The broad contours of two competing narratives on the origins of the GFC are what David Brooks brilliantly outlines in his op-ed piece for the New York Times. Dubbed as"Greed and Stupidity" or alternatively as I have framed it, dishonesty and incompetence. In any principal-agent relationship, there are always two problems to look out for: dishonesty, in which case the need is for the principal to motivate the agent to take his view of things; and incompetence, in which case greater monitoring is required. Policy, to be on the mark, has to address these agency costs.
This is how the greed narrative is broken down. It is essentially an amplified version of the situation faced by most emerging markets where the dominance of a certain class of moneyed elites, or oligarchs, holds sway over political or ruling elites. With their entrenched interests in keeping things the way they are, any attempt at reform will simply wither at the vine. The most coherent expression of this is encapsulated in "The Quiet Coup" by Simon Johnson in The Atlantic. In essence, it is a moral hazard problem, one of "keeping the bastards honest."
Johnson uses statistics covering the last three decades to illustrate the growth of the finance industry in the US. From a low of 16 per cent at the outset, its share of corporate profits rose to 41 per cent in the last decade, and with this came a rapid wage disparity between average workers in the finance industry and other sectors. With increased wealth and prestige came influence and power. The revolving door between Wall Street and Washington produced an incestuous relationship which spawned lax regulation and increased risk-taking.
This is how the greed narrative is broken down. It is essentially an amplified version of the situation faced by most emerging markets where the dominance of a certain class of moneyed elites, or oligarchs, holds sway over political or ruling elites. With their entrenched interests in keeping things the way they are, any attempt at reform will simply wither at the vine. The most coherent expression of this is encapsulated in "The Quiet Coup" by Simon Johnson in The Atlantic. In essence, it is a moral hazard problem, one of "keeping the bastards honest."
Johnson uses statistics covering the last three decades to illustrate the growth of the finance industry in the US. From a low of 16 per cent at the outset, its share of corporate profits rose to 41 per cent in the last decade, and with this came a rapid wage disparity between average workers in the finance industry and other sectors. With increased wealth and prestige came influence and power. The revolving door between Wall Street and Washington produced an incestuous relationship which spawned lax regulation and increased risk-taking.
A nuanced and slightly more convincing explanation is offered by the incompetence argument. Its takeoff point is the increased diversity and complexity of bank operations and the ignorance of senior bank executives with regard to the nature of assets they were handling. It is essentially an information problem. The mutation of investment banks from partnerships to publicly listed companies and their subsequent merger with commecial banks bred a lack of transparency and accountability. Yet with all this centralisation of authority, why were the captains of industry asleep at the wheel?
The basic answer is complacency. They thought that they had figured out a way to manage and diversify away systemic risk. As Felix Salmon points out in his riveting article for Wired Magazine, they were enamoured and gradually seduced by the elegance of a mathematical formula, known as the Gaussian copula developed by an actuarian by the name of David X. Li working at the time for JP Morgan Chase, which was published in The Journal of Fixed Income back in 2000. The fact that this theoretical model was not subjected to more scrutiny and empirical evaluation really says something about "group think" and herd mentality in the so-called Information Age.
The analysis of Li sought to simplify the manner by which to estimate the corelation of undesireable events like defaults occurring in two separate loan contracts. He used the prices of an instrument known as a credit default swap in lieu of actual default histories to determine the coefficient of corelation. Using this approach, it was possible to bundle junk bonds together and still come up with triple-A rated instruments known as collateralised debt obligations or CDOs.
Nevermind that the coefficients actually may change as circumstances on the ground become fluid. Though elegant, the brittleness of the solution became evident once it was tested by the hard reality of unforeseen external circumstances such as the rise of China and the flooding of the financial sector with fresh capital seeking safe yet solid returns.
Financial innovations based on the Li formula spawned complex instruments too opaque to comprehend or monitor since doing so required intimate knowledge held by the mathematicians closely linked to the models used for underwriting such contracts. On top of that was a system based on the "cult of accountability", the search for standardised measues of achievement with which to rate the performance of financial executives who were paid according to the amount of such contracts they had floated and not on how well the instruments performed thereafter.
In other words, these numerical methods did not square with real performance on the ground, and they could be "gamed" by the executives whose activities they were meant to control. This created a pseudo-objectivity which as Jerry Z Muller writes makes this the first epistemologically driven recession the world has seen (epistemology being the study of the limits of knowledge, or how we know what we think we know).
