The cause of the crisis (and how to prevent the next one)

by Russ Roberts on November 19, 2011

in Gambling with Other's $, The Crisis, Uncategorized

One standard narrative of the cause of the financial crisis coming from people generally on the left is that a free-market ideology blinded policy-makers. They foolishly followed a policy of deregulation that allowed banks to run amok. And calls for regulation, such as attempts to regulate the derivative market, were ignored.

This theory is partly correct. There was some deregulation–various policy changes that let banks expand their activities. What this narrative ignores are other government policies that raised the likelihood of irresponsible investing but that were not based on a free-market ideology. In the particular, there were the relentless bailouts of large creditors that took place in the run-up to the crisis–interventions that were inconsistent with free-market ideology and that destroyed the feedback loops that might have prevented the crisis from occurring. The question remains as to whether these rescues did indeed encourage recklessness and imprudence. Maybe the mess would have happened anyway. Many argue that financial crises happen without such encouragement–every once in a while markets go haywire. According to this argument, investors get overconfident, ignore the possibility of loss, throw caution to the winds and so on. In this story, the financial crisis we’re still in is just another example of human frailty–greedy investors suffering from hubris and overconfidence.

In my essay on the crisis, Gambling with Other People’s Money, I provide some evidence that investors in large financial institutions were aware of the potential for bailout and acted accordingly. They invested their own money much more prudently than the money of the firms they ran, for example. And in one story recounted by Andrew Haldane, bankers confessed that they anticipated being rescued which is why their stress tests were so mild. Haldane, in a recent speech, provides other evidence that market outcomes in advance of the crisis anticipated rescue. I am currently revising my essay–the plan is to issue it as an e-book and I will try to provide more examples, still of past rescues that I missed in the first version.

Expectations are hard to measure. So inevitably it is difficult to “prove” in any scientific sense that past rescues were decisive in creating the current mess.

But now we have a new test. Have the rescues of the creditors of Bear Stearns and AIG and Citigroup and Bank of America had any effect on the probability of a future crisis? In the free-market narrative, the answer is yes. I suppose those who blame deregulation and ignore other types of intervention could say that past rescues had no effect but recent ones do matter. But either way, it’s interesting to think about whether recent bailouts induce future recklessness.

I’ve been thinking about this after reading this remarkable observation from Scott Sumner:

Consider the following:

Banks pour huge amounts of money into one particular asset class.  They are encouraged to do this by public policymakers, although there is some dispute about whether that was the main reason for their decisions.  These assets have a long tradition of doing well, although a close look at the evidence would have raised red flags.  The asset market in question suddenly takes a big dive as default risk increases sharply.  This drags down many large banks, forcing policymakers to provide assistance.

What have I just described?  The sub-prime fiasco or the PIGS sovereign debt fiasco?  I’d say both.  I’d say these two crises are essentially identical.  (I should clarify that by “essentially identical” I mean in essence, not in every detail.)

Of course the sub-prime crisis came first, so let’s consider the dominant (progressive) narrative of the sub-prime crisis.  If you read the mainstream media you will see it described as a sort of morality play; the evils of deregulation, which allowed the greedy big banks to take highly leveraged gambles with other people’s money, and then off-load the risk on to both taxpayers and unsuspecting buyers of MBSs.  Or something like that.

Obviously it would be impossible to tell a similar story for the sovereign debt crisis.  No regulator in his right mind would ever contemplate telling big banks not to buy European sovereign debt because it’s too risky.  Indeed the previous attempt atregulation (Basel II) encouraged banks to put funds into those “safe investments.”  Blaming the euro crisis on deregulation doesn’t even pass the laugh test.  The criminals were the regulators themselves.  Is the term ‘criminal’ hyperbole on my part?  Not at all.  Suppose Enron executives had used the same accounting techniques as the Greek government.  They’d all be in jail.  And as for Berlusconi, what can one say about a leader who continually passes laws exempting the Prime Minister from the very crimes he was accused of having committed?  As Keynes said:

“Words ought to be a little wild, for they are the assaults of thoughts on the unthinking.”

So here’s what I wonder.  Assume the eurozone crisis was obviously not caused by deregulation and greedy bankers.  Then if the sub-prime crisis was basically identical, at least in its essence, how can deregulation be the root cause of the former crisis?  I’m not saying it’s logically impossible, but doesn’t it seem much more likely that there’s a deeper systemic problem, which transcends this glib cliche?

That deeper systemic problem is that the government protects large banks. Sometimes they try to use large banks to accomplish various social policies. If it doesn’t work out (or if banks just get in trouble on their own) the largest ones who have lent money recklessly often (almost always) get all their money back anyway. What Scott Sumner is pointing out is that it’s hard to argue that imprudence occurs naturally when the effects of rewarding imprudence are so dramatic and obvious. Banks invest in AAA-rated stuff that really isn’t AAA. whether it’s subprime MBS or sovereign debt. Because regulation let’s them use ridiculous leverage for “safe” assets that are rated AAA, that’s where they head and they use as much leverage as they can even though such leverage puts them at tremendous risk where a small drop is asset values makes them insolvent. But they don’t really have to worry about that risk because the government has their back.

Government protects large banks in two ways. When large banks want freedom to take more risk, policymakers say that’s a good idea because markets will restrain risk-taking. When large banks get in trouble, the government makes sure that they get their money back plus interest, anyway. The policymakers can’t justify this policy on free-market grounds. That would be ludicrous. So they explain that it is necessary that banks that lent money recklessly get all their money back plus interest because any other alternative would harm the economy. It’s heads they win, tails we lose. It’s private gains and social losses.

There are only two solutions, broadly defined, to this problem. One is to return to a world where institutions that make bad decisions pay a price. No more creditor rescue is the first choice. Let the natural feedback loops of profit and loss restrain recklessness. When that fails, investors lose all their money so even when it fails, lessons get learned. Regulate more wise is the alternative to this policy.

The standard argument against no more rescues is that the price is just too high–there would be catastrophic consequences. But we’ve got those consequences anyway and while transferring money from taxpayers to really rich bankers. The second problem is that policymakers will simply be unable to keep the promise of not bailing out creditors. But if the political will came from the people, politicians could stand strong.

As for the idea of regulating more wisely, where is the evidence that such a policy could possibly work?

So if and when Greece and Italy can’t honor their promises, promises mainly made to large financial institutions, are we really going to allow them to keep those promises anyway with German money or ECB money or Fed money? Yes, the effects of letting those banks fail may indeed be horrific. But if we bail them out again, we may as well just give up. What kind of world is it where banks live recklessly off the rest of us? What kind of world is it where the so-called capitalists operate outside the rules of capitalism?

Be Sociable, Share!



133 comments    Share Share    Print    Email


Jon Murphy November 19, 2011 at 10:32 pm

Question Russ:

Couldn’t the moral hazard incurred by bailouts of financial institutions play on their decision making, if not on a conscience level on a sub-conscience level?

I mean, let’s assume that these bankers weren’t (are not) actively making investments expecting government bailouts, could it be that the possibility played on their decisions indirectly?

