Behavioral Finance and the Crisis

David Brooks argues that the current financial crisis will be a coming out party for behavioral economics. His starting point is Greenspan's recent confession:

As Alan Greenspan noted in his Congressional testimony last week, he was “shocked” that markets did not work as anticipated. “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”

But this misses a key point. The major players were rational. They made money because they received bonuses based on returns that hid risk. The problem was agency not irrationality. What Greenspan apparently missed is the fact that the managers of corporations do not have interests that coincide with the shareholders. The separation of ownership and control is an old issue in economics. We know that when agency problems arise incentives are need to get the agent to act in the interests of the principal, here the shareholder. To get agents to pursue profits incentive contracts give them shares. But the downside risk is zero -- you cannot indenture as a slave a manager who loses big money. Hence, the manager has big incentives for risk taking. This is what happened.

Now one can argue that the boards of directors or very top managers should have watched risk more closely. But they were booking large profits and large bonuses. Had they believed that markets were efficient they might have wondered how they were earning such large returns -- where are the associated risks that allow this. But instead they assumed markets were inefficient and assumed they had hired wizards. Notice that this is exactly the opposite of the view that Brooks is expressing.

This is not to say that behavioral finance may not have good insights about issues related to the financial crisis (and finance in general, here is a survey), but certainly not in the way argued by Brooks and most commentators today.

New Bretton Woods?

Sebastian Mallaby discusses the possibility of a new Bretton Woods agreement. He points out that it will be important how China reacts to the situation:

Today it is the rising power that pursues mercantilist policies via its exchange rate. China's leadership, which sits atop an astonishing $2 trillion in foreign-currency savings, could trade a promise to help recapitalize Western finance for an expanded role within the IMF. But China may simply not be interested. The future of the global monetary system depends on whether China aspires to play the role of Roosevelt -- or whether it prefers to be a modern Churchill.

But I wonder about another problem. The Bretton Woods agreement had the benefit of having the century's greatest economist, John Maynard Keynes, essentially running the show. He led the British delegation. There are plenty of good economists today, but any new agreement is going to be led by Presidents and Prime Ministers. Who will be the Keynes of the new agreement?

Flight to Safety

The unwinding of the carry trade and the flight to safety is causing the yen and dollar to appreciate. This is what is spreading the crisis to many emerging markets.

I gave a talk on the financial crisis this week and I noted that this crisis was unlike typical ones in one big way. When most countries experience a financial crisis currency flows out and the biggest problem is to defend the currency. The IMF then comes in and pushes lower government spending to create confidence in the future of the economy. But our crisis has caused the dollar to appreciate as the whole world demands the safety of the dollar. Hence, our government is increasing spending. We have created a new type of financial crisis. That is the risk when it comes from the financial center.

Are Banks Lending?

Joe Nocera argues in the NYTimes today that many banks are using their recapitalization to buy other banks rather than make loans. While he decries this tendency, it still represents some consolidation of the financial sector. That should make it healthier. I think that lending will be down because of fear of recession and tightening credit standards. After making so many bad loans, banks are going to look tougher at credit standards. That seems like a rational response to what has happened. It will make the recession more severe.

What this really points to is that now the recession is not due to lack of liquidity but to fear of lower earnings. The impact of the financial crisis has already been felt. Genie cannot get back in the bottle.

Recession May be Bad

Officials at the Treasury and the Federal Reserve are expecting a serious recession, according to this article in the Financial Times. One quote captures the feeling, that from former Fed Vice Chair, Alan Blinder:

“It looks to me like the economy has fallen off a cliff...The game is now about making sure this recession is less deep and less long than the 1982 recession.”

One difficulty in forecasting how deep this will be is the fact that the crisis is international. Another, is to understand how US households will respond to the cut in their wealth. Will savings rise in reaction? We have depended for a decade on households consumption based on the growth in asset prices. Now that households cannot rely on this, what will happen to consumption?

Causes of the Financial Crisis

Tyler Cowan discusses the causes of the financial crisis in the New York Times. His one paragraph summary is that:

Over all, then, the three fundamental factors behind the crisis have been new wealth, an added willingness to take risk and a blindness to new forms of systematic risk. All three were needed to bring about the scope of the current mess — so that means we’ve had some very bad luck on top of everything else.

New wealth matters because it led to the savings glut and a fall in real interest rates. The money had to go somewhere. The problem is where the financial system channeled those savings.

It is important to also recognize that when a boom takes place those who are betting on the bubble continuing are making large gains. They tend to shout down then naysayers at that point. That is why it is hard to implement any policy to pop the bubble. Given this is unlikely to ever change, one would hope we can at least implement policies that reduce systemic risks. But that is also easier said than done.

What's Next

Joe Nocera discusses some proposals to deal with the housing problem, which is, after all, the core problem of the financial crisis. Until we deal with this problem in some way the crisis is likely to get worse, not better.