Reward Cards, Interchange Fees, Class Warfare (22 June 2010)

I have never really understood the popular zeal for enrolling in airline-loyalty programs and collecting miles toward discounted flights or whatever else one uses that company scrip for. Part of my skepticism stems from a belief that companies don't particularly deserve any loyalty -- why blunt the beneficial effects of corporate competition? -- and if they did, it wouldn't be because they bought it with an intentionally confusing price-discrimination scheme that charges different prices according to how many arbitrary, bureaucratic hoops one is willing to jump through in hopes of bargains. (It's especially weird when airline-mile-collecting chumps are depicted as corporate-class swashbucklers. The film Up in the Air had an ambivalent take on this -- it seemed to admire its characters for the loyalty-program mastery that seemed to be part of the attempt to satirize them as tools.) Loyalty programs seem to present the promise of a deal down the road as a beguiling substitute for an actual deal in the here and now. It's an ongoing implementation of the rebate strategy, in which retailers get consumers to pay full price and hope they screw up or forget to apply for the money that they understood at the point of sale as a discount. it is confusion as a business strategy, and creates even more of an incentive for businesses to flood the zone with disinformation and fine print.

These programs are a manifestation of what Michael Betancourt, in this article, calls "agnotologic capitalism: a capitalism systemically based on the production and maintenance of ignorance." In such an economy, profits are secured by duping or trapping people, distracting them at the key moment in which they enter into contracts not in their best interest. Or to put this another way, firms sell consumers the pleasures of distraction, paid for by entering into unfavorable contracts regarding the goods the consumers are ostensibly interested in instead of the pleasures. Airline customers are buying the pleasures (such as they are) of playing the miles game as much as the flights themselves.

Lately, in an effort try to take the world as it is rather than stubbornly refuse to acknowledge it, I have signed up for rewards programs for several airlines, but all that I've accomplished by doing that is a tremendous spike in the amount of junk mail I receive -- mainly offers to sign up for miles-based credit cards through which I earn miles for using the card instead of cash. Such rewards cards are the basis of the credit-card-company racket of collecting more interchange fees -- the processing costs merchants must pay when their customers use plastic. This leads to a roundabout series of cross-subsidies, as Kevin Drum argues here, in which the poor subsidize the rich:

Banks charge merchants far more in interchange fees than it costs to actually run their payment networks, and merchants pay because they have no choice. Visa and Mastercard are functional monopolies, so if you want to do business with them — and what merchant can afford not to? — you have to pay whatever they tell you to pay. This cost gets passed on to consumers, of course, and the poor and working class pay it. The middle class and the rich, however, don't: they basically get the fees rebated in the form of reward cards.

The most diabolical aspect of this is that I become the agent of destruction: reward cards give me an incentive to use credit, which makes retailers increase the cost of goods for all customers, regardless of whether they use credit or not. It enlists me in the effort to exploit the poor, investing me in the structure of society that makes my advantage seem contingent on the continued disadvantage of those below me. Rewards programs are basically disguised class warfare. Middle class people like me get "rewarded" -- that is, we don't get punished by having to pay the passed-through interchange costs -- for being middle class.

Mike Konczal has much more about interchange fees here. Two highlights:

1. "The system is set-up to encourage you to use credit as much as possible, and then pay that credit off later. This is not an accident. The common phrase among credit card company people is that people are “sloppy payers”, and these sloppy payments function as a major profit center for businesses. This system also transfer money upwards in a regressive, tax-free manner and distorts prices so that shareholders of financial companies can get a cut." This is more agnotology at work. We basically pay for privilege of being care free about money, not simply the stuff we get with a credit card. Companies hope we will slip up and be careless, and thus promote such carelessness in most of their marketing materials. Credit card companies have put themselves in the business of encouraging us to be "sloppy."

2. "this is the payment system. If it was a random consumer good, I would care much less about cross-subsidies and squeezing. If people who drink their coffee black subsidize cream and sugar coffee drinkers, whatever. But this is the very mechanism of which our economy runs – the way in which we trade goods and services. If distortions goes to the core of the economy, it doesn’t surprise me that we have a lot of bad scenarios much further downstream." The payment system is not some God-given thing, as Konczal points out, it's "not a state of nature event" but the complex product of institutions, regulation, convention, social trust, and so on. All payment systems have clearing risks, and it seems to me that one of the justifications for federal states is to minimize that risk so that commerce can flourish; banks, on the other hand want it to be a profit center.

Happily, it seems that interchange will indeed be facing new regulation soon. Felix Salmon notes that this may have some effects that middle-class credit-card users won't like: "if credit-card interchange fees stay high while debit-card fees fall, then merchants will simply start offering broad discounts to anybody using cash or debit, essentially forcing customers to pay extra for all those frequent-flier miles and cash rebates." I hope that eventually means the end of credit-card reward programs in general.

