No Trust Left
While most economists are busy discussing the origins of the current crisis, a few are looking ahead. One nice think-piece is by Daron Acemoglu, of MIT, which draws three lessons. I like the third lesson the most:
The third notion that has also been destroyed by recent events is at first less obvious. It is also one that I strongly believed in. Our logic and models suggested that even if we could not trust individuals, particularly when information was imperfect and regulation lacklustre, we could trust the long-lived large firms - companies such as the Enron's, the Bear Stearn's, the Merrill Lynch's, and the Lehman Brothers's of this world - to monitor themselves and their own because they had accumulated sufficient reputation capital. Our faith in long-lived large organisations was shaken but still standing after the accounting scandals in Enron and other giants of the early 2000s. It may now have suffered the death blow.
If right, Acemoglu is onto something big. Trust is essential to business activity, and losing it may result in bigger cataclysms down the road. For those interested in how trust develops, read Trust in Large Organizations, by my co-authors Andrei Shleifer, Rafael La Porta and Florencio Lopez-de-Silanes.
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The document presents many important points with which I fully agree and so you will have to excuse me for highlighting what I do not agree with.
1. It starts out by saying “We do not yet know whether the global financial and economic crisis of 2008 will go down in history as a momentous or even uniquely catastrophic event”. Unfortunately I have no doubt it will, and also that anyone believing the contrary does not really understand the full meaning of systemic risks.
2. It states “But they also make the economy more vulnerable to certain low probability, tail events precisely because the interconnections that are an inevitable precipitate of the greater diversification create potential domino effects among financial institutions, companies and households.”
I would phrase that quite differently by saying that what happened was an increase in the probability of tail events… as implied in the question… what is the risk of so many falling simultaneously over a single financial precipice, with or without the empowerment of credit rating agencies?
The previous is one of my main objections to the whole regulatory philosophy embraced by the Basel Committee, and the following is what I told the participants when invited to give my opinion as an Executive Director at a Risk Management Workshop at the World Bank in May 2003:
“I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This surely must be setting us up for the mother of all systemic errors.”
3. And with reference to creative destruction the following is what I said in the same workshop:
“If the path to development is littered with bankruptcies, losses, tears, and tragedies, all framed within the human seesaw of one little step forward, and 0.99 steps back, why do we insist so much on excluding banking systems from capitalizing on the Darwinian benefits to be expected?
There is a thesis that holds that the old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than today’s no burning at all, that only allows for the buildup of more incendiary materials, thereby guaranteeing disaster and scorched earth, when fire finally breaks out, as it does, sooner or later.
Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.
Knowing that “the larger they are, the harder they fall,” if I were regulator, I would be thinking about a progressive tax on size.”
4. The document mentions “we mistakenly equated free markets with unregulated markets”. This is wrong and also a current line of argumentation used by many of those who want to take the opportunity of this crisis to load us up “with renewed vigor” with masses of new regulations.
What those many who like me have always believed that markets operate better when free hold is that regulation is needed exactly when the markets are not really free and a lot of asymmetrical powers exist. For instance I believe in a free market of risk information but I do not believe in the creation of a risk-information oligopoly like that handed over to three credit rating agencies by the financial regulators. To say that these regulators were “lured by ideological notions derived from Ayn Rand novels rather than economic theory” is nonsense.
5. “In hindsight, we should not be surprised that unregulated profit seeking individuals have taken risks from which they benefit and others lose.”
And let us sure hope it continues to be so.
6. The document says “greed…when unchecked by the appropriate institutions and regulations, it will degenerate into rent-seeking, corruption and crime” and yes that could happen… but just like greed when checked by the inappropriate institutions and regulations could also degenerate into rent-seeking, corruption and crime.
7. The document makes frequent and important references to the need of “emphasizing the implications of current policy proposals on innovation, reallocation and political economy foundations of the capitalist system.” I agree completely with that but must also express my regret this was not done previously as it could have saved us the many wrong capital allocations that resulted from the wrong regulations… as in … is consumer debt good for developing countries?
With respect to the minimum capital requirements based on “risk” this is what I said at the Workshop I mentioned before:
“The other side of the coin of a credit that was never granted, in order to reduce the vulnerability of the financial system, could very well be the loss of a unique opportunity for growth. In this sense, I put forward the possibility that the developed countries might not have developed as fast, or even at all, had they been regulated by a Basel.”
8. Now on the whole issue of “Trust”, the real “death-blow” and that has the market now gasping to regain some of the oxygen trust signifies was not caused by the individual failings of any corporations but by the very wrong message the financial regulators sent out with respect to the credit rating agencies, namely “if they are good enough for the financial regulators they must be good enough for you”.
Posted by: Per Kurowski | Jan 20, 2009 5:17:49 PM