Why the Moral Hazard Argument Fails

Ok, this post should be more accurately titled, several reasons why the moral hazard argument fails.  So the progenitor of this post is a July planetmoney podcast about the financial reform act.  I'm not going to rehash the podcast.  Listen to it yourself.  One of the contributors stated the argument for moral hazard.  Namely, if bad behavior isn't punished, bad behavior will continue unabated, and in fact, worsen to the point of systemic failure.  In the case of finance, this argument was applied most recently to Lehman Brothers during the financial crisis.  Hank Paulsen was worried that if the government bailed out Lehman, than it would send the message to the markets, no worries no foul, go ahead and invest poorly and mismanage your companies, because you've got a money back guarantee.  And of course, Paulsen let Lehman collapse, and the market dropped a thousand points overnight.  That in itself is an argument against moral hazard, but that's not where I'm going with this.

Here's the point.  The fear of moral hazard shows a fundamental lack of understanding about human motivations.  Humans not only repeatedly act against their own best interest, they are effected by both short term and long term interests in unpredictable ways.  Economists are particularly guilty of this, and this is why behavioral economics is becoming a big field.  So to draw a coralary here, the argument for capital punishment has always been:  It's a deterrent to the most heinous of crimes.  Well, dozens of studies over the years have proven that to be false.  There is no deterrent factor to the practice of capital punishment.  Likewise, the notion of certain corporate death ("CCD"), provides no fear for companies, or investors to change their habits. 

Why is that?  Companies aren't people.  Even the smallest company isn't a person.  While people may act to prevent their own death, there is no consistent rationality to demonstrate even that fact.  But even if you assume it's truth--and I don't--the fact is that companies never act like people.  The larger you are, the less of an identity you have.  AIG, for example, is composed of hundreds of small companies that were eaten by the larger fish, who kept three quarters of the staff, dumped the rest, claimed the assets for the parent's balance sheet and wrote off the liabilities as a restructuring charge.  Hundreds of different entities, all moving about on their own recognizance.  All loosely controlled by corporate management.  But even that doesn't hold true because, though company loyalty is a nice thing for managers, even managers routinely betray their company's best interests for temporarl payoffs that may or may not exist.  The runaway derivatives trading of the last decade is ample proof for that.  No one knew that George Bush, a Republican president, was going to issue the largest bank bailout in American history, the only reason the bailout was assumed was because we all knew deep down that letting everyone fail who deserved it would have been total death for the country, for the world.  Simply put, the argument for Moral Hazard relies on so many baseless assumptions that the only rational way to prove it would be to rely on statistical data, of which there isn't enough to come up with even a biased sample.

But even this isn't exactly the topic I wanted to rave about.  The guys at Planetmoney believe that if you guarantee companies, and risk moral hazard, you risk destabilizing the markets in an exceedingly critical way.  This would be true, if it were a risk.  I don't think it is, unpredictable risks aside.  And don't talk to me about Black Swans, because the financial crisis wasn't unpredictable.  Everyone and their blind, three legged hamster knew it was coming.

Listen: If I buy, again let's use everyone's favorite bully boy, AIG stock, I'm not buying it on the premise that the money is safe, but that I expect to make money on the return.  This is critical to my point.  The safest possible investment you can make, is in treasury stocks, so this can't be a matter of mere safety.  We're talking about returns.  So when I buy AIG stock, it might be nice to know it's backed by the government, but I'm buying it because I think it's undervalued and that it will reap a decent profit in terms of dividend, and in terms of rising stock price.  And that means, that I have to know something about AIG.  The Planetmoney men were concerned that the destablization would occur because the values would become essentially meaningless.  While that is a valid fear for entirely different reasons, like short-selling, I don't think there's any real fear of that for the overall market for stocks.  You have to know something about the company, you have to be making and upgrading your assessments of your positions.  And you have to do it fairly often.  And that means people making valuations--people struggling to name the price of an asset.  And that's what the market is--a place where prices are named and called.  To wit, a government backstop on corporate assets doesn't have the catastrophic effect on markets that media fear mongers would have us believe. 

