October 20, 2017
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Take the fiddle out of markets

By Edwin Dean

Should we blame economists for our current financial crisis? The answer is “yes — but,” and the “but” is just as important as the “yes.”

First, let’s see why part of the answer must be “yes.” In the lead-up to the 2007-2009 crisis, economists developed models of financial markets based on certain assumptions about human motivations. But these models overlooked the fact that perverse incentives had crept into the financial markets — so the models were out of touch with current realities.

A key example of perverse incentives was the way banks paid mortgage brokers: they paid them a percentage of the dollar value of the mortgage deals they originated. So brokers could boost their earnings by increasing the number of their deals, regardless of borrowers’ ability to repay their mortgage loans — surely a perverse incentive. As a result, “no doc” deals became very common — “no doc” means that borrowers were not required to document their ability to repay loans.

Banks, themselves, worked under perverse incentives. By the late 1990s, banks had ceased retaining most of their new mortgages; instead, they sold them to other financial institutions. So banks, like mortgage brokers, had little interest in the quality of deals; if borrowers did not repay their loans, the originating bank suffered no consequences. Conveniently, banks could boost their income by extending more and more mortgage loans, regardless of quality.

Economists also overlooked another set of perverse incentives. Investment banks were tempted to borrow more and more money, because this increased their ability to invest in securities that seemingly yielded handsome returns. Freed in 2004 from earlier constraining regulations, they did exactly that. They invested huge sums in new, complex securities that few people fully understood — including securities based on the value of “no doc” mortgages. By the time it collapsed in early 2008, the investment bank Bear Stearns held $33 in securities for every $1 of its own capital! Such a high “leverage ratio” seemed to raise the bank’s profits, but it also greatly increased its risks. Again, the incentive was perverse.

Economists knew of these perverse incentives, but omitted them from their models of financial market risk. The shiny beauty of their elegant mathematical models, based mainly on pure theory and past economic trends rather than recent institutional developments, blinded them to the new perverse incentives.

Economists also deserve blame because they opposed strong regulation of financial institutions, except for ordinary commercial banks. Worse, in 1998 some economists opposed the regulation of the burgeoning markets for the new, complex securities; and in 2004 very few opposed the easing of investment bank regulation.

Now — in the perfect vision afforded by hindsight — we know that very light regulation of investment banks and other financial institutions was a terrible mistake.

In a nutshell, mortgage brokers, investment banks and other banks were all playing the markets like a fiddle. Economists failed to say “stop the music.” So, yes, they do deserve blame for the recent financial crisis.

Yet, there is good reason to say “yes — but.” For starters, other irresponsible parties deserve most of the blame. In the larger scheme of things, economists were bit players in a long-running, complex drama with many villains: greedy mortgage brokers, short-sighted speculators at financial institutions, and permissive federal regulators and members of Congress.

Further, some economists warned us before the crisis of dangerous behavior in financial markets. Robert Shiller of Yale, Nouriel Roubini of New York University and Paul Krugman of Princeton were among those who issued timely warnings.

Finally, we should be grateful to economists because so many have emphasized the benefits of free markets — and this emphasis is still fully valid outside the financial realm. History shows us that when markets are free, ordinary people often benefit immensely. The German “economic miracle” of the 1950s, the amazingly rapid economic growth of China and India in recent decades, and the long-term rise in the U.S. standard of living all are due largely to free market economic policies.

As we strive to eliminate perverse incentives and devise more stringent financial regulations — and we surely must do this — let’s not lose sight of the demonstrated benefits of free markets.

We need to take the fiddle out of the markets — not throw the markets out with the fiddle.

Edwin Dean, an economist and seasonal resident of Vinalhaven, writes monthly about economic issues.

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