Roughly speaking, there are four steps to every decision. First, you perceive a situation. Then you think of possible courses of action. Then you calculate which course is in your best interest. Then you take the action.
Over the past few centuries, public policy analysts have assumed that step three is the most important. Economic models and entire social science disciplines are premised on the assumption that people are mostly engaged in rationally calculating and maximizing their self-interest.
But during this financial crisis, that way of thinking has failed spectacularly. 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.”
So perhaps this will be the moment when we alter our view of decision-making. Perhaps this will be the moment when we shift our focus from step three, rational calculation, to step one, perception.
Read it all. I am all for “behavioral economists and others who are bringing sophisticated psychology to the realm of public policy.” But we do not just need psychology we need hamartiology–a sense of sin. The core reason for misperception is, in C.S. Lewis’ phrase, because we are “bent–KSH.”
But, in fact, the organizations were trying to protect their own self-interests. Interest rates were kept so low by Greenspan that the lenders had to expand their base of debtors, in order to make a profit. The threat of liberal Congresspersons to regulate banks who did not want lend to non-credit worthy persons further spurred the loosening of credit requirements. Then when liberal Congresspersons raised the portfolio limits of Fannie and Freddie to take these loans off the hands of the front line lenders, those front line lenders no more saw any risk and greedily made more and more of these loans and transported them to Fannie and Freddie and into bundles to be put up as securities for sale around the world. Fan and Fred’s executives had the backing of Congress, so they built up their portfolios and left with their extravagant bonuses, one of them who received over $100 million in bonuses, Franklin Raines, to go advise the Obama campaign. Then as the market filled with these worthless loans, the mark to market rule showed them to be valueless on the books of the lenders who still retained some of them, and concern in Congress developed, such that Sen. Shumer of NY just had to let the public know in his open letter about the problems at IndyMac, which caused a run there and started the whole meltdown. One has to wonder about the timing of all of this and Sen Shumer’s letter, from a political standpoint. But in a summary response to David Brooks article and Greenspan’s wonder, the lending institutions were taking care of themselves. They were just in an environment in which other forces were not watching sufficiently (though McCain and Hagel tried in 2004) to keep the lenders from going too far with their own self-interests – like little kids who eat ice cream but eating too much makes them sick.
Staying away from the political and sticking with the economics, while I too am a devotee of behavioral economics, I think the argument that banks et al didn’t act in their self interest misses the important drivers of the situation. Compensation systems in large Wall Street firms have for years economically induced short term profit maximization, by paying out large portions of huge annual bonuses in cash without any mechanism for recapture or penalty in the future if deals went south in the future. This problem has been amplified in the hedge fund world, where managers receive annual payouts of 20% of profits so long as fund valuations kept rising. The only recapture mechanism, the so-called “high water mark” rule that stipulates that profit share payouts are not made if a fund valuation does not exceed the high water mark in prior years, doesn’t function effectively because successful fund managers will shut down a fund once it has one or two bad years and then restart with a clean slate and a new “high water mark”.
Kendall is certainly right that we need a sense of sin, and also a greater sense of honor and shame associated with one’s impact on the institutions and industries in which one works. But we also need compensation systems that don’t encourage financial industry leaders to take a “maximize profits now” approach to managing the businesses entrusted to them.
An inflationary monetary policy combined with low interest rates encourages high time preference. So rationally, the thing to do is get yours while the gettin’s good.
#2, I don’t think you can separate the political from the economic in this mess. But your message of the short term maximization of profits on Wall Street went all the way down to Main Street. The “salesmen” for the frontline lenders were on commissions for the loans they could close. Thus, they closed as many as they could, regardless of the credit worthiness of the debtor. And, as #3, said, they got what they could while the gettin was good. There was little honor and no shame in the entire system … only greed and power. But has that not been the driving force of society for so many decades? Where are the standards of “honesty is the best policy” and the work ethic of our past. Now parents take a school system to court, if it attempts to discipline a student for cheating. Cheating is rampant in our schools, in our work place, even in our churches. As our Christian morals have been banned from our schools and workplaces by court’s decisions over the decades, our morality has failed us in all parts of our life. And our churches have tagged along in unison, never lifting a finger to inject Christian morals back into our social lives. We do need a sense of sin, but to have that, we have to know or believe we have done something wrong or that there is a rule (or law) we have broken. When we have no standards to guide us, we have no sense of sin. This is, by the way, the cheap grace of TEC – as the Bp of NH puts it, “we’re all going to heaven anyway, so it doesn’t make any difference what we do here.” Lord have mercy on us.
This four-step framework is interesting but ignores two important points – unless you have perfect information, you can only make a best-assessment of what is in your self-interest; and unless you have perfect control, the actions of others may influence the “payoffs” of your competing options. Game theorists and strategists would recognize point 2 immediately – most scenarios are dynamic, and payoffs inter-dependent. Look at the oil market bubble – most reasonable obervers believed a sustainable price of oil was near $70 per barrel; certainly no estimate of demand justified $140 per barrel. But while speculation pushed up prices, it was short-term rational for banks, hedge funds, etc, to go long commodities (usually with leverage). Otherwise, you left money on the table. Once the bubble started to collapse though, the last people in got hammered. Similar things happened in commercial paper, REITs, housing, etc.
Part of the blame lies in the version of economics most of us learn that is too heavy on macroeconomics. We get exposed to the big levers (tax rates, currenciy rates, interest rates, market returns, savings rates, etc) but miss the point that these aggregates are based fundamentally on the actions of individual people or individual firms. And none of these individuals or firms have perfect information or perfect control
“When we have no standards to guide us, we have no sense of sin.”
Blessings on you Billy, for I have been talking about the effect of the absence of standards for a long time, and it is pleasant to have some outside corroboration. And Billy’s point is completely clear:Much of what has been done badly will not cause any of the offenders to have a feeling that they have done wrong. Misjudged cause and effect, but no sense of being fundamentally in the wrong. Where there is no integrity, no honor, no admission of the existence of guilt and remorse – surely these negative emotions should be done away with for they destroy self-esteem – then sin is meaningless. I would therefore ask Kendall, where the sense of sin is going to come from. Larry
Organizations do not have self interests.
In particular, corporations do not have self interests. Corporations are legal fictions. For an economist/scientist to put them in the same bucket of “rational agents” as individual human beings is a fundamental error. It suggests that the past several generations of economists have been very narrowly “educated”.
“Corporations do not have self interests. Corporations are legal fictions” —Marion R [#7]
Agreed.
_ _ _ _ _ _ _ _ _
“For an economist/scientist to put them in the same bucket of ‘rational agents’ as individual human beings is a fundamental error. It suggests that the past several generations of economists have been very narrowly ‘educated'”
Economists recognize that a corporation is a mode of organizing people and has no mind or will of its own. Many economists take care to refer to a corporation’s “owners” (shareholders) and “managers” (officers and directors). The fundamental problem of corporate governance is that the managers, who effectively control the firm, have interests that can diverge from those of the owners.
Billy is right. ‘ …as the Bp of NH puts it, “we’re all going to heaven anyway, so it doesn’t make any difference what we do here.†Lord have mercy on us.’ The good Bp of NH fails to note that actions are fruits of the spirit. It does matter what one does here because that is a reflection of his spirit. A good Christian will be a good person, imo. The learned Bp is not the last word on who gets to heaven, thank God. The last word is The Word.