Bryan Caplan  

Financial Dysfunction: Who Shares the Blame?

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Against Merit Pay for Teachers... Henderson on Sargent and Sims ...
When people eat and drink too much, most of us blame the consumer.  Businesses don't force anyone to become obese alcoholics; they're just responding to consumer demand.  If people started spending their money more wisely, business would uncomplainingly cater to their new choices.

Of course, you could blame both consumers and sellers.  If sellers were more puritanical, supply would fall, prices would rise, and consumers would respond with wiser choices.  But however you turn the problem, consumers clearly bear a large share of the blame.

This point immediately came to mind when Paul Krugman wrote:
Wall Street's Masters of the Universe realize, deep down, how morally indefensible their position is. They're not John Galt; they're not even Steve Jobs. They're people who got rich by peddling complex financial schemes that, far from delivering clear benefits to the American people, helped push us into a crisis whose aftereffects continue to blight the lives of tens of millions of their fellow citizens.
Paul makes a valid point here.  Many, perhaps most, of Wall Street's products are junk.  I couldn't sell them with a clean conscience.  So why do "complex financial schemes" - and not-so-complex schemes like the typical actively managed fund - survive and prosper?  Because of consumers! 

Consumers of financial products could simply buy and hold an internationally diversified index fund.  That's what I do.  Whenever anyone asks me my "expert opinion," I tell them to do the same.  Unfortunately, most consumers of financial products fail to exercise common-sense skepticism.  They credulously fall for pompous personality cults.  They buy into get-rich-quick schemes.  And above all else, they refuse to admit their own ignorance - that they have near-zero ability to pick good investments or good investment managers.

Of course, consumer demand isn't the only problem on Wall Street.  Many "complex financial schemes" are about regulatory arbitrage - finding perverse incentives and enthusiastically responding to them.  And the perversest incentive of all is "Heads you win, tails you get a bailout." 

There's no reason to excuse businesses for their role in these evils.  But once again, there's plenty of blame to go around.  Politicians, yes.  Regulators, yes.  But above all, voters.  They, too, fail to exercise common-sense skepticism.  They, too, credulously fall for pompous personality cults.  They, too, buy into get-rich-quick schemes.  And above all else, voters refuse to admit their own ignorance - that they have near-zero ability to pick good policies or good policymakers.

To repeat, there is plenty of blame to go around.  But if I could reform only one set of malefactors, I'd choose voters without hesitation.  You don't need to imagine a libertarian electorate.  You just need to imagine an electorate that greets any bailout or subsidy proposal with a knee-jerk, "Prove the benefits exceed the costs" - and humorlessly punishes leaders who spend without such proof.  If politicians faced such an electorate, they'd have a strong incentive to keep regulators in line and ignore rent-seeking businesses.  And without bailouts and subsidies, regulatory arbitrage isn't very enticing.

In this world, there'd still be plenty of businesses selling crummy investments to credulous consumers of financial products.  But consumers' shortage of skepticism would be no one's problem but their own.
 


COMMENTS (16 to date)
Brian writes:

why do "complex financial schemes" - and not-so-complex schemes like the typical actively managed fund - survive and prosper? Because of consumers!

Nonsense. The government gives consumers huge tax breaks for investing through 401k, 403b, and defined benefit pension schemes. The 4XXx versions require them to pick from among the funds their employers have been bribed by sharp salesmen to sell to you. The defined benefit plans are managed by an agent you don't get to vote for and who usually knows nothing about finance. That agent decides what to invest your money in based on the strippers and steaks the Wall Street robber barons buy for him.

And that is the source of a large share of the money Wall Street makes.

Individuals do better.

Tax code locked-away investment benefits are the root of most bad decisions to invest your money. The tax code also drives financial leverage by massively favoring debt over equity, leading to bailouts of 33-to-1 leveraged firms.

Add that to the SEC's effective mission of pumping up regulatory arbitrage for connected insiders and Krugman's paragraph is fully correct.

Randy writes:

Much of what is referred to as "investing" is actually "gambling". But so what? If I wish to consume gambling products then who should tell me I can't? The real question is, why are politicians involved? Answer; because they are gamblers too, and they want to use political methods to be certain that they win. I say kick the politicians out of Wall Street. Then let the winners win and the losers lose.

rpl writes:

Brian, I'll be the first to say that fees in 401k/403b funds are too high, but it's far from being "a large share" of where Wall Street makes its money. In fact, it's peanuts compared to what they make on structured finance. Moreover, when it comes to regulatory arbitrage, leverage, and the rest of the Wall Street excesses, the relatively staid offerings in 401k/403b plans are blameless. Meanwhile, the risky and highly-leveraged types of investment vehicles that led to the bailouts, the Magnetars, CDO-squareds, and so on, aren't for sale in any retirement plan. They were traded between investment banks and other "shadow banking" entities.

I'm sorry, but your story just doesn't fit the facts, at least where defined contribution retirement plans are concerned.

fundamentalist writes:

Krugman is simply wrong and advertising his ignorance. He should read "Slapped by the Invisible Hand" so that he can talk intelligently about finance.

Wall Street financial products are not junk. They were carefully designed using the best financial economics theory. The mortgage backed securities that everyone loves to hate today were praised by Greenspan and most top economists before the crisis.

