Wednesday, August 10, 2011

Michael Lewis's 'The Big Short' (5 May 2010)

I borrowed The Big Short by Michael Lewis from a friend the other day and am rapidly reading my way through. I'm glad I waited until now to read it, because it makes for a smoother ride having already tried to digested the mechanics of Goldman Sachs's Abacus deal and the Magnetar trade. Some of it was familiar from my Portfolio days as well. The book masquerades as an aw-shucks account of some of the people who figured out that all the subprime lending made for a titanic house of cards and how they managed to get rich from their insight, but beyond that it's a pretty far-reaching critique of financial capitalism.

The way ideologues defend the inherent instability of the capitalist system ("creative destruction," etc.) is that competitive innovation may destroy individual firms but overall society reaps benefits from their espousing better ways of doing things. A firm that makes, say, steel cheaper buts the inefficient steelmakers out of business but lets society do more with steel.

But when capitalism is dominated by finance (and finance by 2007 was responsible for over 40% of all business profit in the U.S. by the mid-00s), competition and innovation become a matter of merely betting against fools rather than fixing the system that produced them. Financial innovation didn't allocate capital for the betterment of society; it allocated capital for the enrichment of Wall Street douches.

The people Lewis writes about don't seem especially douchy, and Lewis tends to try hard to make them sympathetic Cassandra figures who were on a quixotic quest to expose a financial system that had become systemically irrational. And they were merely acting on the basis of the prevailing ideology when they recognized that the whole financial system could meltdown but did nothing to prevent it and everything they could to profit from it -- their profiting from it, according to capitalist ideology, was supposed to be an expression of the system fixing itself. In reality, their wisdom that could have prevented financial calamity instead helped enable and intensify it. The glorification of markets presumes that everything of social worth and everything about human behavior is a matter of incentives, and anything worth doing will ultimately be incentivized. But there was no way to incentivize the prevention of financial disaster.

So Lewis's protagonists could have been heroes, might have mitigated a catastrophe, but instead fomented a profitable disaster because capitalism suggests that heroism is measured in profit and that profit can't be wrong. And many people probably still think that (what could be wrong with making money?), despite all the collateral damage to those who had nothing to do with subprime lending but ended up out of a job anyway, or the people who are still paying off an oversize mortgage on a house that got to be way, way, way overpriced thanks to the investment bankers' heedless rapaciousness inflating housing bubbles with insanely easy credit.

Market fundamentalists still probably think it's better to let a "self-regulating" system crash completely -- making a few winners and a society of losers -- then to have regulation (of derivatives, of rating agencies, etc.) designed to prevent such things from happening. That's the essence of Goldman's eagerness to hide behind the "sophistication" excuse that Thomas Frank points out in this WSJ op-ed. Nothing could be wrong with the gambling proclivities of sophisticated, consenting bankers, regardless of the collateral damage of their actions, which they seem simply to ignore as irrelevant. Lewis's book reveals that no matter how smart investors were, nothing they could do would prevent economic disaster. Frank's op-ed (a recapitulation of some of the arguments he made in One Market Under God) points out how the supposed sophistication of players in financial markets is used as an excuse to eschew regulation.
If the public is "smart," then who needs the nanny state? Meanwhile, as the familiar expression goes, those who support regulation "think you're stupid." So: Goldman Sachs builds up the "sophistication" of its counterparties because that, apparently, is what will get Goldman itself off the hook. And the boosters for the broader market build up the "sophistication" of small investors because that will get the market generally off the hook, by summoning up an "investor class" that will carry on Wall Street's war against the regulators.
(A variant on this is the idea that regulators are inevitably the people too stupid to hack it at the banks they are hired to regulate, so it all is a big waste of time.) Regulation, the banks allege, prohibits smart people from acting on their intelligence in the markets, thus wasting it. But what really happened in the past decade was that all the sophistication deployed in markets led only to making a bigger and bigger meltdown. The sophistication on various sides of trades doesn't balance out and produce optimal outcomes; it swirls and eddies and produces economic death spirals. Everyone tries to find the bigger fool, and everyone ends up getting made a fool of.

Paul Krugman argues here how regulation could have prevented what Lewis describes -- what Krugman calls "white-collar looting." And in this statement to a congressional subcommittee, Jamie Galbraith explains how the assumptions of market fundamentalism provided ideological cover for fraud.
Latter-day financial economics ... necessarily treats stocks, bonds, options, derivatives and so forth as securities whose properties can be accepted largely at face value, and quantified in terms of return and risk. That quantification permits the calculation of price, using standard formulae. But everything in the formulae depends on the instruments being as they are represented to be. For if they are not, then what formula could possibly apply?

Further discussion from James Kwak of the pros and cons of the financial regulation debate taking place now in Congress can be found here.

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