UPDATE: Salmon has more on payment systems in this post. The essential point: "Being able to easily pay for things without worrying about the mechanism is a great public good." We don't want to have to decide between modes of payment anymore than we want to have to second-guess our doctors about what they prescribe for us, as advocates of competition in health care demand we do. Competition among payment systems seems like a libertarian idea that can be logically defended but is wildly impractical and would b counterproductive in reality. As Salmon writes, "The fact is that payments are a utility; they’re regulated like utilities; and utilities tend not to see much in the way of innovative new entrants."

And as my friend's old landlord, who refused to take checks, liked to say, "Cash is king."

NBA Arbitrarity (18 June 2010)

I haven't watched much NBA basketball over the past decade, and it's not just because the team I used to follow, the New York Knicks, have stunk for all those years. It's more that (a) there seem to be long stretches where players don't have to give as much effort, as compared with, say, hockey, and (b) I began to have the distinct sense that the refs controlled the game more than the players -- that at any point, the game could be determined by free throws because the refs are at their own liberty to enforce the nebulous rules how they see fit. That's apparently what some believe happened in last night's championship game. Matt Yglesias writes:

I do want to note a complaint from a Celtics loyalist about “how the refs inexplicably decided to call touch fouls on the Cs in the 4th qtr leading to 21 laker FTs. That’s on pace for 84 FTs for the game.” I haven’t gone back and watched the tape or anything, but it was definitely my sense during the game that the officiating standards suddenly tightened in Q4 for no real reason. There are always a lot of complaints out there about the quality of NBA officiating, and I think they’re generally a bit overstated once you consider the inherent difficulty of the job. But it really is crucial that even if things sometimes get missed that people still feel there’s some kind of consistent theory of what the rules are, and I really don’t get that from the NBA.

This is hardly an isolated incident. (Consider, for instance, Lakers-Kings Game 6, in the 2002 playoffs.) One can crunch the data on home-court advantage and easily conclude that the refs favor the home team under the pressure of pleasing the crowd, even if the refs are not flat-out corrupt. Yglesias captures well what's wrong: the rules about fouls seem arbitrary, and this makes the refs' judgment seem subjective, governed by their own obscure agenda. But this is not because they have an agenda; it's just there is no "right way to call the game" that the refs' performance can be judged against. It often seems as though fouls can be called whenever, on whoever, on any scoring attempt that is not a jump shot, and even then, a foul can typically be called when players block-out for the rebound.

Baseball umpires are surely not flawless, and they often decisively affect a game's outcome, but you can usually have the satisfaction of pointing to exactly which calls were blown, as in the case of umpire Jim Joyce missing a call to spoil the perfect game pitched by Armando Galarraga. The Celtics fans have nothing nearly so concrete to point to; they just end up sounding like spoilsports, loony conspiracy theorists.

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.

Bookies on Wall Street (28 April 2010)

One of the most famous passages from Keynes is this one (bold added):

If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, “for income”; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator. Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism — which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.

It's hard to follow the Goldman Sachs hearings without thinking of this. The standard ideological defense for the finance industry is that it matches savings with investment opportunities and leads to a more productive use of capital for the benefit of society as a whole. But the financial crisis and its string of revelations about what Wall Street was actually up to makes that notion seem ludicrous and naive.

What the financial innovators were doing seems a lot like bookmaking. Ryan Avent points approvingly to this passage from The New Yorker's James Surowiecki:

No one on any side of this debate appreciates the casino analogy, but I think it’s still the most useful way to think about this question: when you place a bet on the Super Bowl, the casino is taking the other side of that bet. In many cases, it’ll balance the bets it makes on both sides of the trade, so that it’s exposed to no risk and it collects the certain profit from the spread. Regardless, though, any individual bettor knows that if he wins, the casino loses, and vice versa. That is, he knows the casino is on the other side of the trade. Levin seems to be saying that this means there’s a conflict of interest between the casino and the bettor, and that it’s illegitimate for the casino to take the bet. But there’s no conflict, because everyone knows what the deal is. And as long as the bet’s honest, and as long as the price is fair, the casino is doing right by the customer, because the customer is getting exactly what he wants: a chance to speculate.

That Wall Street was running a casino for speculators seems exactly right, and who cares whether it bothers bankers? Call it what it is. When you make synthetic CDOs, you are basically facilitating gambling -- these instruments didn't contribute much to encouraging socially beneficial investing. (At Interfluidity, Steve Waldman sheds some light on what function synthetic CDOs originally served for banks -- basically it allowed for regulatory capital arbitrage.) (UPDATE: This NYT discussion looks at the social worth of CDOs. All the contributions are worth reading.)

