The economy’s willing executioners

Who killed the economy? Hint: call your lawyer.

The witch hunt to expose the people responsible for the current financial crisis has been underway for several months, and there is no shortage of suspects. This week, however, I read a couple of articles that together lay out the best case so far.

Why Wall Street Always Blows It by Henry Blodget in the current Atlantic Monthly puts the reader in the shoes of someone sitting on a bad mortgage and at risk of being laid off. He surveys the list of candidates to blame for the mess we’re in.

  • There were the predatory lenders of course. Mortgage brokers sold millions of “ticking time bombs” known as ARMs, and they encouraged people to lie about their incomes. But this was fine because a) home prices were going to go up forever, b) the buyers were probably going to sell before the mortgage rate adjusted anyway and c) they got fat commissions and bore none of the risk.
  • There were the sleazy real-estate agents. Many probably knew it was a bubble but wanted to close as many sales as they could before it popped. On the other hand, real estate agents are always trying to close as many sales as possible, and most were probably as deluded and blind as everyone else.
  • What about home buyers? If a mortgage broker encourages you to lie about your income, does that make it OK? A lot of people who knew it was a bubble expected it to burst five years ago and stayed out of the housing market only to see a gazillion idiots get crazy rich. Only then did they finally decide to jump in – right at the peak. The bottom line is that too many people forgot a home is a home first and an investment second.
  • There’s Wall Street of course. ‘Nuff said.
  • On the other hand, Investors demanded that their banks and brokers deliver higher returns than all the other banks and brokers, and if they failed, then the investors simply moved their money to one of those other ones. When this happened, bankers and brokers got fired. So, the career incentive (to not get fired) ended up outweighing the incentive to invest prudently, and bankers and brokers made more and more risky bets in a race to outdo each other.
  • There’s the SEC, whose leaders seemed to be mostly concerned with positioning themselves for future jobs in the Wall Street firms they were supposed to regulate.
  • And there’s Alan Greenspan, who most people now agree kept interest rates too low for too long.

The second article was a two-part Op-Ed piece in the New York Times by Michael Lewis and David Einhorn:

  1. The End of the Financial World As We Know It
  2. How To Repair a Broken Financial World

Lewis and Einhorn look at many of the same players, but they focus more on the SEC and the ratings agencies:

It’s almost as if the higher the rating of a financial institution, the more likely it was to contribute to financial catastrophe. But of course all these big financial companies fueled the creation of the credit products that in turn fueled the revenues of Moody’s and Standard & Poor’s.

These oligopolies, which are actually sanctioned by the S.E.C., didn’t merely do their jobs badly. They didn’t simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: rather than expose financial risk they systematically disguised it.

A big theme across these three articles is incentives. No one had any reason to care about the larger and long term consequences of what was happening. The short term – in some cases just the next commision – was all that mattered. Everone was making money, so everyone just assumed the system was working. The few naysayers who insisted it shouldn’t be working – or, preciently, that it would soon stop working – weren’t taken seriously.

Bernie Madoff’s victims are a case in point. They were happy enough not to ask any questions about where the exceptional returns were coming from, as long as there were returns. That Madoff, like most scammers, was unwilling to disclose anything about his investment strategies didn’t stop them from handing their money over.

Investors’ enthusiasm for complex and inscrutable investment vehicles like CDO’s and credit default swaps was not that different. People didn’t care to know what was happening inside the black box, as long as money was coming out of it.

Americans accept the reality of a broken and corrupt system – even take pains to preserve it – as long as enough people think they can personally profit from it. Most people may over-estimate their ability to predict the collapse of the system in the hope of timing their exit. They lose money and eagerly join the witch hunt.

Nonetheless, Americans still prefer this corrupt system for the same reasons people play the lottery. The lottery has a few winners and a multitude of losers, but the people who spend loads of money playing it no doubt imagine they will win someday. A corrupt system by its very nature offers opportunities for crafty and motivated people to “win,” and the possibility of tremendous wealth for a few is more enticing to too many Americans than guaranteed prosperity for all.

And this is why it will never be fixed.

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