Russ Roberts November 19, 2011 at 10:42 pm

Sure. I don’t think they necessarily sat around thinking–this is a lousy investment but who cares, we’re going to get bailed out! It’s that the natural sources of caution were muted.

Jon Murphy November 19, 2011 at 10:44 pm

Of course, that’s something impossible to prove. You can’t prove one’s sub-conscience thoughts.

Ubiquitous November 20, 2011 at 1:50 am

Of course, that’s something impossible to prove.

No, it’s not impossible to prove. Just through plain introspection, no one can doubt that he would be more likely to act in a riskier manner than he otherwise would if he knew, ex ante, that his sufferings and his losses would be spread out to others, or that he would be bailed out by government, if his decisions proved unsuccessful, ex post.

Anything that reduces the inherent opportunity cost of an action increases one’s inattentiveness to any inherent risks it would have.

vikingvista November 20, 2011 at 3:54 pm

U is right. Its existence is easy to prove. The scale of its impact, however, may be impossible to determine.

Invisible Backhand November 19, 2011 at 11:06 pm

“The TBTF (too big to fail) theory is how libertarians blame gov’t for the banksters. It’s related to the “Why do you make me hit you?” theory. Both theories are BS.”

Invisible Backhand November 20, 2011 at 1:26 am

My name is Invisible Backhand and I am paid to troll here and post these things.

I invite everyone on Cafe Hayek to post at least once under the username “Invisible Backhand” to experience the pleasures of trolling: In the Name field, type “Invisible Backhand”; in the E-mail field, type your email; in the Website field, copy/paste the URL of the web page you happen to be on in Cafe Hayek. Then troll-away! Remember to post something (1) stupid, (2) leftist, and (3) (4) forgettable.

Good luck to all potential Invisible Backhands. Marxists everywhere wish you the best of luck!

Invisible Backhand November 20, 2011 at 9:59 am

Good luck on the rabble rousing. Do you need instructions on how to set up your avatar?

Invisible Backhand November 20, 2011 at 5:01 pm

One troll’s “rabble rousing” is another troll’s “expression of First Amendment rights.” I see which side you’re on, impostor.

Invisible Backhand November 21, 2011 at 9:22 am

Do I have to be enrolled in graduate school before I post something stupid?

Invisible Backhand November 20, 2011 at 8:22 pm

You’re a fraud. I’m the only authentic Invisible Backhand. And I’ve got the bona stupides to prove it.

Martin November 20, 2011 at 3:28 am


I wouldn’t even say that the natural sources of caution were muted, I would argue more for a world where banks outsourced their risk management to regulators. I have no evidence for this, however the following seems plausible to me:

Assume you’re a risk manager at a bank, your colleagues are taking various risky positions, you’ve checked and you’re like ‘okay guys, it looks weird, but there is nothing wrong with it’. Now the regulator comes along and is spooked out about those positions and goes ‘what is going here, could you explain this to me?’ after several hours of explanations – there are many positions – the regulator understands like half but insists that you neutralize the other positions.

Now you think he’s just being silly, but now the compliance department shows up because (some of the) management is spooked and tells you to neutralize those positions and don’t take those positions anymore lest the firm gets in trouble with the regulator.

Your colleagues are obviously not very pleased about this as their positions have just been neutralized ex post and they’d very much like to know this stuff ex ante. They want some sort of certainty to know what to expect from you.

Now you have three groups that you need to find some way to please: the regulator, management and your colleagues. Clearly the cause here is the regulator as that set this all off. So what do you do? You tell your colleagues that they won’t get trouble from you if they invest in what the regulator ‘recommends’ or has approved of in the past.
Part of you doesn’t mind too much either as this absolves you of any responsibility, it’s not satisfying, but you get your paycheck and you don’t have as much of a downside when something goes wrong you can always point to the regulator that he agreed/approved.

In conclusion, the result is then, as above, that the regulator determines the risk management of the bank(s). The natural sources of caution have not been muted, they just have been replaced by other sources. And when the regulator/regulation was wrong, then a lot of banks will have gone wrong at the same time. And this seems to be the case with the ‘approved’ investment in appropriately rated securities.

Martin November 20, 2011 at 3:54 am

Of course I could write something like this about the regulator and the creditor as well and how all of this results into the unintended homogenization of risk and therefore the increase of systemic risk.

The regulator can only sign off on what he knows so therefore all knowledge specific to the firm and that is non-transferable to the regulator due to constraints (e.g. time, communication skills etc) will have to disappear off the books.

The creditor does not know everything about the firm, but when a regulator comes along arguing that the firm is doing badly, the creditor will change its opinion of the firm based on its prior on the regulator and the firm. Only when the prior of the regulator is such that he knows that the regulator is often wrong will what a regulator says have very little impact/no impact at all. That however requires some heroic assumptions wrt the knowledge of the creditor.

My apologies for these long two posts on your blog. I hope if you’ve come to the end of it that you that you feel it was worth it.

steve November 21, 2011 at 7:50 am

I would say that the banks believed their own models. Rather than underwrite, they hedged. In all of these explanations you need to be able to explain AIG and the incredibly small amounts they were charging for their coverage. You also need to be able to explain liar’s loans. EVeryone knew they were more likely to default. Yet, originators were selling them and investment banks were buying them.


Invisible Backhand November 20, 2011 at 11:51 am

Another important controversy surrounds the phenomenon that some of the largest banks seem “too big to fail.” Strictly speaking, however, this is not exactly banking regulatory policy. When larger banks become insolvent, their leadership and top managers are typically removed, and their shareholders are largely (if not totally)
wiped out in a FDIC assisted recapitalization for a rejuvenated bank (like Continental-Illinois in 1984), or in the more common “purchase and assumption” (P & A) deal.

Banking and Financial Institutions Law in a Nutshell, Lovett

The world these agents navigate must, by implication, be a very simple one, pellucid and easy to understand. This simplistic perspective has an eerie similarity to the conspiracy theorizing that haunts popular political discourse, so the economists’ theory-driven ‘‘too-big-to-fail’’ (TBTF) and corporate compensation stories were
perfectly suited to gain wide popularity, and they have. But in this case “the people” are wrong.

Engineering the Financial Crisis, Friedman & Kraus

Large U.S. banks now are so convinced of the advantages of universal banking that they are doing their best to eliminate the “too-big-to-fail” doctrine. Despite some weaknesses, that plan provides cause to hope that American universal banks will continue down the path of expanded powers and modernization.

U.S. Bank Deregulation in Historical Perspective, Calomiris, 2000

When asked about the “bailout,” Treasury Secretary Rubin and former head of Goldman Sachs testily replied, “That wasn’t a bailout …. What the Federal Reserve Bank of New York did was to convene [a meeting]. These creditors made their own private sector decision.”‘

Wall Street Capitalism, Canterbery

This discussion of moral hazard was a poignant anticipation of the much discussed “too big to fail” problem of the recent financial crisis. “Too big to fail” has become a common framing of the relationship between excessive freedom from regulation
and the escalating risk that led to the recent massive government bailouts of financial institutions. Only one major financial institution that was asked to participate in the LTCM bailout refused to do so. This was Bear Stearns, and the Federal Reserve Bank of New York declined to assist Bear Stearns when it became a victim of the subprime crisis a decade later (Cohan 2009a).