The point Surowiecki wants to make here is apt, but the analogy he uses is wrong. His explanation doesn't read like an accurate description of how sports books work. As I understand it, Vegas bookmakers always try to balance bets on both sides of a game by adjusting the odds or the point spread to even out the action. Your bet for a team is matched with that of someone who has the other side. No one bets against the casino at all, unless the bookmakers have badly botched their job. (I think the Scorsese film Casino actually details some of this; De Niro's character, if I am remembering right, is an expert line setter.) The casino is trying assiduously to avoid having action. It doesn't make bets at all. (Unlike Goldman.) The casino collects the vig -- the percent it gets for matching the action (similar to the rake in a casino poker game) regardless of the outcome -- and orchestrates the orderly payouts to winners. But it doesn't care who wins the game, only that it gets played. Like Jay-Z, the casino will not lose ever and all but the most ignorant sports gamblers understand that. They are trying not to beat the casino (by definition impossible), but to beat collective wisdom that has misjudged a likely outcome, or they are trying to get action at a favorable spread before lines move or odds change.

So if Goldman was really like a bookie, its behavior would be sort of excusable -- it was providing a way for gamblers to find one another and gamble and taking its established cut. But if I understand correctly, it was making others responsible for basically bearing the risks of paying off the outcomes of the wagers, and shirking the responsibility of running a fair game that it is supposed to assume to earn its money. As Waldman explains: "When Goldman is shifting risk that it did not wish to bear or hedge to an underwriting client, it is not acting as a market maker. Rather it is acting as an agent for a client wishing to take a position, while imposing the burden of liquidity provision on uncompensated and uninformed underwriting clients. When a bank arranges and underwrites deals to meet its own hedging needs, or especially to take an opposing speculative position, that is also ethically questionable if not plainly disclosed." (That quote probably makes no sense out of context, but I hope it will prompt you to read Waldman's post, which is dense and complex but will reward careful attention if you are curious about what investment banks are actually supposed do when they are not operating like hedge funds.)

And as Surowiecki points out, the legal issue with what Goldman stems not from their bookmaking (though that is arguably the larger moral problem with all of Wall Street in recent years), but from their fraud. Perhaps the appropriate analogy for the allegations regarding the Abacus deal is this: Goldman knew Paulson had fixed the Super Bowl, yet worked hard to make sure enough people were betting on the losing team to fund the payoff on Paulson's inevitably winning bet. The question is whether Goldman should have taken this game off the board.

UPDATE: Subsequent posts by Waldman and Ezra Klein have made me reconsider my analogy. Klein argues that Goldman, like a casino or a bookie, has no obligation to tell bettors its opinion of their bets, even when it knows they are bad bets. It just takes the action. Waldman explains that the Abacus deal did not put Goldman in the position of bookie, and why the bookie metaphor may be altogether inapt:

Goldman wasn’t structuring a trade between two clients, as far as IKB and ACA were concerned. It was working to form a business entity called ABACUS 2007-AC1, LTD and underwriting an issue of securities by that entity. The only clients formally involved were IKB and ACA, and they were on the same side of the deal.
If this had been an adversarial deal, Goldman would have had no obligation to inform the side that wasn’t paying it whether they were making a good trade. But if this had been an adversarial deal, Goldman would have been advising one party or the other. Both parties could not have been its customers.
Imagine you are trying to buy a house. It is contentious. Disputes arise over price, warranties, settlement terms, etc. You would hire an agent, and the other party would hire an agent. Those agents would be different people. The hazards of relying on the same advisor in a difficult negotiation are obvious.

Then he adds what seems to me the key point to remember with regard to "market making": "Goldman was unwilling to make a market for Paulson at a price he would have accepted, so it manufactured an entity willing to do so. Investors in that entity were not informed that they were dealing with an active, involved adversary. And Goldman has the nerve to call both sides of the arrangement 'customers.' "

Goldman Sachs Sued by SEC (16 April 2010)

A few days ago I wrote about the expose of the hedge fund Magnetar, and its shady practice of buying equity in and default swaps on the same CDOs and then working to make those CDOs fail by getting them stuffed with toxic garbage. It turns out that the SEC has charged Goldman Sachs with something similar and is suing the great vampire squid. This seems like the kind of news that should be trumpeted throughout the nation, that finally at least some consequences are being imposed on bankers after they wrecked the economy -- though we shouldn't take away from this the idea that we already have enough regulation in place covering the financial industry and we simply need the SEC to enforce what exists (something enemies of financial regulation occasionally toss out there). From the press release:

"The product was new and complex but the deception and conflicts are old and simple," said Robert Khuzami, Director of the Division of Enforcement. "Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party."

This seems to demonstrate the inherent information asymmetries involved with securitization as it was practiced during the bubble years. If it was rating agencies sleeping on the job, it was investment banks and hedge funds colluding to dupe and deceive outmatched institutional investors. The client in question here was ultimately hedge fund manager John Paulson, widely heralded in the business press for making a killing off the housing crash. Paulson got a company called ACA to put securities of his choosing into a CDO it was managing (Abacus) that Goldman helped put together and sell off to other clients. He then shorted the same CDO with default swaps. The results: The Dealbook rundown explains that "as the Abacus deals plunged in value, Goldman and certain hedge funds made money on their negative bets, while the Goldman clients who bought the $10.9 billion in investments lost billions of dollars."

