Gambling with Other People’s Money

by Russ Roberts on April 28, 2010

in Gambling with Other's $, Uncategorized

My essay on the crisis, Gambling with Other People’s Money: How Perverted Incentives Created the Financial Crisis is now available online from the Mercatus Center and as a pdf. (In the online version, almost all of the footnoted articles and essays are available as links in the text if you want to go deeper.)

Here is the executive summary:

Beginning in the mid-1990s, home prices in many American cities began a decade-long climb that proved to be an irresistible opportunity for investors. Along the way, a lot of people made a great deal of money. But by the end of the first decade of the twenty-first century, too many of these investments turned out to be much riskier than many people had thought. Homeowners lost their houses, financial institutions imploded, and the entire financial system was in turmoil.

How did this happen? Whose fault was it? Some blame capitalism for being inherently unstable. Some blame Wall Street for its greed, hubris, and stupidity. But greed, hubris, and stupidity are always with us. What changed in recent years that created such a destructive set of decisions that culminated in the collapse of the housing market and the financial system?

In this paper, I argue that public-policy decisions have perverted the incentives that naturally create stability in financial markets and the market for housing. 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.

There is a pleasing symmetry in the incentives facing homeowners, Fannie and Freddie, and the banks. All were highly leveraged and used other people’s money to take risks with a big upside and a truncated downside. That’s generally a good deal for risk takers. But it’s not so attractive for the “other people” who lent the money that financed those gambles. What made lenders so eager and willing to finance those risks?

That is the question I try to answer. Along the way I try to show how the incentives facing borrowers and lenders interacted with housing policy. Fannie and Freddie didn’t cause the crisis. But I argue that they were part of the problem.

I plan to blog here at the Cafe on the issues raised by the essay and on new information that comes to light. And in future posts I’ll add some caveats and confessions as to how I got to where I am in my understanding of these issues.

Comments

38 comments    Share Share    Print    Email

Previous post:

Next post: