MORAL HAZARD & CONFLICTS OF INTEREST
The Underlying Causes of the Credit Crunch
FUTURECASTS online magazine
Vol. 11, No. 7, 7/1/09
Moral hazard and conflicts of interest:
The mortgage madness that
preceded the Credit Crunch financial crisis is a story of moral hazard and
conflicts of interest. See, Tavakoli,
"Dear Mr. Buffett."
The interests of agents are never perfectly aligned with those of their principals, creating a persistent challenge to ethical standards.
Government has added the moral hazard ingredient that made it possible for the mortgage madness bubbles to grow big enough to threaten the financial stability of the entire world.
Regulatory oversight is an inherently weak reed, and business cycle contractions generally arrive on the scene only after much damage has been done.
This is nothing new. Adam Smith warned us,
over two centuries ago, that the interests of agents are never perfectly aligned with those of their
principals, creating a persistent challenge to ethical standards. For this
reason, he was highly skeptical of the corporate form of economic organization
and thought that it would be the partnership form that would predominate. See, Adam Smith,
"The Wealth of Nations," Part II, "Economic Policy," at
segments on "Mercantile trading companies" and "Regulatory companies." Smith would thus not be surprised at periodic corporate
he would be amazed at how
well the vast bulk of business corporations are actually run.
There are always unintended consequences to government administered alternatives to market mechanisms.
Fear is in fact essential to balance greed so that the investment markets can produce prudent investing decisions. Caution must balance ambition.
A host of overextended and fraudulent houses of cards were
brought down by the Credit Crunch as is usual during business cycle
contractions. The regulators missed them all, even when knowledgeable financial
experts were shouting the alarm. How much would the damage have been diminished
if the business cycle contraction had come two years earlier? How much would the
damage have been increased if the business cycle contraction had come two years
later? The sums involved were increasing exponentially, and the regulators
were determinedly deaf, dumb and blind to the problems. As late as the spring
of 2007, despite numerous warnings in the financial press, regulators like the
N.Y. Fed and Britain's Financial Services Authority were still spreading sunny
confidence. Thank god for the
Accounting is one of the most nebulous of practical arts and there are always some who succumb to temptation and engage in the arts of creative accounting.
Federal securities regulation is based on disclosure. It is a
truly elegant and valuable regulatory approach. However, it all depends on the reports issued
by management and generated by accountants. The vast majority of these
professionals do their difficult jobs with diligence and amazing skill, but the
conflicts of interest raise powerful temptations at every level. Accounting is
one of the most nebulous of practical arts and there are always some who succumb
to temptation and engage
in the arts of creative accounting.
Neither the regulators nor their political masters have "skin in the game," so political and bureaucratic imperatives routinely become paramount.
Alan Greenspan demonstrated no such courage as he insouciantly watched all manner of asset bubbles exuberantly inflating during his last few years as Fed Chairman.
The government, too, is afflicted by moral hazard and conflicts
of interest. Neither the regulators nor their political masters have "skin
in the game," so political and bureaucratic imperatives routinely become paramount.
Amazingly, Congress is again pressuring banks to reduce lending standards for subprime mortgage borrowers.
The regulatory failures are being used by the regulators as reasons to expand their authority and the scope of the regulations.
Congress, of course, is even worse. Congress has decided that credit
allocation schemes are a cheap way of rewarding their constituents and winning
votes. It became government policy, enthusiastically joined by the Bush (II)
administration, to expand home ownership by reducing mortgage lending standards
and allocating credit into the mortgage market. It did not take long for even
the most wild excesses to be justified as just an effort to increase home
ownership and fulfill this virtuous national policy.
They were leveraged 50-to-1, but they, too, were too big to fail, so their creditors insouciantly kept sending them more money, enabling them to keep digging themselves ever deeper into the financial hole.
The "too big to fail" concept is the most obvious
moral hazard villain. Why shouldn't creditors keep lending to overextended
financial and industrial entities if those entities are so big that the
government will not permit them to fail? The creditors can always rely on bailout
funds from the government. After all, it's only taxpayer money, and in
Washington, the taxpayer is a joke. Thank goodness, Chrysler and General Motors
were ultimately allowed to go through bankruptcy. The world has not come
to an end, and creditors will be more cautious and impose more discipline
on industrial borrowers in the future.
The effectiveness of Keynesian policy is always temporary and dependent on the strength of the currency - and Keynesian remedies always weaken the currency.
Government bailout madness is the response to mortgage madness.
Keynesians rejoice. Like ghouls in the economic night, as FUTURECASTS predicted,
they have risen from the
dead to dominate government economic policy during this financial crisis. However, the effectiveness of
Keynesian policy is always temporary and dependent on the strength of the
currency - and Keynesian remedies always weaken the currency. It should surprise
nobody that instead of ending or even moderating the business cycle, in periods
when Keynesians dominate economic policy the business cycle always becomes
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Copyright © 2009 Dan Blatt