James Kwak and Felix Salmon have analyses that explain why Goldman and not Paulson is the entity being held legally accountable. Salmon:

Paulson and ACA are both culpable, but it’s Goldman which was clearly central to the plan of deceiving investors into believing that the CDO was being managed by people who wanted it to make money, when in fact it was being structured by the biggest short-seller in the entire subprime market. And although ACA should never have been so passive in terms of accepting the names given to it by Paulson, it did reasonably believe, because it was essentially lied to by Goldman Sachs, that Paulson was in the deal to make money on the long side.... The scandal here is not that Goldman was short the subprime market at the same time as marketing the Abacus deal. The scandal is that Goldman sold the contents of Abacus as being handpicked by managers at ACA when in fact it was handpicked by Paulson; and that it told ACA that Paulson had a long position in the deal when in fact he was entirely short.

In other words, Goldman enabled Paulson to make fools out of ACA and all the investors who bought a piece of Abacus, all while collecting the fees for the deal.

Kwak isolates the juiciest quote from the documents, from an email by Goldman trader Fabrice Tourre, who appears to have been the point man on the deal: "More and more leverage in the system, The whole building is about to collapse anytime now…Only potential survivor, the fabulous Fab…standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!" Just another financial mastermind at work.

Magnetar (14 April 2010)

Magentar would be a decent name for a band (it refers to "the super-magnetic field created by the last moments of a dying star"), but it's the name of a Chicago area hedge fund that, according to this ProPublica article by Jesse Eisinger and Jake Bernstein, executed one of the more nefarious (and probably characteristic) trades of the housing bubble. (The story is also featured in this episode of This American Life.) It's complicated but well worth trying to understand. This is the general gist:

According to bankers and others involved, the Magnetar Trade worked this way: The hedge fund bought the riskiest portion of a kind of securities known as collateralized debt obligations -- CDOs. If housing prices kept rising, this would provide a solid return for many years. But that's not what hedge funds are after. They want outsized gains, the sooner the better, and Magnetar set itself up for a huge win: It placed bets that portions of its own deals would fail.

Along the way, it did something to enhance the chances of that happening, according to several people with direct knowledge of the deals. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure.

In short, investment banks needed equity investors to create new CDOs. Magnetar volunteered and then allegedly used its clout as investor to push the CDO managers into toxifying the securities in the structure so that it would fail. Magnetar wanted it to fail, despite owning the equity, because that loss would be made up many times over by the payout on the credit-default swaps (which essentially insure against default) that it had taken out on the crappified CDOs with earnings from the equity. As long as the CDOs paid out, Magnetar could buy the swaps. When the CDO failed, the swaps would give the big payday. It was magic, nearly miraculous -- kind of like magnets themselves. ("Fucking Magnetar, how do you work?")

Along with some useful elucidation, James Kwak explains the significance of this Magnetar business in a post aptly titled "The Cover Up":

The lessons of Magnetar are the basic lessons of the financial crisis. Unregulated financial markets do not necessarily provide efficient prices or the optimal allocation of capital. The winners are not necessarily those who provide the most benefit to their clients or to society, but those who figure out how to exploit the rules of the game to their advantage. The crisis happened because the banks wanted unregulated financial markets and went out and got them -- only it turned out they were not as smart as they thought they were and blew themselves up. It was not an innocent accident.

As Bernstein and Eisinger explain, "From what we've learned, there was nothing illegal in what Magnetar did; it was playing by the rules in place at the time." Obviously these "rules" are useless if they provide no safeguard against systematic abuses and unsustainable banking practices and apparently rampant rating-agency laxity. The whole point of having rules governing the financial sector, after all, is to allow it to function for the common good of the economy -- so that it can match savings with worthwhile investments like the apologists say it does. But instead we had legislation undoing Glass Steagall and forbidding regulation of derivatives, etc. -- establishing rules that made it seem as though the function of a financial system was to guarantee that bankers could make lots of money no matter what happened to the economy at large.

As for what to do about it now, Mike Konczal's useful paper (pdf) about the current state of financial reform is a start.

Financial innovation for suckers (2 Oct 2009)

A reader of Felix Salmon's blog named Chris seems to have written the comment heard 'round the blogosphere, about financial innovation and risk:

The person most willing to take on risk is the one unaware he is doing so. He charges no risk premium…
The resulting market equilibrium is that the guy who is unaware of the risk ends up loaded with it. Then the music stops.

Salmon's gloss on this is that it serves to explain investment banks' profits during the recent bubble: "They charge their clients a lot of money to take risk off their hands, and then they transformed that risk, using sophisticated financial engineering, into instruments which didn’t, on their face, look risky at all, and which could easily be sold to risk-averse investors. Bingo, massive profits." This means that financial innovation had become a matter of making risk disappear, not managing it better, as was so often insisted a few years ago (all that talk about how CDOs spread risk and made everyone safer, etc.). Financial innovations had become, as Salmon notes, "tools of obfuscation" in the hands of investment bankers. Further proof that the market for financial products is a market for lemons.

