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Is Jeff really saying that moral hazard arguments are irrelevant?

My point would be that it *doesn't matter* whether the bankers had an incentive to run a stress test, unless we have some evidence to suggest that the stress tests they would have run would have been informative. There were plenty of incentives about for people to have correctly anticipated the financial crisis - the fact that they didn't suggests it was primarily a problem of knowledge, not incentives.

Most of this is OK except for praising the Wallison argument that all that matters is the ultimate link between insurer and insured in CDSs. This somehow ignores the phenomenon of leverage ratios rising as more links occur. In a technical sense the claim is correct, but the passing along is what led to those off-the-wall 35-1 leverage ratios that really blew things apart once they started to come apart at the seems.


We are having a failure to communicate. As you know, my own work is grounded on the sort of question you put to Russ, and I agree that Horwitz combined with Friedman makes a pretty good theoretical framework for understanding the crisis. But let me quote a full passage from Mises on the relationship between the incentive and the calculation (knowledge) arguments from Liberalism:

"People are wont to consider socialism impracticable because they think that men lack the moral qualities demanded by a socialist society. It is feared that under socialism most men will not exhibit the same zeal in the performance of the duties and tasks assigned to them that they bring to their daily work in a social order based on private ownership of the means of production. In a capitalist society, every individual knows that the fruit of his labor is his own to enjoy, that his income increases or decreases according as the output of his labor is greater or smaller. In a socialist society, every individual will think that less depends on the efficiency of his own labor, since a fixed portion of the total output is due him in any case and the amount of the latter cannot be appreciably diminished by the loss resulting from the laziness of any one man. If, as is to be feared, such a conviction should become general, the productivity of labor in a socialist community would d
rop considerably.

The objection thus raised against socialism is completely sound, but it does not get to the heart of the matter. ...

Calculation is possible only when one is able to reduce to monetary terms all the goods under consideration. Of course, monetary calculation has its imperfections and deficiencies, but we have nothing better to put in its place. It suffices for the practical purposes of life as long as the monetary system is sound. If we were to renounce monetary calculation, every economic computation would become absolutely impossible.

This is the decisive objection that economics raises against the possibility of a socialist society. It must forgo the intellectual division of labor that consists in the cooperation of all entrepreneurs, landowners, and workers as producers and consumers in the formation of market prices. But without it, rationality, i.e., the possibility of economic calculation, is unthinkable."

I agree with Mises about the _decisive objection_ and I agree with the Jeff about policy induced structural ignorance (as opposed to rationally calculated ignorance). But as my "footnote" suggests, I disagree about his understanding of "rationality" and "self-interest" and the role played by these propositions in an explanation of the market. But again, I think there is a disciplinary divide in language, as I think Russ (who I agree with) reflects in his reaction. In short, incentives and motivation are NOT the same thing. Jeff is talking about motivation for particular actions, economists are talking about the systemic incentives which produce patterns.

Hey, Pete, thank you for the plug. I'm not sure what the disagreement here is, though, if any--not even linguistic.

The story that Wlad and I tell about the financial crisis *is* an incentives story: the Basel rules established incentives for leveraging into AA- or AAA-rated MBS, which the rule makers gave a much lower risk weight than for all other securities except government bonds. (BTW, the latter provision seems to explain the panic last week about Greece: European banks are heavily invested in govt. bonds, which are treated even better than highly rated MBS by the Basel rules).

So Wlad and I aren't "against incentives" as explanations of economic phenomena. We use them ourselves in our explanations of economic phenomena. We just want to add a significant place for ignorance, where it seems warranted.

(*I* [Jeff, not Wlad] am "against incentives" as explanations for most *political* phenomena, such as ideology and ignorance, for just the reason, Pete, that I think you're referring to: in reality, most political actors are not, as a matter of empirical fact, IMHO, *motivated* by monetary or even electoral incentives.)

But in our work on the crisis, Wlad and I are talking about the economy, where, arguably, the differentiating factor (from the polity) is the cultural acceptability and, empirically, the widespread fact of pecuniary self-interest as the dominant motive.

My only difference with Russ Roberts (I don't know how Wlad feels about this) is about whether, as a matter of empirical fact, TBTF considerations entered into the calculations of bankers in any significant way. Russ's distinction between them being dominant considerations and smaller factors is fine, but there's excellent evidence that, however large those undominant TBTF considerations might have been, they were not large enough to be significant causal factors in the crisis.

I present the evidence at

Let me also second Anthony Evans's BRILLIANT point against some ambiguous evidence that Russ presents in favor of TBTF being a decisive factor. Russ points to a speech in which, supposedly, bankers "looked at their shoes" when TBTF was mentioned as a reason banks didn't perform severe stress tests. Anthony points out that even if there had been no TBTF bailout possibility, the bankers *wouldn't have known what to test for.*

Again, empirically: nobody (not even Robert Shiller, as I've discovered) anticipated more than a year before the bubble popped that it was, indeed, a nationwide housing bubble, as opposed to one in a few cities.


I just want to respond to your point about the housing bubble and not the other stuff. I agree that many didn't see it (though I actually think technically there are issues here related to "bubbles" that John Cochrane talks about in his interview with Cassidy in the New Yorker which are live issues). But I know of one very successful wealth manager who clearly saw it. He was a former Goldman-Sachs guy and he positioned himself and his clients in anticipation of the crisis at least 5 years ago (if not more). Fred and I have mentioned him several times on the blog and the reason is simply, he based his investment strategy based on Austrian economics (and has been doing so very a long long time). And this is not someone who was always a naysayer (e.g., Jim Grant). A broken clock gets the time right twice a day, but this particular case the individual was right on a variety of twists and turns. And his clients benefited greatly.

He cannot be the ONLY person to have analyzed the situation correctly.

On the broader issue of motivation versus incentive, we are still talking past each other, but blogs are not the places to sort that out. Instead, that is for journals, professional dialogue, and personal conversation.

Ah, addendum: I think I see the misunderstanding.

In the AEI paper, Wlad and I echo Alchian in accounting for the *success* of capitalism (such as it is) as being due to the experimental weeding-out process of interfirm competition. We therefore say that *defenders* of capitalism are ill served by economists' tendency to reduce everything in the economy to incentives (leaving out ignorance of what will or won't make a profit or a loss).

Once the defenders of capitalism follow the economists on that, they blur the decisive advantage of "laissez-faire" capitalism over more-regulated variants: regulations impose one idea (the regulator's) about, say, what will make for prudent banking onto the entire system. If the regulator happens to be wrong (due to his ignorance of the future), the whole system collapses.

In contrast, when one possibly self-interested (but not necessarily so) banker makes a mistake, only his bank collapses. At least, before TBTF was turned from a notion into a reality!

I should have added -- knowledge of the economist versus knowledge of the practitioner. They are separate, and it is important to keep that distinction. Out guessing the market is something theorists cannot do.

"The SIVH has no empirical support" is pretty much true.

"Incentives play a minimal role in in politics" is not. I could expand on that, but for now I'll offer an example. Ted Kennedy was a senator for more than four decades. Were his positions on major issues best explained by ideology and/or ignorance (I think Jeff and I agree they are connected)? It seems to me that he had an incentive to take the positions he did on most issues, and that his ignorance and ideology were merely incidental. Whether expansion of CHIP, airline deregulation, or whatever, it isn't hard to track down the incentives he was responding to as a representative of special interests. What I'm not sure of is whether the argument is that politics truly is an incentive-free zone or merely that tangible incentives fail to explain voter behavior and more generally, public opinion.

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