Wednesday, April 28, 2010

Gambling with Other People's Money

Russ Roberts, a professor at George Mason University, has written an essay on the financial crisis entitled Gambling with Other People’s Money: How Perverted Incentives Created the Financial Crisis that is well worth the read and pertinent to today's debate on financial reform. A pdf version is available also.

A short excerpt from the essay outlines the premise:
Over the last three decades, government policy has coddled creditors, reducing the risk they face from financing bad investments. Not surprisingly, this encouraged risky investments financed by borrowed money. The increasing use of debt mixed with housing policy, monetary policy, and tax policy crippled the housing market and the financial sector. Wall Street is not blameless in this debacle. It lobbied for the policy decisions that created the mess.

In the United States we like to believe we are a capitalist society based on individual responsibility. But we are what we do. Not what we say we are. Not what we wish to be. But what we do. And what we do in the United States is make it easy to gamble with other people’s money—particularly borrowed money—by making sure that almost everybody who makes bad loans gets his money back anyway. The financial crisis of 2008 was a natural result of these perverse incentives. We must return to the natural incentives of profit and loss if we want to prevent future crises.
The author summarizes his argument as follows:
1. It isn't "too big to fail" that's the problem, it's the rescue of creditors going back to 1984, encouraged imprudent lending and allowed large financial institutions to become highly leveraged.

2. Shareholder losses do not reduce the problem even when shareholders are the executives making the decisions

3. These incentives allowed execs to justify and fund enormous bonuses until they blew up their firms. Whether they planned on that or not doesn't matter. The incentives remain as long as creditors get bailed out.

4. Changes in regulations encouraged risk-taking by artificially encouraging the attractiveness of AAA-rated securities.

5. Changes in US housing policy helped inflate the housing bubble, particularly the expansion of Fannie and Freddie into low downpayment loans.

6. The increased demand for housing resulting from Fanne and Freddie's expansion pushed up the price of housing and helped make subprime attractive to banks. But the ultimate driver of destruction was leverage. Either lenders were irrationally exuberant or were lulled into that exuberance by the persistent rescues of the previous three decades.

HT: Cafe Hayek


  1. When I get the time I'm going to read this because the subject fascinates me and incentives are always worth analyzing. I, of course, have my own theories and like many others they point to Greenspan and Bernanke.
    One area, though, I don't think is well appreciated is the herd instinct and it is a bit more subtle than people think. When markets go crazy and you're an institutional manager it is very difficult to do what you feel is right because you are in a performance derby and it puts a lot of pressure on you. A good example is 1999. Many people felt that the market was way overdone as it was gaping upwards but if they sold stocks and the market craziness persisted their performance would suffer, it would be widely reported by the consultants and accounts could be lost - big accounts! The safe way to play it is to go along with the crowd.
    The same thing happened in 2006 and into the fall of 2007.
    When I left the institutional business and focused on managing my own money where I didn't have to answer to anyone it was a big relief.

  2. The Encore Career Telesummit is by far the largest and most comprehensive event of its kind, ever. The lineup of world-class speakers, information-packed presentations, and jam-packed weekend event is guaranteed to draw thousands of listeners from all over the globe.

    Visit Encore Career