One might argue further that the innovation was designed to trick not gullible investors but the rating agencies those investors relied upon, only it's probably true that the rating agencies were in on the scam all along and didn't need deceiving -- they got paid when the instruments become AAA rated, and they helped the banks figure out how to make them pass muster.

It seems obvious that regulation should aim to prevent hiding risk from being a profitable business. If there is to be an overseer of systemic risk, that regulator's main function would be precisely to ensure that risk is visible and not tucked away in the shadow-banking system. The larger question is whether there is any way to direct innovation efforts toward things that actually help society rather than destroy it in the name of private gain.

Why did people think house prices can't fall? (7 July 2009)

When I was looking to find a new apartment, I was in the office of a parasitic bloodsucker -- whoops, I'm sorry, a real estate broker -- in my neighborhood (brokers have locked down the apartment market in my corner of New York pretty tightly, largely because of immigrant and absentee landlords). This particular broker also showed houses for sale, and his office was decorated with a cartoon that depicted a broken-down old couple hobbling along in the street, above a caption that mocked them: "They are waiting for home prices to drop." I thought of that cartoon while reading this Mark Thoma post about what caused the housing bubble, which takes as its jumping-off point this post at the NYT economics blog by Ed Glaeser. Glaeser admits that "The housing price volatility of the last six years has been so extreme that it confounds conventional economic explanations," and agrees with housing economists Case and Shiller that "housing bubbles were fueled by irrationally optimistic beliefs about future housing price appreciation." He uses the Las Vegas bubble as his example:

I once thought that the Las Vegas housing market was so straightforward (vast amounts of land, no significant regulation) that no one could be deluded into thinking that prices could long diverge from construction costs, but I was wrong. I underestimated the human capacity to think rosy thoughts about the value of a house.

My father lived in Las Vegas in the mid 1990s, and when I would visit, I would be astounded by the exponential growth along the I-215 corridor. It seemed utterly senseless -- shopping centers that hadn't existed on my previous visit would be filled to capacity with virtually full parking lots (I'm thinking of the Eastern Ave. exit circa 1998), while the centers a few exits back toward downtown would be nearly empty. The fetishization of the new shopping centers was indicative of the insanity that was free-floating through the region then. The new housing developments would already be started before the road grid even reached them. Planners had a difficult time coming up with all the new names for all the new cul-de-sacs being created. And the new homes were presumably being purchased by the new arrivals to the area, who by and large were construction workers in the home building business. It didn't take a genius to figure out that pattern was unsustainable.

The key question, that Glaeser declines to try to answer here, is why did people think such "rosy thoughts"? Thoma quotes Shiller, who argues that housing bubbles have happened because "people believed that both land and building materials were becoming relatively more scarce over time," which is plainly false. Still, how come people in Las Vegas and Henderson believed houses would continue to go up, against the obvious evidence in front of their face of the utter lack of land and materials scarcity? Thoma suggests people assume a long-term premium on their "investment" in a home, because they make a semi-conscious connection between buy-and-hold investing in the stock market (presumed to bring surefire 8 percent returns over the long haul) and home ownership. But buying a home is a consumption purchase, not an investment.

The question then is why people were so quick to view housing as a great investment and all those renters out there as "suckers" who were "just throwing their money away." The answer, I think, is straight-up propaganda. Consider how often the NAR economist is cited in the press as an objective expert on the meaning of housing data. Consider how much blather we hear from politicians about the ownership society and the sanctity of home owning. Think of the tax breaks and subsidies that homeowners get and seem to believe they deserve. Think of the whole parasitical class of real estate agents and the relentless advertising on their behalf and on the behalf of the mortgage lenders and banks.

In the U.S. an ideology about homeownership has become entrenched that seems guaranteed to produce irrational (by economists' standards) views about home owning. So it's hardly surprising that this ideology yielded a housing market full of deluded buyers and sellers who had little understanding of the true value of what they were bargaining over. Sadly, very little has been done, even now, to dismantle this erroneous view of housing. Perhaps because of the vested interests -- I doubt my neighborhood broker has taken down his cartoon.

Blaming everyone and no one (9 June 2009)

Feeling a bit sorry for the bankers, historian Harold James in this Project Syndicate op-ed attempts to shift some of the blame for the economic crisis on, of all things, postmodernism.

Other academic disciplines have looked rather smugly at the public humiliation of their colleagues in economics. The non-mathematical appear to have their revenge, as the perils of over-reliance on complex symbolic notation and arcane formulae are relentlessly exposed.
In fact, developments or fashions in other academic disciplines and also in the general culture contributed at least as much to a willingness to engage in absurd risks and to provide and accept valuations of complex and inherently unfathomable securities. The general cultural developments are sometimes termed post-modernism, which involves the replacement of reason by intuition, feeling, and allusion.

