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An Accident Waiting to Happen

(A shameless ‘I told you so’ polemic’ -- but with an optimistic punch line)


What Was Really Wrong?

The 2008 financial crisis is rooted in seriously flawed theories and regulatory structures.


Modern economic theory assumes that all risks can be reduced to known probability distributions that are common knowledge – everyone knows what the true probability distribution is. The assumption is crucial for building mathematical models; but it bears little resemblance to reality and sustains the dangerous belief that diversification eliminates risk and thus the need for case-by-case judgments.[1]

In a 1994 article ("Return to Judgment," Journal of Portfolio Management[2]) I challenged a 1974 claim (in the same journal) by Paul Samuelson that investors should construct passive market portfolios and “throw away the key.”

Unfortunately the use of models based on the same flawed assumption continued to expand and lots and lots of keys got thrown away. Valuing securities taking into account the vagaries of specific circumstances – trying to get a handle on “unsystematic” risk – finance professors taught, was a wasted effort.

In March 2002 someone who was writing a survey for the Economist about the future of capitalism asked me to offer a prognostication. Capitalism, I emailed him, was in great shape – except in the financial sector because of the pervasive belief that diversification was a substitute for due diligence.

“I think the financial system faces a much sharper change from the trajectory its been on since the early 1980s -- much more so than in the other elements of the modern capitalist system (e.g low taxes, deregulation, cost conscious managers, privatization, cross-border trade and investment) that I think are here to stay. Of course if the financial sub-system really starts unraveling, the other elements may also be affected.

“One reason for expecting a sharp change is simply that trees don't go to the sky. The growth in the value of financial assets (and in the incomes of bankers) has far outstripped the rate of growth of the real economy (and of other working stiffs). The inevitable mean-reversion is already in place witness NASDAQ and VC returns. Heck one of these days, we might even see the S&P trade at a reasonable P/E.”

“But that's not the main dimension of the system that's out of whack. In fact, I think the absurd valuations themselves may be a symptom of flawed assumptions about agency problems. To simplify: when a "principal" provides capital to an "agent" he faces two kinds of problems -- that the agent is a crook and that the agent has bad judgment. I don't see too much of a direct problem on the crookedness side--the rules of the game haven't made outright stealing any easier over the last few decades. The systemic problem lies in the lax control over errors of judgment. This has arisen because of the mistaken belief that diversification (and well aligned incentives) can substitute for the control of bad judgment through due-diligence and oversight. Everyone has bought into the belief — investors, intermediaries and implicitly (through the promotion of market liquidity) regulators — that diversified portfolios make the problem of bad judgment disappear. Actually, diversification complements due-diligence and oversight; relying on diversification as a substitute exacerbates the problem of bad judgment. Incentives to cheat also may increase -- many fraudulent schemes start out as cover-ups for mistakes.

A regulatory apparatus, first established in the Great Depression, has underpinned the breadth and depth of U.S. stock markets. But, it has also have severely impaired corporate governance. For instance, rules prohibiting insider trading and requiring disclosure encourage trading by keeping the casino honest; but, placing special burdens on insiders, discourages stockholders from accumulating control positions or even serving on the boards of directors. Inevitably boards comprise individuals who don’t have a significant economic stake in the company.

Takeover threats may deter flagrant abuses but aren’t a substitute for informed oversight by insiders. In banks and other financial service firms, even that threat is absent because regulations (and highly leveraged capital structures) make hostile takeovers practically impossible.

(I had discussed the trade-off stock market liquidity and governance in a 1993 article in the Journal of Financial Economics[3], and then in several more popular pieces in the Harvard Business Review, the Financial Times[4] and the New York Times[5] and in a Royal Society of Arts lecture[6]. My 1988 doctoral dissertation[7] had shown that the much feared corporate raiders curbed only the extreme cases of mis-governance, and that too, just the problem of over diversification).

The unintended consequences of Depression Era rules on banking have inflicted even more damage than did the stock market rules.