Who Are The Criminals, Hagan

Invisible Backhand November 20, 2011 at 5:08 pm

My name is Invisible Backhand and I approved this paid trolling.

As everyone can see, I excel at copy/paste. In fact, I majored in it at Karl Marx University in Leipzig, where the Stasi sent me for my advanced indoctrination and brainwashing.

Darren November 21, 2011 at 12:48 pm


What matters are the ideas, not who’s words they orginally happened to be. The same ideas could be rephrased, but the idea unchanged. Of course, someone would would ask for a link to the original anyway.

Invisible Backhand November 22, 2011 at 2:14 am

“What matters are the ideas, not who’s words they orginally happened to be.”

As profound as it is original. May I copy/paste you on that?

Daniel Shapiro November 19, 2011 at 10:35 pm

Wow, this is outstanding, Russ!

Nikolai Luzhin, Eastern Promises November 20, 2011 at 12:03 am

This is truly one of the most misinformed and intellectually dishonest pieces of writing I have ever read.

Let’s, first, understand why we had a financial crisis.

First, several borrows lied on their loan applications, taking out loans they could not repay and which they had to plan to repay.

Second, investment banks (not banks) funded and oversaw the bundling of these loans into securities, which they could resell. Most every agrees this too was a criminal operation, albeit only on or two prosecutions have taken place. Banks cannot sell securities.

Third, much of the damage was done overseas, where banks had an amazing appetite for this junk.

Four, at the same time, Wall Street became a casino. Synthetics are nothing but gambling contracts. As many have said these “products” have no benefit.

As for non-synthetics, a lot of other really lazy people bought the product. AIG and BofA (Countrywide) had a bundle of the stuff off books.

Investors in these companies had no means or method of knowing the risk nor means nor method of controlling the risk.

Almost all investor equity has been wiped out. While AIG, BofA, still exist, their shareholders have experience moral hazard.

Who has escaped: upper management at most banks, including investment banks (but not the CEOs) and Goldman Sachs. IOW, those who were running the ships knew they would come out ok and they did.

Too Big to Fail. Because Merrill Lynch is now inside BofA, it and 7 or other 8 Banks have become too big to fail since the crisis. Since letting any of these banks fail would be the equivalent to asking Iran to build a nuclear bomb, we ought to have downsized the 10 largest banks through Dodd Frank. However, the deregulation crowd opposed to doing such.

Randy November 20, 2011 at 7:56 am

There is no need to regulate. Just let them fail.

You folks don’t like big banks. I don’t like big effectively politically owned banks. The solution is the same. Let them fail.

Invisible Backhand November 20, 2011 at 10:01 am

No no, THIS caused the world economic collapse:

Darren November 21, 2011 at 12:51 pm

Just let them fail.

No, they can’t be allowed to fail. Instead, they should be confiscated by Government which will run them much more efficiently and won’t make any mistakes doing so.

HaywoodU November 20, 2011 at 10:33 am

This quote seems apt:

“Mr. Luzhin, what you’ve just said is one of the most insanely idiotic things I have ever heard. At no point in your rambling, incoherent response were you even close to anything that could be considered a rational thought. Everyone in this room is now dumber for having listened to it. I award you no points, and may God have mercy on your soul. “

Nikolai Luzhin, Eastern Promises November 20, 2011 at 12:04 am

should read “several million borrowers lied”

Seth November 20, 2011 at 12:42 pm

Why wouldn’t creditors check to see if they lied?

Seth November 20, 2011 at 12:43 pm

Seems like that would be a very basic and prudent thing to do.

Andrew_M_Garland November 20, 2011 at 12:57 pm

Our financial crisis is not an obscure, unpredictable event that overwhelmed good practices. Housing policy, government control, and unconstrained lending to buy votes was obviously dangerous.

It required active disregard for the rules, in the House Financial Services Committee under Congressman Barney Frank (D-MA), among others. The government put up a sign “We buy bad loans made to poor people”, and banks and financial institutions supplied those loans as required and requested.

We Guarantee It – The Government Caused the Economic Crisis

Jon Murphy November 20, 2011 at 12:59 pm

Don;t forget that the Affordable Housing Act (authored by Frank) all but required banks to give sub-prime loans

muirgeo November 20, 2011 at 1:06 pm

Educate yourself Jon. When you start trying too blame this all on Barney Frank it is clear you are unserious or Fox and Rush indoctrinated or some combination there of.

muirgeo November 20, 2011 at 1:08 pm

Actually here is Barney Frank defending himself and making your position look silly as it is.

Methinks1776 November 20, 2011 at 1:11 pm

Yeah, Jon, you idiot. You need to EDJUHCKATE yerself at MEDIASMATTERS. Then, EWE can finally reach Muirdouche’s ORACLE uv SHITPIE level and ewe will be WURTHIE.

Sam Grove November 20, 2011 at 1:20 pm

Actually here is Barney Frank defending himself and making your position look silly as it is.

Deflecting blame from themselves is skill required of any successful politician.

muirgeo November 20, 2011 at 3:56 pm

Refute the specifics of what he said Sam or you are simply the deflector you claimed HIM to be.

Andrew_M_Garland November 20, 2011 at 1:02 pm

“Why wouldn’t creditors check to see if they lied?” is a great question.

Our congressional solons told loan originators that they should trust the information which loan applicants supplied and swore to. Fannie and Freddie accepted (bought) these loans without the requirement to verify the loan information.

Politicians now claim that the financial industry defrauded the government through shady practices. The proof that this is not true: there is no prosecution of the loan originators for their supposed misconduct. Loan originators did exactly what congress required and expected.

Seth November 20, 2011 at 1:50 pm


I was wondering if Nikolai could offer arguments for this behavior that don’t rely on Russ’ moral hazard logic.

He might say that nobody understood the complicated credit instruments. But that also leads back to Russ’ argument (why wouldn’t they take the time to understand them?)

He might say people had a lot of new found and unfounded confidence in the quants. I think this is true. But I still think there’s an extra hidden step in the logic there that leads back to Russ’ claim. That step is, ‘well, even if the quants are wrong, what do I think will happen?”

Mesa Econoguy November 20, 2011 at 1:44 pm

Muddy Puddle, why were borrowers even allowed to “lie?”

Didn’t lending standards have to erode first?

How did lending standards erode?

Your incessant vacuous incoherence is mildly entertaining, but you have made it highly obvious you never completed the 10th grade.

Yergit Abrav November 20, 2011 at 1:23 am

Russ, I feel the following point is underplayed.