Sure. That seems fair enough. It is easy to picture the trading floor at Goldman Sachs littered with Lyotard, easy to imagine risk management falling through the cracks because all the continental philosophy bankers customarily read persuaded them they should believe in nothing and that so-called "risk" was just a signifier with no fixed transcendental relevance. When they were through decentering their subjectivity, the minions at credit-rating agencies went ahead and gave structured securities whatever the hell rating was requested; after all, any evaluative criteria will be compromised by the tautological assumptions that are always already tacitly accepted.

As far as I can tell, James is not joking. He wants readers to believe that postmodernism is responsible for a climate of irresponsibility among bankers on Wall Street -- and not something more immediately salient and obvious like, say, greed. This is an actual, undoctored quote from James's essay: "At the era's height, major financial players built vastly expensive collections of highly abstract modern art. A post-modern neglect or disdain for reality generated the sense that the whole world was constantly shifting and malleable, and might be as transient and meaningless as stock quotations." It seems a pretty postmodern way to argue, actually; just present a few incoherent juxtapositions of vaguely associated notions and demand that readers tease out and decide what it might mean (or better yet, have them settle on undecidability itself). James argues that financial innovation, political cowardice, and postmodernism all worked together so that "every sort of value - including financial values - came to be seen as arbitrary and fundamentally absurd." But just because philosophers may have been exploring the possibility that there was no "there" there with regard to Western values doesn't mean they advocated the idea that fictitious values should be actively created to artificially inflate asset values, or that derivatives whose notional value far exceeded the assets from which they were derived should be written. Just because both critical theory and quantitative finance are hard for laypeople to comprehend does not make them morally equivalent. And the fact that a postmodern analysis could be used to elucidate the techniques of finance (the building something out nothing aspects of it anyway) revealed how awry finance had become; it didn't supply a justification for it. Greed did that. The spirit motivating philosophers ( a concern for ways in which ideology distorts what passes for truth) is fundamentally different than the one that spurred financial innovators; to elide them is to discredit the whole notion of responsibility, which seems to be James's aim. In his final paragraph, he laments the possibility that society might regress to a "medieval" witch-hunt mentality by playing blame games. Better by far to suggest that everyone is responsible in some small way and preserve the existing social order.

A non-risible critique about the role of ideas in the crisis from Neil Sinhababu can be found here, and it demonstrates how a postmodernish style of inquiry can actually help unmask problems rather than contribute to them:

economists have managed to convince people of indefensible views on normative topics such as what it's rational for individuals to do, what's an appropriate object of moral criticism, and what would be a good distribution of resources. I don't know how many of them would, when pressed, defend these sorts of claims -- their discipline isn't supposed to be one that makes normative claims.
Saying you're not making any normative claims is, of course, a good way of getting people to accept the normative claims you make. A lot more in this sort of thing depends on the sorts of emotions that get communicated as people talk about stuff and the loaded words you use. Pareto optimality, for example, has 'optimality' built into it, and who doesn't like optimality? Of course, as Rawls tells us, a distribution where one person owns all tradable goods and services while nobody else has anything is Pareto optimal.
In any event, this is the kind of thing we ought to be concerned about, both as citizens and as philosophers. While ideas from other parts of academia can't get out to the public, economists are convincing people of ridiculous theses in moral and political philosophy that their research doesn't even support. (It probably helps that widespread social acceptance of these theses is favorable to the interests of very wealthy people.)

Undoing ideology with policy (24 April 2009)

When an industry gains disproportionate social power, as the finance and real-estate industries had in the pat decade, there must be an associated ideology that legitimates that ascendancy. It surprises me that this notion sometimes seems a shocking discovery to those who cover business, as though it never occurred to them that they were dealing in ideology in their coverage of CEOs and on earnings calls and in shareholders letters and the rest of the official communications from corporate America, not to mention the efforts of their lobbying arms to plant their preferred soundbites into the speeches of politicians. Of course, those in the business press often function as ideologists themselves, suffering from the "cognitive regulatory capture" that Willem Buiter claimed happened to the Federal Reserve under Greenspan. Business journalists often seem more enamored than critical of the titans of industry who deign to speak to them, and they typically accept in its entirely ethics derived from a faith in deregulated markets. Workers are depersonalized into "labor" or "wages" -- an unfortunate cost of doing business and an obstacle that the heroes of capitalism must overcome.

They are used to economists playing by the same rules, so they seem a bit flummoxed when someone like MIT economist Simon Johnson (interviewed here by Salon) rises to prominence by declaring the obvious point that the finance industry exercised political power for its own good and not the good of the country. But that is how the system plainly works; I don't think one is being unduly cynical to recognize that in the US, money is openly and obviously used to gain political power (via campaign contributions and marketing efforts), which is then used to further an industry's agenda. The "good of the country" is an afterthought, a premise cooked up in the ex post facto spin.