Econtalk and Stimulus

This post will be a hodgepodge. As usual, being so far behind the times, I recently discovered the wonder of podcasts. When looking for a podcast on accounting, I discovered the George Mason University's podcast "Econtalk." The first cast was pretty interesting, with some neat concepts. But the second podcast really stuck in my craw. First off, the guy who hosts the show, was educated at University of Chicago. For those of you not in the know--this is a very conservative economic philosophy. Their bias--which the host admits most frankly--is against government intervention in the free market. Fairly standard stuff. From his point of view, I would be dubbed an interventionist. I don't care for the term, I think the implied meaning doesn't really capture what I believe at all. Liberal economists (or faux economist students--like myself) don't really think of their vision as an intervention into a formal entity "The Market Mechanism" but as part of an entirely different mechanism, that requires public action in the form of rules, regulation, including private and public auditing and ratings entities.

What's worth writing about this you lunatic? You say free market principles have been prevalent for the last century? Well, sure. But for the first time in sixty years the prevailing winds are blowing my way. People actually want more regulation. And the good folk of Econtalk (they really do seem like nice guys too) are horrified by this. According to them, the essential cause of the current downfall was that the market wasn't really free. That regulation was in fact the cause of the crisis. To most of us, this seems ludicrous. But I can sort of understand their point, if only from the level that most socialists have long defended their beliefs, namely "No government or society larger than a village has ever practiced true socialism, so therfore you can't disprove it's legitimacy." Insert free-market capitalism and you've essentially made the same argument. There are always rules and regulation on the exchange of goods. I mean, there wouldn't be a market if someone didn't guarantee a free market space to begin with. Maybe I don't understand the theory. And I'll admit, I certainly haven't read any of their works.

They did raise an interesting point. They are, of course, opposed to the stimulus. On a couple of levels. For one thing, the market mechanism for dealing with failure is harsh. Nul-survival, if you can't make the grade, you go bankrupt, and the market dealt you the hand you deserve. On another level, they don't like the bank bailout for similar reasons, but also for the idea of moral hazard. On a more complex level though, they dislike the intervention in the market mechanism because from their standpoint it reduces market efficiency. Prolongs the pain. They say things like, bank failure isn't that bad. I find this reprehensible. In a healthy system that would be true. But Hank Paulsen's stand against Lehman nearly unhinged the system. If they'd let AIG go under, the banking system would have been effectively demolished. The auto industry would have tanked the next day. There literally would have been riots. Complete panic. I believe that they think that very unlikely. But for what reason? They also oppose the stimulus because they find the public works proposals, what they label as Keynsian economics, to be demonstrably proven false. They say that the last sixty years of economics have roundly disproved the idea that public works programs stimulate the economy. That's wrong for two reasons. 1) The Chicago school of economics has been THE school of economic thought for the last sixty years. No wonder there aren't too many studies that prove they are wrong. 2) There hasn't been a significant public works project other than The Big Dig (a total disaster), in the last sixty years. How could they have even done a study? And the last big public works programs were wildly successful, namely the New Deal, (and no I'm not disregarding The War.)

Here's what got me. They qualified their disdain for the public works programs by saying that they were not opposed to the idea of the programs and development. They were opposed to them being labeled as a stimulus. !!! !!! Only academics could give a damn. They were upset by the fact that the bill was perhaps a misnomer! Positivists are people who adhere to logic and law regardless of the emprical outcomes of their choices. People like this stun me. I like a good logical argument, and you'll see me make a lot of them. But sometimes, and this is what seperates the positivists from their counterparts, sometimes the rule doesn't fit. And where it doesn't fit, adjustments must be made.

However, I find myself agreeing with them. For different reasons. Calling it a Stimulus bill was a hat tip to George Bush. Fuck him. And his party. Enough nicey nice. And that was a mistake. Calling it a stimulus, and keeping Geithner and Bernanke (I like Bernanke, but he's part of the old system, with which I believe we need a clean break,) only served to prolong Bush era policies. The market is demanding something else. Which is why it hasn't calmed the markets at all, but instead only exacerbated the situation. You want to bail out the banks? Fine, call it what it is. The works projects should have been a different bill anyway. My other half thinks that they packaged them together as a way to get them through Congress. Maybe she's right. I don't know. As a matter of policy, I really think the Dems could have pulled it off. But not without a rhetorical flair and daring that they have not been able to carry off for sometime. Harry Reid must go.