It is creditor discipline rather than a feeling of security of bank executives (waiting for bailouts) that is the problem. If depositors and other creditors of banks have no reason to differentiate institutions they gravitate to those with the greatest returns. Those with the greatest returns also tend to be the riskiest. This concentrates capital / leverage in risky institutions as a matter of course. In fact one could argue the bank executives are doing what their creditors (inc. depositors) want! Take for example the widely used FDIC insured CD’s of companies like suntrust or countrywide bank as an example.

Perhaps if creditors felt at risk the market for institutional debt would tell us something about credit-worthiness of different institutions that any single bank manager or executive would never know or understand themselves?

While I doubt you disagree with this outright, its a matter of degree. I notice your narrative focusses on banks themselves and not creditors of banks. I think its a problem of creditor discipline more broadly – i.e. the banks when they are the creditor (AAA / sovereign bonds) or creditors of the banks (money market funds, checking accounts, bank paper (short term funding), bank issued bonds etc.

Russ Roberts November 20, 2011 at 1:27 am

It is all about creditors. Creditors restrain recklessness. When creditors have nothing to lose, recklessness increases. Read my essay. It’s all about creditor rescue. That’s what matters.

Yergit Abrav November 20, 2011 at 1:46 am

Making my way through it now. Its a great read and certainly drives the creditor discipline point home. Thanks for sharing.

Nikolai Luzhin, Eastern Promises November 20, 2011 at 8:41 am


It is not about creditors, it is about the managers of creditors. Creditors lost huge; managers little. Remember the bonuses paid tat AIG to the people who bought their junk

Bastiat Smith November 20, 2011 at 1:58 am

I like these longer posts. It results in fewer and better quality posts from people that read them. The trolls and are easier to spot and the low marginal value commentators (Maybe this one!) don’t bother reading and commenting.

Chucklehead November 20, 2011 at 2:53 am

Whether is is large banks or central banks, artificially low interest rates or printing money, governments use policy try to export their unemployment and use debt to buy votes to stay in power. The responsible suffer first until everyone suffers.
You can solve a debt problem with more debt, just like you can solve alcoholism and drug addiction with more alcohol and drugs. They die sooner rather than later.
Every governmental system assumes that positive trends are here forever. When they prove to be bubbles,, the reaction is to “double down”, hastening their own demise. Governments ignore risk that does not serve its agenda. They cling to models that prove wrong, and fall back on their good intentions. In a collective system, there is no responsibility.
To get back to your point, yes they will be bailed out, but not by the Fed as it is now politically crippled, to a small degree by the ECB, to the limit where Germans allow, but mostly by the IMF issuing SDRs, the new fiat currency.
I am puzzled by your surprise. It has been a long time since capitalists have run any government institution, especially in Europe.

Darren November 21, 2011 at 12:55 pm


LA-Econ-Guy November 20, 2011 at 3:43 am

My related but non-economic question: Are there theories or proposals to successfully reduce government’s role in a democracy? It seems that with economic success, the citizens of free societies allow their governments to expand their breadth and depth. Milton Friedman (a personal hero) brilliantly lectured and engaged people to promote his ideas to limit government’s role, but to little avail in shaping long term public opinion. Today, many “conservative” politicians, think tank types and activists attempt to continue that discussion, but a lot of them seem like complete and utter dingleberries. And waging the battle on the editorial pages doesn’t seem to be cutting the mustard. Has anyone in political science or economics tested, or at least proposed reasonable concrete methods to change public opinion? Is someone looking at a long-term strategy? Or is this a struggle that can only resolve with a devastating economic catastrophe? Man, that would suck.

Robert Szarka November 20, 2011 at 8:33 am

Actually, Friedman, and folks like him, had a lot more impact than you suggest. (Ronald Reagan, for example, cited Friedman as a direct influence.) When we look around and see rampant interventionism in today’s economy, it’s easy to miss how much better things are in at least some areas than they were in the 60s and 70s. Transportation and telecommunications are two great examples of industries that have a lot less intervention today than they did back then. Barriers to international trade are also lower. And it’s been about 35 years since we’ve had a draft, despite much military adventurism.

I’m just old enough to remember when a long-distance call could cost over $4/minute (in 1970s dollars!) and air travel was too expensive for the average family–and when both of those things changed practically overnight. IMHO, it’s worth remembering how far we’ve come in these areas, and reminding folks what the heyday of “regulation” really looked like.

J Storrs Hall November 20, 2011 at 7:33 am

If the bailout of too-big-to-fail banks is really about saving the economy, it should obviously include breaking the banks up and firing all the officers.

Harold Cockerill November 20, 2011 at 9:04 am

Saving the economy was the cover for the bailout. Bailing the banks out was so they could survive and all the chiefs not lose their jobs.

Greg G November 20, 2011 at 7:41 am


You tell an important part of the story here but I think a lot more emphasis needs to be put on the mix of short versus long term incentives for executives at TBTF companies. If you can make tens of millions of dollars in a single year making big bets with other peoples money AND you are likely to be fired if you can’t match your competitors results, the result will be reckless behavior whether or not there is a prospect of bailouts.

Alan Greenspan:” I made a mistake in presuming that the self-interest of organizations, specifically banks and others, was capable of protecting their own shareholders and the equity in the firms”

Organizations don’t make decisions. People do. And when they do, they usually put their own interests ahead of the organizations that employ them.

kyle8 November 20, 2011 at 7:47 am

One of the problems that I see in the USA corporate world, But I don’t know how to fix it. Is that the Boards of Directors of our largest companies have become incestuous swamps.

Often the same person, (many times a former CEO) will sit on the board of several different firms at the same time They hire from the same pool of the “Best and the brightest”.

Many times these are men who have presided over huge losses in some corporation or other and got a big golden parachute. Then they get hired by their friends for a chance to ruin another company.

Nikolai Luzhin, Eastern Promises November 20, 2011 at 8:48 am


you post is too funny. The reason why BODs act as they do is tht they are pure Hayekian.

Our Courts, which are controlled by upper management and BODs apply the business judgment rule. This is the central pillar of the law and economics school, its Hayekian achievement. Under that rule, regardless of how negligent either management or the BOD happens to be, neither has liability to shareholders.

IOW idiot, what you see out of BOD behavior is de-regulated Hayekian conduct.

This is the point of Greenspan’s testimony when he admitted his entire intellectual framework was work before Congress. He thought these people would behave other than according to Lord Acton’s rule. BODs have absolute power and hence are completely corrupted.

IOW you just spilled the beans on why Russ and this blog are a joke

Matt November 20, 2011 at 11:16 am

You left out the point about how the Illuminati controls the whole world.

Harold Cockerill November 20, 2011 at 12:41 pm

Matt, you are not supposed to bring that up. You’re going to get us all in trouble.

Jon Murphy November 20, 2011 at 12:43 pm

Yeah, WTF, man?

vikingvista November 20, 2011 at 3:55 pm

I thought it was the Koch brothers who did that.

Matt November 20, 2011 at 11:02 pm

There goes my membership.

Jon Murphy November 21, 2011 at 1:40 pm

“I thought it was the Koch brothers who did that.”