Policy Prescriptions
If the greed narrative is to be followed, then the obvious solutions to the crisis have to do with curbing dishonesty among the bankers. How do you reduce the power of entrenched interests? Well, to take an extreme case, Vladimir Putin's approach was to prosecute the dishonest crooks, takeover their operations, break-up their monopoly. Curb their excesses by putting a tight rein on the level of compensation they are allowed to have. A softer version would be that held by McCain. Say "no" to government bailouts. Let them have the "freedom to fail" as the recent White House announcement over General Motors tried to signal.
If on the other hand the incompetence narrative is to be followed, then the solution would entail simplifying contracts, making them easier to subject to regulatory supervision and managerial control, not substituting due diligence for diversification, gaining a better handle on what it is that forms the underlying value of assets. In other words, improve the quality of information being transmitted.
Finally, whatever narrative you subscribe to, there is one conclusion that both will support. This is the need to reinstate rules that prevent banks from getting "too big to fail", "too complex to manage" which was what the Glass-Steagall Act of 1934 was designed to do following the (last?) Great Depression. Unfortunately, the opposite has happened with Goldman Sachs and Morgan Stanley becoming bank-holding companies like the bailed-out Citicorp to be monitored by some supervisory body yet to be named. The question now is whether the authorities will be sophisticated enough to stay on top of these large complex organisations, or will we be substituting market failure with government failure in the not too distant future.
The basic answer is complacency. They thought that they had figured out a way to manage and diversify away systemic risk. As Felix Salmon points out in his riveting article for Wired Magazine, they were enamoured and gradually seduced by the elegance of a mathematical formula, known as the Gaussian copula developed by an actuarian by the name of David X. Li working at the time for JP Morgan Chase, which was published in The Journal of Fixed Income back in 2000. The fact that this theoretical model was not subjected to more scrutiny and empirical evaluation really says something about "group think" and herd mentality in the so-called Information Age.
The analysis of Li sought to simplify the manner by which to estimate the corelation of undesireable events like defaults occurring in two separate loan contracts. He used the prices of an instrument known as a credit default swap in lieu of actual default histories to determine the coefficient of corelation. Using this approach, it was possible to bundle junk bonds together and still come up with triple-A rated instruments known as collateralised debt obligations or CDOs.
Nevermind that the coefficients actually may change as circumstances on the ground become fluid. Though elegant, the brittleness of the solution became evident once it was tested by the hard reality of unforeseen external circumstances such as the rise of China and the flooding of the financial sector with fresh capital seeking safe yet solid returns.
Financial innovations based on the Li formula spawned complex instruments too opaque to comprehend or monitor since doing so required intimate knowledge held by the mathematicians closely linked to the models used for underwriting such contracts. On top of that was a system based on the "cult of accountability", the search for standardised measues of achievement with which to rate the performance of financial executives who were paid according to the amount of such contracts they had floated and not on how well the instruments performed thereafter.
In other words, these numerical methods did not square with real performance on the ground, and they could be "gamed" by the executives whose activities they were meant to control. This created a pseudo-objectivity which as Jerry Z Muller writes makes this the first epistemologically driven recession the world has seen (epistemology being the study of the limits of knowledge, or how we know what we think we know).
Policy Prescriptions
If the greed narrative is to be followed, then the obvious solutions to the crisis have to do with curbing dishonesty among the bankers. How do you reduce the power of entrenched interests? Well, to take an extreme case, Vladimir Putin's approach was to prosecute the dishonest crooks, takeover their operations, break-up their monopoly. Curb their excesses by putting a tight rein on the level of compensation they are allowed to have. A softer version would be that held by McCain. Say "no" to government bailouts. Let them have the "freedom to fail" as the recent White House announcement over General Motors tried to signal.
If on the other hand the incompetence narrative is to be followed, then the solution would entail simplifying contracts, making them easier to subject to regulatory supervision and managerial control, not substituting due diligence for diversification, gaining a better handle on what it is that forms the underlying value of assets. In other words, improve the quality of information being transmitted.
Finally, whatever narrative you subscribe to, there is one conclusion that both will support. This is the need to reinstate rules that prevent banks from getting "too big to fail", "too complex to manage" which was what the Glass-Steagall Act of 1934 was designed to do following the (last?) Great Depression. Unfortunately, the opposite has happened with Goldman Sachs and Morgan Stanley becoming bank-holding companies like the bailed-out Citicorp to be monitored by some supervisory body yet to be named. The question now is whether the authorities will be sophisticated enough to stay on top of these large complex organisations, or will we be substituting market failure with government failure in the not too distant future.