In the interview Johnson suggests that economic realities will be sufficient to dispel the effects of that spin. In response to whether greater regulation and a mandated bank breakup would end the oligarchy, he replies:

The breaking of the belief system is an outcome of the crash. The belief system is kind of a perpetuating mechanism but when the economic realities change, people stop believing the same things. I think one advantage of a society like the United States, a democracy, is that we can change our minds pretty quickly on some things, even some firmly held beliefs. I am not saying throw capitalism out with the bath water. I'm saying big finance has just become too powerful and it needs to be reined in. There are some relatively straightforward technocratic steps that can be taken that will move us in the right direction. But I'm not a starry-eyed idealist -- I don't think this is going to change massively overnight.

Throughout the interview he is at great pains to avoid being marginalized as a "radical," to shift the sense of the center toward his position through a kind of rhetorical calm. That's certainly a prudent course, though the country may be more in the mood for scapegoats and show trials than incremental change. The banking business would like us to believe that it was just a few bad apples who can be tossed out while keeping the ideology in tact, whereas the rabble-rousing, tea-bagging set seems to want vengeance. The danger is that the fervor for scapegoats could prove a distraction, leaving the underlying system unaffected. In this you can see how the right-wing may hope to steer the populist uproar.

Addendum: Matt Yglesias makes a related point here, where he wonders why Americans seem to think CEOs have more credible opinions on policy than other citizens.

Zack McMillan of the Memphis Commercial Appeal recounts for us a great moment in ideology in America, as FedEx CEO Fred Smith deigns to speak to the Memphis City Council. Note that the very premise of the event, that a wealthy CEO should be considered a source of public policy insights, is, though very common in today’s America, a highly ideological notion. Relative to a person selected at random, Smith is no more likely to have substantive insights into the issues facing the Memphis City Council, but much more likely to be deliberately lying in order to personally enrich himself.

But in the United States, when a wealthy and powerful person wants to opine on public affairs, this is viewed not with suspicion (”what’s this rich guy trying to pull?”) but with delight. The mere fact that someone is rich is held to demonstrate that he’s entitled to massively disproportionate political influence even beyond what he’s able to directly purchase.

Needless to say, Smith's ideas were entirely self-serving.

Crybaby bankers (21 April 2009)

Be sure to sharpen your pitchforks before reading Gabe Sherman's New York magazine schadenfreude-fest about pouty investment bankers, who from behind the cloak of anonymity complain about how unfair life has suddenly become for them. It turns out the bankers are "angry" because they are having to pay higher taxes and because their plutocratic bonuses seem to be a thing of the past. As Sherman notes, "In a witch hunt, the witches have feelings too" -- but then, one could sympathize with the witches because they were singled out unfairly by an unruly mob of religious bigots. The fury at the bankers, in their callous cluelessness and their reckless endangerment of the global economy in pursuit of an extra Hamptons mansion or two, seems altogether justified and rational. The bankers aren't some misunderstood group of well-meaning citizens; they are a group that prided themselves on their sharklike mercilessness and tenacity in extracting every last bit of advantage for themselves, and they would smirk when they rehearsed the exculpatory excuse that such single-minded greed had the inevitable by-product of economic efficiency. They were wrong about that, and they should probably get as much forgiveness as they would give us if we were opposite them at the bargaining table.

When bankers were capitalism's winners, they had no problem lording it over everyone else; it seems appropriate they taste the full sting of loserdom. Sherman writes that Wall Street bankers, analysts, and traders "had believed Wall Street was where the winners of American capitalism went. Now they were feeling shamed for their work." To which I would say "good" -- only the rest of the article makes it clear that they are a group incapable of feeling shame.

What I found most irritating is the expression of overclass entitlement in such complaints as this:

“No offense to Middle America, but if someone went to Columbia or Wharton, [even if] their company is a fumbling, mismanaged bank, why should they all of a sudden be paid the same as the guy down the block who delivers restaurant supplies for Sysco out of a huge, shiny truck?” e-mails an irate Citigroup executive to a colleague.

This is a good reminder that those cretins at "elite" schools really do think they are better than you, regardless of what they or you do -- or rather that whatever they do is inherently more important and valuable because of their pedigree. As Sherman puts it, "they see themselves as the fighter pilots of capitalism," to which Time blogger Justin Fox replies, "Actually, they may more closely resemble the bumper-car drivers of capitalism, spending more time tangling with each other than doing anything useful."

From the sound of the people whining to Sherman, the bankers lost sight of the principle that meritocracy have some clear relationship to merit. Instead they assert a marketocracy and claim that it amounts to the same thing. One banker declares, "The truth is, the market determines what people are worth." Um, that's not the "truth" as in being some fundamental law of society. That's an ideological precept that has been concocted to rationalize drastic income inequality. And do bankers really want to start measuring what people are "worth" by the money they make, by market performance, at this juncture? Considering all the value banks have destroyed, that must mean the investment bankers are actually "worth" less than nothing -- they owe society several years of their working lives, by that sort of accounting. The "truth" is that people who work for no other reason than money will take as much as they can get at all times, unless some greater authority sets a limit. Will that limit seem arbitrary to them? Of course. But the amount at which they would feel content will always be arbitrary as well, since it is always at least one dollar more than whatever they are currently receiving. Listening to investment bankers' advice on compensation would be like canvassing for ideas about drug-law reform in the parking lot at a Dead show.