The Koch Brothers are the Illuminati, you fool! Geez, why just tell them the entire master plan!

vikingvista November 21, 2011 at 1:49 pm

“Geez, why just tell them the entire master plan!”

To whom it may concern:

The person previously known as “vikingvista” is taking an extended vacation at the farm, and will no longer be posting. Anyone who has had private correspondence with him should please contact for further information.

Sam Grove November 20, 2011 at 1:24 pm

The reason why BODs act as they do is tht they are pure Hayekian.

That’s just pure stupid.

kyle8 November 20, 2011 at 1:53 pm

God but you are an idiot. I don’t know exactly how to describe what sort of corporate system we have in place today but it sure as hell isn’t Hayekian or free market.

The government is involved in each and every step of the process. There are government groups watching over every single corporation and there are literally thousands of different incentives and subsidies both in law and the tax code.

I am tolerably certain that if we did have a real free market then the behavior I describe would bring about a loss of money and confidence and therefore would be self correcting.

Idiots like you constantly decry the free market when in fact we have not had anything like a free market since the 1840′s.

Nikolai Luzhin, Eastern Promises November 21, 2011 at 10:47 pm


You remark shows how little you know and how dense you happen to be

BODs act as they do because they have total freedom of action. They don’t face personal risk for their actions. The corporation may, but not them personally. They have all the freedom of action you all worship

Methinks1776 November 20, 2011 at 8:50 am

If you can make tens of millions of dollars in a single year making big bets with other peoples money AND you are likely to be fired if you can’t match your competitors results, the result will be reckless behavior whether or not there is a prospect of bailouts.

The appropriate response is “so what?”.

If the “other people” are people who willingly invested in or lent to the institution, then they took that risk and they should bear the consequences. How they behave is none of our business. It only becomes our business when we are forced to make them whole when we lose.

Besides, it is not at all imprudent to roll the dice with a small portion of your portfolio. Risk and reward are positively correlated. It’s not unreasonable to “swing for the fences” with money you, as an investor, can afford to lose. If nobody ever did take such risks, no start-up would ever get funded. 80% of start-ups fail within a short time period.

And don’t get all romantic about the agency problem. It’s smaller than you think. The managers of these institutions have a lot of pressure from shareholders to take more risks. The real question is why are the creditors (who don’t benefit from any returns that might result from more risk taking) allowing them to do it? Why do they keep lending as the balance sheet deteriorates?

Methinks1776 November 20, 2011 at 8:52 am

“we lose”=”they lose”


Yergit Abrav November 20, 2011 at 9:41 am

Meithinks said:

” The real question is why are the creditors (who don’t benefit from any returns that might result from more risk taking) allowing them to do it? Why do they keep lending as the balance sheet deteriorates?”

yes, exactly. excoriating bank executives makes leftists “feel good”, gives politicians cover to do more of what they do best, but does not address the problem… at all…

Greg G November 20, 2011 at 10:33 am


I am not “excoriating bank executives.” I am saying they are behaving the exactly the same way most people would faced with the same set of long term versus short term compensation incentives.

Yergit Abrav November 20, 2011 at 7:13 pm

Greg G – you know very well what the common narrative is on this topic and its completely fair for me to use the term excoriate. I’ll concede that you personally in the above post were not excoriating, and perhaps I was unfair to read your post as supporting or otherwise being a part of that narrative.

I believe the common narrative to be wrong and only satisfies people’s urges to identify a scapegoat.

Greg G November 20, 2011 at 7:55 pm


Saying that the problem is with the incentives rather than the individuals is the OPPOSITE of scapegoating.

Nikolai Luzhin, Eastern Promises November 21, 2011 at 10:51 pm

Methinks doesn’t understand why creditors continue to lend, showing that she doesn’t understand the first thing about economics or business.

A lender doesn’t make a loan because it is a good loan. A lender makes the least bad loan. Lenders do not have choice between lending and not lending. If they do not lend they go out of business. Thus, they are always looking for the least bad loan, as they much dance as long as the music plays

Jon Murphy November 20, 2011 at 8:52 am

“Organizations don’t make decisions. People do.” Are you saying corporations are people? :-P

But overall, I think we agree with you. The incentives are messed up (part of the reason I oppose publicly traded banks). There is actually an article i read regarding this. I’ll see if I can find it for you.

Greg G November 20, 2011 at 11:34 am

No, if corporations were people then they could make decisions…. and run for office as well.

Yergit Abrav November 20, 2011 at 9:38 am

See, this is exactly the narrative that is wrong but appeals to envy… its about creditor bailouts… firing some bank executives doesn’t change a thing if you still bailout the creditors. I do not think the bank executives that take the place of the ‘punished and fired’ bank executives will be any different, without creditor discipline.

Methinks1776 November 20, 2011 at 9:54 am

Exactly. The next crop has the same incentives as the previous crop.

Another point is that for managers, a bailout is by far not the preferred outcome. Creditors are simply made whole. Every outcome is a win for them. A bailout is not cost-free to managers. They are maligned, fired and threatened when there’s a bailout. How big was the angry mob threatening the lives of the executives of AIG creditors? There wasn’t one.

Yergit Abrav November 20, 2011 at 10:13 am

Yep. No sane manager wants to fail, consciously. Not a great resume builder, that, and surely the long term bonuses and rewards are higher at a successful firm.

This is also why we must agree that managers “need” the creditor discipline to know the limits of risk taking…

Methinks1776 November 20, 2011 at 11:11 am

Absolutely. But, if for whatever reason (and there may be some rational reasons outside of an expected bailout), creditors chose to live with that risk.

So….let them live with it.

muirgeo November 20, 2011 at 11:30 am

Good post Greg. While we shouldn’t bail them out. History shows boom and bust is the natural state of a poorly regulated market. And I don’t think it was very efficient or fun. I don’t think there was a precedent for those big speculators in 1929 and with todays complex markets those in the know will have enough of an advantage to get out while they can. There’s just no reason to set up our banking system like a casino unless you want to run the casino or work at one.

Emil November 20, 2011 at 1:18 pm

“History shows boom and bust is the natural state of a poorly regulated market. ”

Still beats the steady decline into poverty that is the inevitable result of over-regulated markets

muirgeo November 20, 2011 at 3:58 pm

“Still beats the steady decline into poverty that is the inevitable result of over-regulated markets” Emil

Yep that’s why properly regulated markets are better than both under-regulated or ver-regulated markets.

HaywoodU November 20, 2011 at 5:11 pm

It’s just that easy!

Greg Webb November 21, 2011 at 2:30 pm

Yep that’s why properly regulated markets are better than both under-regulated over-regulated markets.

In theory, perhaps. In reality, there is no such thing as properly regulated markets. Political forces will always push for monetary, fiscal, tax, and regulatory policies to enhance and expand a boom period. Once the bust arrives, political forces push for monetary, fiscal, tax, and regulatory policies to protect political cronies, keep asset prices unrealistically high, and delay any recovery.