In principle the case for bank regulation was strong. The rules protected depositors from imprudent bankers — and bankers from jittery depositors. Before this, the fear of bank runs made depositors and lenders inordinately cautious: Mortgage loans, for instance, rarely exceeded half of the value of the property. The creation of the FDIC both ensured the safety of deposits and also freed bankers from the challenge of earning the confidence of depositors. Bank examiners became the main restraint.

The switch initially produced good side effects. Banks lowered down payments on mortgages, making home ownership more affordable. Regulators also provided the cover needed to pursue innovative risk management strategies. In the ‘70s for instance, banks started using futures to hedge the risks of making long term loans with short term deposits. Without deposit insurance -- and the reassurance of state supervision -- even sophisticated depositors would shun banks that traded futures. Paltry passbook rates simply wouldn't compensate for the risks.

Eventually however, more complex and dangerous innovations flourished under the regulatory canopy. Regulators apparently succumbed to the idea that if a little financial innovation was good, a lot must be great. Banks directly or indirectly enabled instruments that were far outside the regulators’ capacity to monitor.

Banks’ CEOs weren’t on top of things either. Freed of both stockholder and depositor restraints, banks (and their financial next of kin) became sprawling, unmanageable enterprises whose balance sheets and trading books are but wishful guesses.  CEOs famously frolicked on golf courses and at bridge tournaments while their businesses imploded because they didn't know any better.

President Clinton says the collapse was triggered by the absence of good investment opportunities outside housing. In my view the system was an accident waiting to happen and anything could have triggered it. If we want to identify a particular trigger, I would vote for the knock-on effects of the rapid advances of the Chinese economy: As Ned Phelps and I wrote in 2005, China increased its capacity to produce modern goods for international markets more quickly than it increased its capacity to consume such goods. This created a “savings glut’. But if the Chinese saved, someone had to borrow. And the borrowing had to be channeled through a financial system that could screen for creditworthiness and guarantee repayment. The US financial system offered the illusion of such a capacity but in fact buckled under the amounts that passed through it.

What Now?

Besides the financial costs to taxpayers and the global economic slowdown, the dysfunctions of the financial system have exacted a serious toll on the legitimacy of providing great rewards for great contributions.  Finance certainly contributes to prosperity, but the vast wealth secured in recent years by a small number of financiers does not map into a commensurate increase in their economic productivity: they haven't created or financed new industries or turned around failing companies.  Rather they have used subsidized borrowing to leverage the returns of questionable schemes, secure in the knowledge that if things go wrong the authorities will step in, trying to shore up asset prices or prop up failing counterparties.  The sharp rise in income inequality at the top of the scale owes much more to reverse Robin Hood regulation than to a small decline in personal income tax rates.

The haste with which Congress is being railroaded into passing a $700 billion bailout is disquieting. The establishment tells us that unless we act immediately, catastrophe awaits.

But on what theory or evidence? And consider the source – the very same crowd that didn’t see it coming.

And what’s the worst case consequence of no bailout?

The Dow falls, 1000, 2000, 3000 points? So what – financial markets fluctuate? (After word: The Dow in fact did fall precipitiously after the bailout was passed. Would the Dow in fact have fallen more if there had been a more measured and thoughtful response? Did shouting “fire-marshals!” in a crowded theatre really help? )

We enter a deep recession? That’s more serious – but take a deep breath. The US did endure a very serious recession in the early 1980s. Unemployment and interest rates were in double digits. But that was, most would consider, a necessary cost of wringing out inflation and restructuring the old economy. There was no quick fix.

As against this possible downside, we have the near certainty that that a hasty $700 billion bailout will be mismanaged or worse. For some people, is this an opportunity to rake it in or what?

Neither presidential candidate has offered a plausible long term fix.

McCain rails against greed – but that’s not a strategy.

Obama, like many others, favors bringing the regulatory system into the 21st Century because "old institutions cannot adequately oversee new practices."

Sounds great, but which agency has the capacity to spare? Bank examiners continue to struggle with traditional lending, and the Fed hasn’t yet mastered the problem of central banking in a globalized economy. And, adding capable regulatory staff to oversee fiendishly complex innovations and institutions – and then keeping them from going over to make the big bucks on Wall Street – isn’t like recruiting baggage screeners at airports.

A Modest quasi-libertarian proposal

Rather than trying to keep up with the never ending proliferation of innovations, it is time regulators pulled commercial banks back into traditional lending. Let's instead revive the radical idea of narrow banking and tightly limit what banks (and any other entities that raise short term deposits from the public) can do: nothing besides making loans and simple hedging transactions that examiners who don't have PhDs in finance can monitor. And, certainly, no willy-nilly diversification or Rube Goldberg financial supermarkets.

Anyone else: investment banks, hedge funds, trusts and the like can innovate and speculate to the utmost, free of any additional oversight. But, they would not be allowed to trade with or secure credit from regulated banks, except through prudent, well secured loans. This simple, “retro” approach would protect depositors, limit the risks of financial contagion, allow the FDIC and Fed to focus on their primary responsibilities, and not require new agencies or more regulators. Less, would in fact, be more.

Unfortunately the panicky response to the crisis is moving us even further away from narrow banking – witness the conversion of Morgan Stanley and Goldman Sachs into bank-holding companies to be regulated by the Fed. This is wrong-headed – if the Fed couldn’t control the tangled mess at Citicorp how is it going to cope with more Too Big Fail and Too Complex to Manage mega-banks?

(I made the old argument[8] for narrow banking in a presentation at a conference held at the council on Foreign Relations in November 2007 and then in a New York Times op-ed (forthcoming). My critique of mega-banks is in a Forbes.com op-ed.)

Some Good News

Until very recently many scholars and financiers claimed that the “sophistication” of the US financial system was a prime cause of US prosperity. If this was really true – and the system is shorn of its refinements we would have much to worry about.

But is it?

Certainly a modern economy needs sound financial basics – stock markets, banks, insurance companies, venture capitalists, commodities exchanges etc. But there is no evidence, that all the bells whistles that have been developed over the last couple of decades are have created value.

In fact the claims in favor of increased sophistication are implausible on their face. Can we really believe that a financial sector that accounted for more than a fifth of the profits of the S&P 500 (and that does not include the profits of the hedge funds) have produced improvements in mobilizing or allocating capital of that magnitude?

More likely, innovators and entrepreneurs in the real economy prospered in spite of the talent and funds that were taken up by the expansion of the financial sector. So if the financial sector shrinks back to the “basics” so much the better for long run prosperity.

Also encouraging, even if there is a recession: Our Venturesome Economy (TM !) has demonstrated a capacity to develop and deploy innovations that sustain our long run prosperity in good times and in bad. Personal computers recall took off in the dark days of the early 1980s. But we mustn’t let the ill-will generated by bad financial innovations lead to policies that harm innovators in the good economy! Clean out the stable, but please keep the horse.

(This was written on September 30th 2008 (before the bailout). I believe its all still valid.)

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[1] As I said to a friend who was contemplating investment in a dodgy “emerging” market: “Giving your money to twenty thieves is no better than giving it to just one.”

[2] "Return to Judgment," Journal of Portfolio Management, V 20, N 2:  pp. 19-25, Winter 1994.

[3] "The Hidden Costs of Stock Market Liquidity," Journal of Financial Economics, V 34, 1993: pp. 31-51.

[4] High cost of liquidity, Financial Times, December 13, 1994

[5] Fair Stock Markets:  The Hidden Cost, The New York Times, January 22, 1995.

[6] The hidden costs of investor protection: lessons from the US, Royal Society of Arts Journal, V CXLII, N 5452, July 1994: pp. 27-34. (from lecture delivered to the Royal Society of Arts, London April 13, 1994)

[7] Published in "The Causes and Consequences of Hostile Takeovers," Journal of Applied Corporate Finance, V 2, N 2: pp. 36-59, Summer 1989.

[8] See for instance Robert Litan’s Ph.D. Dissertation: An Economic Inquiry Into the Expansion of Bank Powers.