Sherman recounts how Wall Street came to gobble up a greater percentage of the corporate profits earned in the U.S. economy, which supplied them with the firepower to press for more financial deregulation. He quotes economist Simon Johnson, who's article on the subject in the Atlantic is essential reading: "“The system as a whole became unstable because Wall Street developed this disproportionate influence. It’s an entire system of belief they had to create." That belief system involved the idolatry of deregulated markets (which basically render them less transparent) and risk-spreading procedures which maximized the cut for middlemen -- which is essentially what investment bankers are. But the ideology they espoused claimed that this process was generating economic efficiency, not profits for parasites. Perhaps at the dawn of the financial free-for-all, bankers worked harder to find better ways to allocate capital, but by the end they were merely rent seekers who felt entitled to their cut by virtue of their pedigree, by a sort of plutocratic fiat. Their hard work went into what Johnson has labeled "tunnelling" -- insiders funneling money out of legitimate enterprises because they know the end of the bubble is near.

In short, the New York article succeeded in accomplishing its goal with me; it made me disgusted and angry. Ryan Avent implies that there might be something irresponsible in this:

Personally, I find this all very disconcerting. A round of all-out class warfare would be good for no one, and I generally agree with the idea that markets ought to set compensation levels. The brazenness with which executives are disregarding public concern over these issues is just adding fuel to an already uncomfortably hot fire.

I don't agree that "markets" (in practice, often boards of directors) set compensation levels appropriately -- it seems like a market for lemons, at this point, and is ripe for reform. And if it takes class-warfare rhetoric to steel the resolve of politicians to do something, than articles like Sherman's are probably valuable. The problem is that financial journalists do little complaining about executives' brazenness during ordinary economic times, when political action might actually work as preventive care rather than triage.

"Bankruptcy for profit" (10 March 2009)

Economist Simon Johnson, of the excellent Baseline Scenario blog, wrote a post that effectively sums up what is so frightening about the predicament the big banks' negligence has put the U.S. in. Obviously, it's not that the U.S. is in danger of becoming a social democracy or a socialist state or whatever making Limbaugh's legions whine -- I would welcome that sort of development anyway. And banks have never been a purely private industry anyway; they have always relied on certain dispensations and implicit guarantees from the state to operate. The real danger is that the current chaos and uncertainty in banking will worsen the principal-agent problem and lead to the sort of corruption we associate with organized crime becoming entrenched in the official economy.

Maybe I'm naive, but part of American "exceptionalism," it seems to me, is its complacency about corruption, as though its highly ambitious and self-interested capitalists instinctively shy away from compromising the system by cheating it, by abusing the commercial codes of trust that allow the economy to function and thrive where graft-laden bureaucracies falter. But downturns challenge that faith, and well-placed people begin to see more advantage in rewarding themselves financially than in the glory of power in a proud and growing economy. Johnson's post explains how that may be playing out now.

Boris Fyodorov, the late Russian Minister of Finance who struggled for many years against corruption and the abuse of authority, could be blunt. Confusion helps the powerful, he argued. When there are complicated government bailout schemes, multiple exchange rates, or high inflation, it is very hard to keep track of market prices and to protect the value of firms. The result, if taken to an extreme, is looting: the collapse of banks, industrial firms, and other entities because the insiders take the money (or other valuables) and run.
This is the prospect now faced by the United States.

This analysis suggests some of the powerful incentives various financial players have to create more confusion than what the volatility in the markets have already generated. They can profit personally, or at least protect themselves, and the expense of the system generally. The scheme of bailouts as they are being conducted currently by the state, play right into these players' hands.

The course of policy is set. For at least the next 18 months, we know what to expect on the banking front. Now Treasury is committed, the leadership in this area will not deviate from a pro-insider policy for large banks; they are not interested in alternative approaches (I’ve asked). The result will be further destruction of the private credit system and more recourse to relatively nontransparent actions by the Federal Reserve, with all the risks that entails.

Responding to Johnson's post, Yves Smith points to a 1994 paper by economists George Akerlof and Paul Romer that makes a similar point. Their argument is a kind of moral-hazard variant that sees an incentive for corruption in the wake of bailout plans.

Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society's expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations....Unfortunately, firms covered by government guarantees are not the only ones that face severely distorted incentives. Looting can spread symbiotically to other markets, bringing to life a whole economic underworld with perverse incentives. The looters in the sector covered by the government guarantees will make trades with unaffiliated firms outside this sector, causing them to produce in a way that helps maximize the looters' current extractions with no regard for future losses.

Then we have an economy that lacks even the pretense of competitive meritocracy, an inherently unsustainable one in which connections to favored firms is all that matters. Those firms profit without sustainable business models, at the expense of firms that might have such models, until the economy grinds to a halt. That may actually be what has already happened.