Jon Murphy November 20, 2011 at 4:01 pm

“History shows boom and bust is the natural state of a poorly regulated market. ”

Actually, history doesn’t show that. History shows that booms and busts happen regardless of how regulated a market is.

steve November 21, 2011 at 7:55 am

Actually, Reinhardt and Rogoff showed that banking crises most frequently follow liberalization of banking rules.


Darren November 21, 2011 at 1:19 pm

Actually, Reinhardt and Rogoff showed that banking crises most frequently follow liberalization of banking rules.

What were they liberalized *from*? Were the overregulated? Were they being propped up by overregulation and liberalization meant they has to face reality? If this was the case, would there have been a problem if they had been forced to adjust to reality without regulatory support all along?

Greg Webb November 21, 2011 at 2:24 pm

History shows that booms and busts happen regardless of how regulated a market is.

Exactly. Government monetary policy simply lengthens the boom by masking economic reality. Thus, the resulting bust is more pronounced than it would have otherwise been.

muirgeo November 20, 2011 at 11:42 am

Maybe the creditors are like the hockey players Thomas Frank talks about (from a recent RSA podcast) who with no rules will not wear helmets. They increase their advantage with no helmets ( better field of vision, better hearing ect… but then everyone is not wearing helmets and getting pucks to the head.

If they vote in private they all vote there should be a helmet rule so the head injuries stop but no one has the advantage of playing without a helmet. Sometimes you do need rules. Claiming you don’t is simply a matter of dogmatism. The creditors should be wearing helmets and one rational approach seems to be to requiter much higher capital requirements.

See Russ’s 8/11/2011 Econtalk

Russ Roberts November 20, 2011 at 12:00 pm

I talk about the incentives facing managers in the longer essay, if you’re interested.

Good organizations figure out ways to encourage employees to serve the customer and the organization. Those that do not disappear, unless they’re in the financial sector. (Or automobiles, recently.)

Greg Webb November 21, 2011 at 2:42 pm

“Organizations don’t make decisions. People do. And when they do, they usually put their own interests ahead of the organizations that employ them.”

This is a very true statement. But, let’s make a few alterations to present an equally true statement:

“Government doesn’t make decisions. People do. And, when they do, they usually put their own interests ahead of the country’s citizens that employ them.” That is the essence of public choice economics. And, it is also the underlying principle behind the concept of limiting the power granted to the federal government as so wisely understood by the nation’s founders.

kyle8 November 20, 2011 at 7:43 am

If there is too much political will to provide a bailout and our leaders will not allow a large financial institution to go belly up. Then I offer a partial solution.

Make it mandatory that if the firm gets bailed out then all top executives have to be fired and pay fines of several million dollars from their own private accounts.

Yergit Abrav November 20, 2011 at 10:17 am

Wow – this has an additional socially deleterious effect of offering politicians built in scapegoats (appealing to our worst instincts). Brilliant.

Now exactly how would this help anything?

Methinks1776 November 20, 2011 at 12:05 pm


Except that managers who don’t take the risks shareholders want them to take will simply be fired and we’ll end up with managers who are willing to swing for the fences. To entice a manager to take that kind of personal risk, compensation packages will go through the roof. Just off the top of my head – the pool will be limited to the poorest among the candidates (who are probably the least experienced or the worst candidates for the job) and who have every incentive to swing for the fences because they have the least to lose. I mean, if you already have millions, why risk it all to go run some bank where you’ll be pressured to take risks that only YOU will have to pay for it it all goes pear shaped? The less experienced with fewer personal assets will simply declare bankruptcy and have little incentive not to swing for the fences. If they win, they become rich (and can quit), if they lose, they’re no worse off. How does that make things better?

It’s the creditors who don’t benefit from the upside when risk is piled on. If they don’t worry about losing, they don’t care how much risk managers take and they keep lending as the risk grows. It seems simpler to just let the creditors lose along with the shareholders, don’t you think?

jjoxman November 20, 2011 at 7:54 am

A thought occurred to me regarding this whole issue. Lehman and Bear held oodles (their whole balance sheets really) of MBSs. But they are investment banks. Goldman, JP, and other investment banks have been making more money on proprietary trading in the 2000s than on actual investment banking activities. Time was, investment banks made their money on bringing private companies to the public markets (IPOs) or facilitating mergers.

What does this have to do with anything? I maintain that a little regulation called Sarbanes-Oxley (2002) is a major factor in causing investment banks to move into proprietary trading because it dried up the IPO market. And Bear and Lehman, because of the mispricing in MBS market, thought there were arbitrage profits to be had and moved fully into that field.

Essentially I’m saying the story isn’t quite complete the way it is told now. It wasn’t just making real estate look good and socializing losses of banks, although those are critical parts of the puzzle. I think legislation like SOX that made investment banking less lucrative pushed former investment banks away from their traditional roles and into riskier areas.

Methinks1776 November 20, 2011 at 9:18 am

I don’t think Sarb-Ox was the driving force behind the rise of prop trading. Prop trading predates Sarb-Ox. Since most banks have both prop trading and traditional advisory I-banking businesses (that generally specialize in concocting value destroying deals), when one business ebbs, the other tends to flow. When the I-banking business stumbles, the bank looks to prop trading for profits and vice versa. But, that was the case before Sarb-Ox. Also, the IPO and M&A business didn’t dry up after Sarb-Ox. It fell off a cliff after the tech bubble burst. Not that Sarb-Ox didn’t help keep it down.

I-banks have been known to take positions in the securities they underwrite – usually through the exercise of the “greenshoe option” on hot issues. But, my understanding is that the biggest issue for some of the banks was not their own MBS portfolio. It was the collection of MBS they had underwritten and not yet brought to market. The market fell apart and they got stuck with the securities they had underwritten and now couldn’t sell.

Yergit Abrav November 20, 2011 at 9:44 am

” But, my understanding is that the biggest issue for some of the banks was not their own MBS portfolio. It was the collection of MBS they had underwritten and not yet brought to market. The market fell apart and they got stuck with the securities they had underwritten and now couldn’t sell.”

This is correct. It is also where the bulk of losses on commercial real estate and loans for LBO’s came from too (e.g., “pier loans”). This is verifiable from i-bank’s financial reporting on write downs during the 08/09 timeframe.

jjoxman November 20, 2011 at 1:59 pm

So, your first paragraph basically illustrates my point. The magnitude of SOX may not be that big, but there are other factors limiting the desire to become a public company in the U.S. So my point is that if you can’t make as much bank on traditional i-banking, you move to other methods, like prop trading.

On the 2nd para, this is I’m sure true for some banks, but not for Lehman and Bear. They held MBS much more than they issued them.

I think it is an empirical question what the magnitudes are, and it’s probably worth looking into. I know one guy at Purdue or Indiana U that is looking into the prop trading issue.

Methinks1776 November 20, 2011 at 10:25 pm


I was responding to this:

I maintain that a little regulation called Sarbanes-Oxley (2002) is a major factor in causing investment banks to move into proprietary trading because it dried up the IPO market.

Sarb-Ox didn’t help the IPO market and I have no idea how much it hurt new issues. But large prop trading operations at I-banks pre-existed Sarb-Ox and the tech bubble bursting.

As you say, I-banks tend to grow whatever part of the bank happens to be profitable. When deals were plentiful, they grew their I-banking departments. When deals dried up, they fired bankers and grew their trading operations. But saying that they “moved into prop trading” sounded to me too much like that was something new for them after Sarb-Ox.

I’m not sure the magnitude of Sarb-Ox wasn’t that big. How many deals weren’t done because of it?

jjoxman November 21, 2011 at 7:00 am

Yeah, I probably overstated the case on the SOX score.

Hard to know how many deals were prevented. VC was less active in the 2000s than in the 1990s overall. I do know there is evidence that small public firms decided to go private in greater numbers post-SOX.

So here’s a question, though – is prop trading more lucrative in volatile markets than in calm markets?

Methinks1776 November 21, 2011 at 10:29 am

Oh yes, they did, didn’t they? I forgot about that. And the Damndest thing about the unseen is it’s so hard to measure.

Yes, in general, when volatility picks up prop trading is more lucrative. In 2008, prop trading desks at the banks were doing very well and everyone on them was depressed because they knew they wouldn’t be paid for it.

If you get your hands on that prop trading research, would you mind letting me know? Sounds interesting.

jjoxman November 21, 2011 at 6:42 pm


The researcher is Charles Trzcinka at Indiana U. I don’t see the paper up on his website yet – probably still a working paper. I’ll keep you up to date.

Methinks1776 November 21, 2011 at 9:40 pm

Merci! I’ll make a note of it.

Nikolai Luzhin, Eastern Promises November 21, 2011 at 10:52 pm

the ole excess inventory problem

Rick November 20, 2011 at 8:42 am

In a recent econtalk episode, Kaplan challenges your moral hazard argument (last part of your discussion with him) by noting that other leveraged products of banks ( leveraged loan markets) did not experience the same poor performance as sub prime.

I am very interested to hear your thoughts on this challenge.

Jon Murphy November 20, 2011 at 8:47 am

I think the easy answer to this question would be that sub-prime mortgages were tied to the real estate market which was destined from the 90′s for a massive downturn. Other leveraged products were a bit more…diverse.

Nikolai Luzhin, Eastern Promises November 20, 2011 at 8:51 am


You won’t hear anything.

Facts never matter around here

The fact is that millions of borrowers lied, taking out loans they could not and did not intend to repay and the investment banks went along because they could sell the product to someone else

jjoxman November 20, 2011 at 9:11 am

“Facts never matter around here”

As evidenced by your every post.

Greg Webb November 21, 2011 at 2:19 pm

Another swing and a miss. So, how many strikeouts does that make Luzha?

Jon Murphy November 20, 2011 at 9:03 am

I think something else that gets lost in this discussion is the topic of interest rates.

Don’t forget that interest rates are calculated by the default-risk free rate + an allocation for risk. So, the riskier the asset, the higher the interest rate charged. A lot of these sub-prime mortgages had high (comparative) interest rates. Bundled together and sold, these securities were often rated AAA. So, from an investor/manager POV, you have high interest rate products that were top-rated AND guaranteed by the government (by Fannie & Freddie). Everybody wins, right?!

And this is where the incentives got messed up. If you remove any of the pieces from this puzzle, the bubble would not have burst as dangerously. No sub-prime bundles, no MBS. No AAA rating, no smoke and mirrors. No gov’t guarantee, no misplaced incentives.

Get rid of these rating agencies; the suffer from the agent problem. Get rid of the government role. Let interest rates, free to float, dictate how risky products are and let investors make the decisions.

Greg Webb November 21, 2011 at 2:18 pm


Jon Murphy November 20, 2011 at 9:08 am

Another thought:

Thomas Jefferson said that banking establishments are more dangerous then standing armies. I tend to agree with him. But we can’t crack down with so many regulations that it ceases to be useful.

Banking is a lot like holding a wolf by the ears: You don’t like it but you sure as Hell don’t want to let it go.

Greg Webb November 21, 2011 at 2:17 pm

Jon, why is the banking system so dangerous? Is it because of its political influence? Or is it the other way around?

I think TBTF banks should be allowed to fail. If the federal government did not always run to the rescue and set strangely low capital ratios (i.e., minimum capital ratios), then you would see banks with much higher capital ratios that also take much less risk.

Jon Murphy November 21, 2011 at 2:29 pm

I think the banking system is dangerous simply because of the way it operates, and the increased moral hazard coming from the government only makes it worse.

How does a bank operate? It taken in deposits. Those deposits do not sit in a safe with the person’s name on them. The bank loans out your deposit through the very next window. For example, the $567,321,690.59 I have in my bank account is not just sitting there. It’s out in the world, building homes and buying cars.

So, that’s the one edge of the sword.

The other edge is if a person fails to pay on their loan. The bank is out that money. They have to eat it. Which means, if I go to withdraw my money and they do not have it on hand, you have a bank run. A collapse of a bank, even a small one, causes problems.

Of course, this is something that cannot be regulated away.

I agree that banks should be allowed to fail. Force them to have better policies to avoid adverse selection. But it is important to realize how important banks are to a society and that they can be dangerous. As we have seen, there is nothing more dangerous than a man not held accountable for his actions.

Harold Cockerill November 20, 2011 at 9:19 am


The deeper systemic problem is the interference of the government at all levels of society. We’ve reached the point government can do anything it wants and the citizen has to ask permission to act. This is not the America the Founders created. The financial meltdown came as a result of government distorting the market for a variety of reasons. It doesn’t matter how or why they did it. They shouldn’t have the power to do it to begin with.

Most politicians see our salvation in distorting the market even more. The population cries for action and the Constitutional restrictions that would protect the masses from themselves have been destroyed. I don’t see this ending very well.

Scott Murphy November 20, 2011 at 9:56 am

Russ, in your interview with Steven Kaplan, he seemed much more agnostic on the role of moral hazzard. He pointed to crashes that occurred in the 1800′s. Even in George Selgin’s favorite example of Scotland there seem to be fairly large crashes. Kaplan’s point seemed to be this is just something we need to learn to live with.

It was definitely the most intriguing counter point to the moral hazard story
(of course his solutions seem the same or similar). I look forward to this e-book and hope that some of Kaplan’s points are addressed!

Methinks1776 November 20, 2011 at 11:19 am

Calculating risk is hard. We tend to be too optimistic about tail risk (I think Nassim Taleb’s failed hedge funds were based entirely on this premise). People sometimes take what is, in retrospect, too much risk. But, those events also informs us about tail risk so that we may better assess risk in the future. It’ll never be perfect, but it can get better with experience. If there are no consequences for risk taking, it stands to reason that risk will be in higher demand.

