how the firm is positioned for the long haul, whether its hand is strong or weak.  Consequently, current earnings are king.  This makes the firm myopic in its objectives.  That has always been a problem.  The corporate takeovers made it much worse.  In case its not obvious, deductibles might have improved the balance sheet long term.  But immediately, they make earnings worse.

The other thing, I believe, that the LBOs did was to create a hunger in the financial houses, to get more of the pie from financial transactions.  Why leave the spoils for Michael Milken and Carl Icahn?  So I don't see it as such a great leap to go from the Junk Bonds of 1980s to the subprime loans and the slicing and dicing of mortgages of the 2000s.

Another piece of history that is omitted in the film is the Asian Debt crisis of the late 1990s.   It is tempting to view the U.S. meltdown as an it-happened-here-first phenomenon.  But it may be more appropriate to consider it part of an ongoing cycle that started earlier.  The fundamental issue then is that cheap credit leads to high leverage, which in turn can lead to default if circumstances change for the worse.   Much of this is bubble driven.   When asset values appreciate rapidly, why be cautious?  Note that in the U.S. the personal saving rate declined precipitously in 1999 (and then stayed low).  Ours certainly was a larger scale crisis.  But that doesn't mean the root cause was of our making alone.

Let me turn next to the issue of creating securities to provide insurance - derivatives if you will.  The word itself is toxic now.  But the concept shouldn't be.  This is a straight economies of scale argument.  Insurance makes sense from the provider point of view if there are a large number of independent risks, so the provider can properly diversify.  This makes natural disaster insurance somewhat problematic, because the risks are correlated.  However, the risk correlation is local.  Globally, a bunch of local risks starts to look independent. Global financial markets are the proper place to bring such risks.  Local insurers, even with reinsurance markets, don't have enough scale to get the right diversification.  This argument is made in a piece by Michael Lewis, written a year before the financial crisis, in Nature's Casino.  It makes for an interesting read, one that provides an argument for securitization.  That argument is not in the film.

Of course, insurance does create moral hazard for the insured regarding inadequate precaution.  Where to site a home, when natural disaster risk is present, is from this point of view the same issue as how big a home to buy, in the presence of default risk.  The moral hazard issue gets nary a mention in the film.  The predatory lenders get all the blame, instead of sharing it.  This is where I have issues with the Occupy Wall Street protests.  They point the finger at the 1%, but don't talk about the responsibility of the 99%.

Finally, let me turn to the last part of the film, where some important economists are depicted either as clueless (like the regulators, Rick Mishkin is cast in a terrible light) or as having completely sold their souls to the devil, getting big-time fees for serving on Bank boards, etc. (so doing the bidding of the financial services industry).  In considering this, let me set Larry Summers aside for a minute on that and talk about the others.

I believe the movie has cause and effect reversed here.  Glenn Hubbard, Chairman of the Council of Economic Advisors under Bush II and current Dean of the Business School at Columbia, is a good case in point.  His views about the relationship between taxation and economic growth, which I disagree with strongly, are what came first.  He's a supply sider and one of the authors of the Bush Tax Cuts.  This makes him kind of a superstar in some circles.  His reputation followed from his academic beliefs.  Here it needs to be pointed out that Economics at the macro level is not science - no controlled experiments are possible.  Cause is imputed from the historical record.  So economists can disagree about cause.  But those disagreements are based on a prior intellectual orientation.  Ditto for Martin Feldstein, also shown in the film, who chaired the Council in the Reagan era.  I believe questioning their integrity was, hitting below the belt.  It is enough to question their views about policy.

I do think Larry Summers is a different animal, in part because some of his academic writings are Keynesian in spirit and in part because quite recently he has been pro stimulus, particularly for relief on the payroll tax.  In the 1990s, however, in his various government roles he was very much a free trader and for deregulation of financial services.  So, how does one square that?  Here is one conjecture and one observation. Not all economists are attracted by political power, but some are and I believe Summers was.  He had conquered the world of academic publishing and was looking for a different game to play.  In the new world, with Robert Rubin his mentor, both free trade (which most economists would ascribe to at first pass) and deregulation in financial services part of the mantra, and the U.S. in high growth mode, forebodings about the impact on future downturns were absent.  These were policies for the present.

This gets me to the observation.  Human nature being what it is, there is a tendency to want to regulate when the economy slumps, to rule out that past indiscretions will repeat, and to deregulate at the start of a boom, to get rid of impediments that might hamper growth.  Alas, having an entirely time consistent view is difficult, particularly if at heart you are a pragmatist.  Ideologues may have it easier on this score, but they have the issue that their ideology may seem out of sync with current reality.  The problem is more severe in that there can be substantial lag between policy implementation and economic consequence.  Further, when living in the present we may not understand the causes of current events.  In the late 1990s there was genuine confusion about whether the Internet had changed the economy unalterably, or if it was a bubble.  The evidence was provided with many companies that had huge growth in usage but had negative earnings.   Would Summers have argued the way he did in the 1990s had he known how the 2000s would turn out?  I don't know.

Let me wrap up.  The film cast the Wall Street Insiders as perpetrators of a crime.  That is probably a good thing.  It implicitly makes us viewers victims of that crime.  That is not a good thing because, apart from punishing the perpetrators, it doesn't tell us what we should want next.  So it missed an opportunity for the audience to learn.  It is still not too late to be asking that question.

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