Andy writes:

I generally exercise common-sense skepticism. As a voter, I am forced to choose between the bad candidate and the worse candidate. I vote against the worse candidate. The best possible outcome is that the bad candidate gets elected. Democracy is wonderful!

You just need to imagine an electorate that greets any bailout or subsidy proposal with a knee-jerk, "Prove the benefits exceed the costs" - and humorlessly punishes leaders who spend without such proof. If politicians faced such an electorate, they'd have a strong incentive to keep regulators in line and ignore rent-seeking businesses.

I don't buy this. The problem is that the bad policy happens years before the voters get to do any punishing. Often after the politicians concerned are retired by the time of the fall.

Mercer writes:

Voters are to blame for products like credit default swaps? Nonsense. Over 90% of voters have no idea what derivatives are.

Are voters to blame for AAA ratings given to sub-prime mortgage bonds? Voters may have wanted the loans but they did not rate the bonds.

John Hall writes:

rpl makes a good point. The complex products, like CDO-squared, caused massive losses. But Wall Street doesn't just make CDO-squared. They generate money from IPOs, M&A advice, underwriting, trading, asset management, custody, etc.

You (Arnold) may think that interest rate swaps in different currencies may not have much value, but large multi-national corporations do. And barrier options that Wall Street trades with hedge funds can make sense for both to enter into. 99.9% of people don't know, or need to know, what a barrier option is. But that doesn't make them worthless.

Your argument is basically no different from arguments that people eat organic food. Someone might tell me it is "worthless" and bad for me. But just because they think it is worthless, doesn't mean that I think it is.

Tom West writes:

I think the problem is more fundamental than having a bad actor.

If we have a company that is doing bio-tech using pathogens that could wipe out much of mankind, most of us would not simply allow the company to continue devoid of regulation until such time as an accident occurred (in which case we could sue :-))

Simply put, the potential price of innovation may be too high for the rest of us to bear, and those attempting to innovate may destroy far more than the direct investors.

I fear very much the same thing of new financial instruments. I am willing to assume good-faith on the part of the participants, but that does not change the fact that innovations meant to increase the return of near riskless investments may, despite the best efforts of everyone involved, turn out toxic.

Moreover, this toxicity has the potential of destroying much more than simply the assets invested, but could, in the worst case, flatten the economy.

I'd say we have ample evidence that while we may not be able to predict how financial innovation may fail (nobody has a crystal ball), we have a case for strongly restricting any type of major financial innovation simply because it's too dangerous in unanticipated ways.

Of course, we all lose out in the meanwhile from the benefits that that innovation brings while it's not crashing, but is it worth the risk?

Blake writes:

Wow. I am amazed at the intentional blindness in these comments. Byran is absolutely right here. In a democracy ALL government policies come from the voters. That includes the tax policies, the existence of 401Ks, and who gets to rate government bonds.

Consumers are making rational self-interested choices that end in disaster because they make those choices within systems designed by VOTERS! Voters elect the men and women who design the system.

Just because voters don't understand derivatives does not mean they are not responsible for their creation. Voters could repeal huge swaths of the tax code tomorrow if they so desired. That they don't is tacit approval, at least if you believe in democratic decision-making.

You can defend voter decisions and therefore the current system or you can criticize voter decisions and the government it has created. But, you can't say "government bad:voter decisions good." Voter decisions=government at least in this democracy.

ChrisH writes:
imagine an electorate that greets any bailout or subsidy proposal with a knee-jerk, "Prove the benefits exceed the costs"

Interesting that in a video lecture on Botswana (linked to from somewhere in the Masonomics Echo Chamber*), it was pointed out that part of the success of Botswana is an obsession with cost effectiveness that's embedded in the political culture.

*I say that with fondness

Doug writes:

Most masters of the universe really are delivering outsized abnormal returns. There are very few billionaires on Wall Street who got rich from selling crappy low performance mutual funds. Most of them are in hedge funds, private equity or prop trading, and do have statistically significant alpha.

If I had the change to invest my money (I don't because their funds are almost always closed because of high investor demand) with George Soros, Jim Simons' Medallion Fund, Stevie Cohen or Carl Ichann I'd take it in a second.

Floccina writes:
When people eat and drink too much, most of us blame the consumer.

You and I would but not a college grad who is a Democrat. (The other Democrats are not well schooled enough to buy what those at the top of the party sell.) College grad democrats would blame the food and drink manufacturers. Of the fact that we do pay enough taxes for education. College grad democrats feel that their educated mind enable them to know better what is good for people.

BTW who gives a worse deal than Wall street and evne worse than Vegas => sate lotteries!

Mercer writes:

"Just because voters don't understand derivatives does not mean they are not responsible for their creation."

So anything that any business creates the voters are responsible for? Does that include businesses that operate illegally like cocaine distribution and auto theft rings?

druce writes:

There's a distinction between McDonald's selling unhealthy food hat will kill you if you eat too much and don't exercise, and food with listeria that will kill you tomorrow.

There's also the small matter of building a robust financial system that won't collapse like a house of cards and need government assistance when one corner blows up. Are consumers responsible for that too?

lemmy caution writes:

I don't buy this. In a representative democracy, the idea that voters can finely control financial regulations or whatever seems silly.

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