Russ Roberts November 20, 2011 at 5:09 pm

That is a legitimate view–that every once in a while, things go haywire. It could be true. But my answer to that is what I say in this post. Do you really think moral hazard had nothing to do with it. Nothing? If you believe that then you believe that the current mess in Europe has nothing to do with moral hazard and that all of the creditor rescues of the last three years don’t increase the risk of future problems. I don’t understand that argument.

Scott Scheall November 20, 2011 at 10:34 am


Excellent analysis. Quick question: where do you see the standard Hayekian business cycle theory fitting into all of this? Couldn’t one make a case that the prime mover here is manipulation of interest rates? In other words, is there anything to be said for the argument that without all of the cheap money made available by the Fed and ECB, the banks would not have had the funds to make all of those over-leveraged (and ultimately bailout-protected) investments in the first place?

muirgeo November 20, 2011 at 10:51 am

“There are only two solutions, broadly defined, to this problem. One is to return to a world where institutions that make bad decisions pay a price.”

Great post. But again… even if we presume we have a solution ( mine being a so-called separation of money and state) and yours as stated above. Let’s go with yours as it’s simple and straight forward.

So how do we do it? What’s the real world way this happens? It’s very simple to make a reasoned statement like yours but to have it happen in reality is a story about David and Goliath.

THIS is were I claim we DO know how to theoretically set up an efficient economy contrary to the Hayekian claims. What we DO NOT know is how to get proper policy instilled that takes power out of the hands of the political class.

Russ Roberts November 20, 2011 at 12:03 pm

It’s up to us. You don’t like the outcome, but the incumbent members of the Republican party appear to have decided that in response to the will of their constituents, they are going to close the gap between very high spending numbers and very low revenues by lowering spending. Again, you may not like this outcome, but it is the result of political pressure from voters. OWS, for all its flaws, makes it harder for policymakers to be “flexible” ie, reward cronies in the financial sector the next time. That is good. And that is how the problem will be fixed. When we the people decide that bailing out friends comes at a cost.

vikingvista November 20, 2011 at 1:38 pm

“they are going to close the gap between very high spending numbers and very low revenues by lowering spending.”

Are you confident this will happen? I suspect there will be no agreements in Congress. This may result in some automatic cuts in non-entitlement spending, but there is no such automatic mechanism for entitlement spending. So for entitlements, spending won’t be cut, and (hopefully) taxes won’t increase. Then either entitlement payments simply stop being issued, or they become debt financed. The latter is more politically expedient, but downgrades will increase the cost of debt. So, the Fed will increase it monetization of it.

In short, the inevitable outcome is monetization of the debt, with inadequate spending cuts.

And since entitlements have COLAs, inflation is inevitable.

kyle8 November 20, 2011 at 1:57 pm

Yes I have to agree with you Viking. we will get no real reform of spending until we are almost in the same shape as Greece.

muirgeo November 21, 2011 at 12:24 am

Greece is in far worse shape 2 years after the so called austerity reforms. It’s Hooverism all over again and it’s still not working.

kyle8 November 21, 2011 at 10:42 am

you have absolutely no idea what you are talking about

Greg Webb November 21, 2011 at 1:44 pm

kyle8 on muirgeo: you have absolutely no idea what you are talking about

Yes, but that won’t stop muirgeo from saying silly things.

vikingvista November 20, 2011 at 2:56 pm

In the last sentence I meant to say that real debt expansion is inevitable, because the COLAs prevent inflating them away. Of course I also believe inflation to be inevitable.

Darren November 21, 2011 at 1:29 pm

COLAs prevent inflating them away

Unless you redefine how the COLAs are caculated, or even the inflation rate itself.

vikingvista November 21, 2011 at 1:37 pm


Very good point.

Greg Webb November 21, 2011 at 2:04 pm

I agree with VV. The Federal Reserve is very susceptible to political pressure and ultimately it will monetize the debt, which will lead to greater inflation. Combine that with the typical political rhetoric blaming others for government’s mistakes, and the country will experience stagflation again.

It is sad too. Because those who fail to learn from history are condemned to repeat it All those who label themselves the best and the brightest failed to learn that Keynesianism failed in the 1930s and lead to stagflation in the 1970s. Now, it would be one thing is their failure to learn from history caused economic problems only government officials and their political cronies. But, the problem is that we will all be burdened with the results of their stupidity.

muirgeo November 20, 2011 at 4:16 pm


How does cutting spending relate to not bailing out the banks? So for me sure austerity will make our economy worse and the bankers love the fact that attention has been directed to spending and away from their bailouts.

Almost no one I talk to is aware of the Fed audit results.

see table 8

The rank and file Tea Partiers as well as the OWS both would agree , I think, to no more bank bail outs. But the money running the Tea Party message directed it away from the banks and towards government spending.

Chucklehead November 20, 2011 at 4:17 pm

As the wise man said “Stop wasting my money and giving it to your friends.”

Greg Webb November 21, 2011 at 2:11 pm

Corrupt politicians, political cronies, and “useful idiots” to the first two never listen to wise men, or the facts, or history, or any one or thing else for that matter. It is sheer arrogance and hubris for anyone to think that he or she knows better than the one who rightfully owns the money in determining how it should be spent.

Sam Grove November 20, 2011 at 1:38 pm

THIS is were I claim we DO know how to theoretically set up an efficient economy contrary to the Hayekian claims.

Claim all you want, efficiency is always sought by actors in an economic system. Messing with price signals misdirects the actors away from greater efficiency.

Any political system that endeavors to direct economic behavior by generating arbitrary price signals will attract those who are willing to generate those signals for their own benefit.

I don’t know of any way to prevent sociopathic actors from seeking political power. They lie as smoothly as normal people tell the truth.

What we DO NOT know is how to get proper policy instilled that takes power out of the hands of the political class.

You refuse to see the solution, which is to distribute power via the market rather than concentrating it in an all powerful institution.

The result of the obvious incentives if equally obvious.

Seth November 20, 2011 at 12:44 pm

Most people can’t recognize a moral hazard, even when their own decision-making is altered by one.

vikingvista November 20, 2011 at 3:34 pm

If you are not the creator of the moral hazard, recognizing the moral hazard doesn’t change how you act. The MH changes what constitutes a rational decision for you.

WhiskeyJim November 20, 2011 at 10:17 pm

We have known for some time that all western democracies are structurally bankrupt absent formidable restructuring; their demographics, social nets and tax pyramid revenue streams absent investment guarantees it. By 2030 debt rollover will consume 20%+ of world GDP. That does not work.

So in at least one respect banking must be a little surreal. The big banks, growing increasingly leveraged, are buying government bonds that by their nature must at some point blow up. Everyone knows this.

I still do not understand why most European bonds are so inexpensive.

Georges Kaplan November 22, 2011 at 5:09 am

“Expectations are hard to measure. So inevitably it is difficult to “prove” in any scientific sense that past rescues were decisive in creating the current mess.”
Yep. The 5-Years CDS spread of Lehman around March 14th, 2008 (Bear Stearns’ bailout) tells a story that clearly supports the moral hazard hypothesis. Roughly 200 basis points (or 2%).

Previous post:

Next post: