Last Temptation of Risk

Barry Eichengreen has an interesting article on the Last Temptation of Risk over at National Interest Online. The point is to explain how economists did not forecast the crisis. His argument is that the problem was not theory. Rather,

the problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists whose scholarship provided intellectual justification for the financial institutions’ decisions. The consequence was that scholarship that warned of potential disaster was ignored. And the result was global economic calamity on a scale not seen for four generations.

Think of agency theory. This certainly predicts the conflicts of interest between shareholders and management that induced excessive risk taking. And information theory suggests that market prices may have plenty of noise, and that sellers will know more about assets they sell than buyers. The ingredients for understanding the crisis was there. So why were they ignored?

Eichengreen argues that we were seduced. Agreeing with the de-regulatory zeitgeist led to lucrative speaking fees and consulting gigs. The Shillers of the world only prosper after the fact, the facilitators during the boom. Hence, he writes:

What got us into this mess, in other words, were not the limits of scholarly imagination. It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises. It was not that economists failed to recognize the role of social and psychological factors in decision making or that they lacked the tools needed to draw out the implications. In fact, these observations and others had been imaginatively elaborated by contributors to the literatures on agency theory, information economics and behavioral finance. Rather, the problem was a partial and blinkered reading of that literature. The consumers of economic theory, not surprisingly, tended to pick and choose those elements of that rich literature that best supported their self-serving actions. Equally reprehensibly, the producers of that theory, benefiting in ways both pecuniary and psychic, showed disturbingly little tendency to object. It is in this light that we must understand how it was that the vast majority of the economics profession remained so blissfully silent and indeed unaware of the risk of financial disaster.

Eichengreen then argues that the increased popularity of empirical economics may help us avoid this problem in the future. I am less convinced by this argument. It is just as easy to cherry pick empirical work as theory. But the major thrust of the article is well worth reading.

Agency

I've said before that the key problem that led to the crisis was agency. Incentives for financial decision makers encouraged risk taking. An article in today's Wall Street Journal provides some evidence, in the form of earnings of top executives in finance and home-building over the last five years. A key finding:

Fifteen corporate chieftains of large home-building and financial-services firms each reaped more than $100 million in cash compensation and proceeds from stock sales during the past five years, according to a Wall Street Journal analysis. Four of those executives, including the heads of Lehman Brothers Holdings Inc. and Bear Stearns Cos., ran companies that have filed for bankruptcy protection or seen their share prices fall more than 90% from their peak.

Of course such earning filtered all the way through the financial system. Bonuses and earnings were high at investment banks because the risk taking led to high current earnings, and because insufficient attention was paid to the associated risks that the decisions that produced those earnings implied.

The key point is that these people were obviously not stupid, and the crisis is not due to stupidity, but rather to a system that rewards current performance without attention to risk. To paraphrase James Carville, "it was the incentive system stupid."

Martingales and the Financial Crisis

This article compares the developments on Wall Street to placing a martingale bet. In the martingale game you bet, say, $100 on a coin flip, and keep doubling down if you lose. The game seems to offer certain gain for no risk. If you lose on the first flip you bet $200 on the next, if it comes heads you are up $100 ($200 minus the $100 you lost on the first flip). Just hang around till you get a heads. Seems a sure thing. The problem, of course, is that it is always possible that you get a run of tails that could wipe you out before you win. This is the "law of gambler's ruin."

What is interesting about the game is that you have a high probability of winning a relatively small amount, and a small probability of losing a huge amount. Notice that as long as you don't have the cataclysmic event you are earning positive profits with seemingly no risk. You are a financial genius. You are imitated by other financial geniuses. You get a large bonus for your invention of a strategy that produces such high risk-adjusted returns.

Only you haven't really earned super risk-adjusted returns. You just have not yet experienced the run that produces the big losses. After all, a run of say 10 tails in a row is not all that likely with a fair coin. In the meantime you are the Lord of Wall Street and a Master of the Universe. You probably are playing this game with a lot of leverage too. So when you do crash, you can take others down with you.

Why do smart Wall Street types play this game? There are various explanations, but one obvious one is that while you earn the good returns you are accumulating bonuses that you do not lose when the crash occurs. The incentive schemes of hedge funds and financial institutions in general encourage risk taking. Given that they do it should not be surprising that financial managers take excessive risks.