It’s the Incentives, Stupid
On Tuesday morning in Washington, Ben Bernanke, the Federal Reserve chairman, gave a speech that read like a sad coda to the “Looting” paper. Because the government is unwilling to let big, interconnected financial firms fail — and because people at those firms knew it — they engaged in what Mr. Bernanke called “excessive risk-taking.” To prevent such problems in the future, he called for tougher regulation.
I can’t help but feel this is the wrong answer. The right answer is to take these large firms and break them up. If they are too big to fail, then create smaller firms that can be allowed to fail. Obviously this would have to take place after dealing with the current crisis.
Further, I think a review of regulations and laws would be in order to see if the government has done anything to promote this result of “too big to fail”. If it is found that this is the case, change those regulations and laws to help ensure it doesn’t happen again.
And “Looting” provides a really useful framework. The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.
Well duh. Anyone who has any familiarity with the literatures on time inconsistency of discretionary policy or economic incentives would see how bailouts are a classic example. “Don’t get too big to fail and don’t take excessive risks…we will not bail you out.” The senior management at these firms realize that is and empty threat and proceed to expand and take greater and greater financial risks knowing that the downside will be covered by the government and any profits they get to keep.
I do think the name of the paper by Akerlof and Romer (“Looting”) is a bit unfortunate. Sure that is one way to describe the situation, but another is that we’ve set up a piss poor incentive structure via laws, regulations, and discretionary policy that has lead to the current situation. In other words, the looters were behaving in an entirely rational way given the situation they were in. Yes, we can be angry at the looters, but what about the people that created that situation to begin with?
At a time like this, when trust in financial markets is so scant, it may be hard to imagine that looting will ever be a problem again. But it will be. If we don’t get rid of the incentive to loot, the only question is what form the next round of looting will take.
And therein lies the problem. As good as Mr. Leonhardt’s article is he still misses the larger point. When the government has discretionary powers, when politicians are self-interested and are subject to periodic popular elections you will have a hard time with “looting”. I’m not saying the government should have no role, but that we have to consider incentives, and politicians as makers of the rules of the game and being self-interested may not always respond in ways that will prevent these less than optimal outcomes. Kydland and Prescott, the two economists who put forward the idea of time inconsistency suggested policy rules rather than discretion. The idea that rules, even fairly complex ones, would at least provide a clear path and reduce uncertainty. I think this is right, for example consider this comment by Luigi Zingales,
The main difference between Keynes and modern economics is the focus on incentives. Keynes studied the relation between macroeconomic aggregates, without any consideration for the underlying incentives that lead to the formation of these aggregates. By contrast, modern economics base all their analysis on incentives. In 1998, when the Fed coordinated the bail-out of Long Term Capital Management, it did not care about the impact this decision would have on the incentives to take risk and price liquidity appropriately. When Mr. Bernanke engineered the bail-out of Bear Stearns, he did not care about the impact this decision would have on the other investment banks’ incentives to raise equity capital at rock-bottom prices. When he changed his position twice in the space of two days, letting Lehman fail, but bailing out AIG, he did not care about the impact it would have on investors’ confidence and incentives to invest. It is this erratic behavior that has spooked the market and created the current economic crisis: in a recent survey 80% of Americans declare that they are less confident of investing in the market as a result of the way the government has intervened.
During Bill Clinton’s presidential election campaign one of the slogans was, “It’s the economy, stupid.” That was a brilliant slogan during a time when the economy was in recession. However, in economics on thing most economists now agree on is that incentives matter. They matter a lot. Today the slogan should be, “It’s the incentives, stupid.” I don’t feel this is given its due by the Obama Administration.