How do we teach this?

By Bill Kaye-Blake 15/02/2013

Reading through the post-mortems of the financial crisis, I’ve been struck by something. The behaviour of the finance sector doesn’t fit the standard economics model, the Samuelson textbook depiction, or the Heckscher–Ohlin model of trade, or the Solow model, or any of the other bog-standard depictions of the economic system that we like to teach.

A key idea is that capital is a factor of production, like labour, land, and maybe entrepreneurship, management, natural resources, human capital, or any of the other factors people like to add. Two things about this capital:

  • capital gets a return for its use, which accrues to the owner of said capital, and
  • owners (capitalists, entrepreneurs, whatever) receive a return commensurate with the risk they take: higher returns are required to entice people to take greater risks (and thereby promote innovation).

But, but, but…that’s not what’s happened.

If you read the accounts of the financial crisis, two things are clear:

1. The people administering the mortgage-backed securities (MBSs) are having a hard time proving they own the mortgaged they say they do. To quote Adam Levitin:

The mortgage foreclosure process is beset by a variety of problems.  These range from procedural defects (including, but not limited to robosigning) to outright counterfeiting of documents to questions about the validity of private-label mortgage securitizations that could mean that these mortgage-backed securities are not actually backed by any mortgages whatsoever.  While the extent of these problems is unknown at present, the evidence is mounting that it is not limited to one-off cases, but that there may be pervasive defects throughout the foreclosure and securitization processes.

That is, these folks aren’t sure of what they own, and yet they are selling derivatives based on what they think they might have. More frighteningly, banks are taking or selling houses they don’t own.

2. Risk and reward are now de-coupled. Companies in the finance sector took gambles on the housing market, and things didn’t go their way. That happens. An evolutionary account of the market economy is that success should be rewarded and failure should lead to extinction. AIG, just to name one company, took massive risk onto its books by insuring the value of MBSs. Their clients claimed against the policies, which was going to drive AIG into bankruptcy. AIG got bailed out, as did a number of other financial firms. So, for finance firms, success is rewarded but so was failure.

Thomas Baxter, Jr., New York Fed:

In the months leading up to early November 2008, AIG had been actively engaged in efforts to negotiate tear-ups of its CDS contracts with its counterparties. AIG was completely unsuccessful. The need for the tear-ups was real; AIG was effectively hemorrhaging cash.

But what happened? Wall Street posted record profits in 2009 and had its fourth-most-profitable year in 2010, after it ‘benefited from a series of federal bailouts as well as low interest rates’.

Why aren’t more economists having a crisis of faith? The story and the models that we use to talk about the economy appear flawed in a fundamental way. It isn’t about innovation and efficiency, the supply side responding to signals from the demand side. Instead, fraud, crime, and collusion seem to be the path to riches.