When it comes to the financial “crisis” (I still don’t like using that word…it’s an invitation to deprivation) I’ve heard various explanations for what got us here, but most of them go something like this:

“Greed got us into this mess”, or, “Banks were way too leveraged so they could make a buck in the short term”, or, “lenders took advantage of borrowers who didn’t know any better and gave them more loan than they could afford”.

I have several questions in response: When did people all of the sudden become more greedy?  Can you give me a date?  Did greed suddenly increase in the mid 1990’s?  Were people in prior decades not greedy?  Is greed a new phenomenon?  When did banks all of the sudden decide to become overleveraged?  If they could have made all kinds of money being overleveraged before, why did they wait until the mid 1990’s?  Why weren’t banks pushing these risky loans long ago?

The obvious answer to all of these questions is the old adage, “there’s nothing new under the sun”.  Greed is not new, and people are no more greedy today than they’ve ever been.  Banks did not all of the sudden decide to overleverage and start pushing bad loans - to do so would be against their own (greedy) interest, as we now see with many collapsing.  If you want to make greed the culprit, you have to also make it the culprit for everything else that happens in the economy, since people are always greedy (or, if you prefer a less pejorative term, self-interested).  That means when wages rise, stocks grow, unemployment drops, gas prices go down and poverty shrinks you have to also blame greed.  Greed is ever-present, so it’s unfair to only blame it when things go bad but not when things go well.  Blaming greed is like blaming gravity.

These childish analysis cannot account for our current financial situation.  But what can?  Why would banks all of the sudden make overly risky loans?  If it wasn’t in their interest to do so before, why now?  Because the rules of the game changed.

I’ve blogged on it here before, and there is lots of great analysis elsewhere (look here and here), but the bottom line is Uncle Sam changed the rules of the game by mandating banks to take bigger risks, creating a “moral hazard” by implicitly or explicitly promising to bailout those who failed, and by sending false signals through the market via artificially low interest rates (which induce more lending than real economic productivity would warrant).  To summarize, banks and financial institutions behaved in a way counter to their own long-term interest because government made it beneficial and in some instances necessary to do so.

A great post by Frederic Sautet at the Austrian Economists blog :

The Failure of Regulation or the Failure to Regulate?

Among the multiple questions that can be asked about the current financial turmoil, this is perhaps the most crucial one. The same issue was raised many times in the past. For instance after the fall of the Berlin wall in 1989, some said that while it showed that the economy in Eastern Europe couldn’t survive at the time, it didn’t prove that communism as a system could not work because its principles had perhaps been misapplied for all these years. This opinion didn’t survive long, however, in view of the successes of the reforms that were taking place in the world at the time (UK, USA, New Zealand, Australia, etc) and the rise of the so-called Washington consensus.

But here we are almost 20 years after the fall of communism in midst of what is perhaps the most serious financial downturn the world has known since the Great Depression. The question comes back again with a vengeance and the voices supporting the failure to regulate view are now pretty loud. See President Sarkozy of France for instance. In the tradition of the populist French right, he is now calling for a “renewal of capitalism” in order to end the abuses of financial speculation. As he put it: “Le marché qui a toujours raison, c’est fini” (the idea that market is always is right is over).

The failure to regulate has also a moral component in this crisis. It is not only the failure to regulate markets because they are prone to failures; it is the idea that society has let highly paid immoral beings prey on the common person (in Main Street). As Dick Meyer on NPR puts it:

"I am now even more firmly convinced that there really is a predator class. The people responsible for creating and bingeing on the mortgage junk bonds, derivatives and financial insurance scams that are now being bailed out are our society’s most educated, highly trained and wealthiest professionals. The Meltdown of ‘08 was not caused by con men, crazed moguls and panicked masses. It was caused by financial bureaucrats of the baby boom generation who were paid megabucks for office jobs, who wear Patagonia fleece, $12,000 Brioni suits and read books about "reinventing the Self.""

While contenders of the free market thought they had lost the battle of implementation but won the battle of ideas, it is now becoming clearer that they lost both. Indeed, if the battle of ideas had been won, fewer voices would now speak against the free market. Instead, central banks are pumping more cash in markets around the world, downward adjustments of prices (and deflation) are seen as the devil, banks are not allowed to fail, and the US government is about to engage in the biggest market intervention it has done since WWII. In 2008 the ideas of the Reagan revolution are dead.

So how do we explain that the problem is the failure of regulation, not the failure to regulate? It is difficult because it goes at the heart of what is proof and truth in economics (i.e. the battle between empiricism and rationalism), but also it seems clear that arguments about market theory are not enough to convince policymakers and the public. One needs more.

Talking to people around me gives me an idea of the type of questions they have. For instance, some think that economists need to be more precise about what ‘regulation’ means, what regulation we are talking about, and why it could have unintended consequences. Some think that regular banks are more regulated than investment banks and are better off. Some don’t understand why standard rules such as prudential capital adequacy requirements are failing. Some believe that the SEC and other organisms lack power to intervene. But most can’t see the role of uncertainty in the system and the limit of knowledge on the part of regulators and actors in the market.

The trouble is that many economic problems are too complex to be understood by non-specialists and thus the public will always be ignorant (this relates to Bryan Caplan’s thesis). Economists have answers that the public won’t listen to or won’t understand. It is a tough job because (free market) economists are permanently caught in some kind of Sisyphean nightmare: called to explain the workings of the market to see their advice ignored over and over again. It’s no wonder why so many decide to become the counselors of the prince.