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Does Majoritarian Democracy Systematically Result in Moral Hazard and Financial Industry Irresponsibility?

May 20, 2010

“In this crisis, average Americans have sent hundreds of billions of dollars to some of the richest people in human history.”   Russ Roberts

Roberts’ quip (from his excellent article “Gambling with Other People’s Money”) above explains why Americans across the political spectrum are disgusted.  A few hundred individuals in the financial services industry who might otherwise have been worth tens of millions of dollars managed instead to get their hands on hundreds of millions of dollars as they destroyed our financial system.  Now we are all suffering higher taxes, higher unemployment, fewer new business starts, tighter capital markets, and lower rates of charitable giving so that a few hundred individuals can buy larger islands and bigger yachts.  It is a disgusting sight, inconsistent with all moral codes and political philosophies.

What if, instead of being a surprising one time disaster, this outcome was a predictable and routine outcome of our political process?  Future economics Nobel laureate Paul Romer explains:

“If you think of the financial system as a whole,” Mr. Romer said, “it actually has an incentive to trigger the rare occasions in which tens or hundreds of billions of dollars come flowing out of the Treasury.”

Romer should know.  He and actual economics Nobel laureate George Akerlof published a brilliant analysis of the S&L crisis of the 1980s, titled “Looting:  The Economic Underworld of Bankruptcy for Profit” which analyzed how some wealthy executives extracted tremendous sums of money from the S&Ls that they “led” while knowing that their decisions would lead the companies to bankruptcy.  Romer and Akerlof conclude:

“Bankruptcy for profit occurs most commonly when a government guarantees a firm’s debt obligations.”

If our best economists knew in 1993, in a widely published article that bankruptcy for profit could occur when government guarantees a firm’s debt obligations, why is it that the U.S. government continue to guarantee debt obligations?  Indeed, not only it continued the guarantees, but it expanded them –  by means of numerous actions supported by both Democratic and Republican Congressmen expanded the scale of its debt obligations through the deliberate growth of Fannie Mae and Freddie Mac.  And note that bankruptcy for profit is merely the most extreme case of moral hazard due to government guarantees; there are plenty of deep moral hazard issues due to government guarantees that could lead to similarly catastrophic outcomes well before we get to the case of outright looters.   (See both Roberts and Macroeconomic Resilience, a brilliant anonymous blogger he cites; see the analysis herehere, and here).

Akerlof and Romer ask the key question at the end of their 1993 paper:

“The S&L fiasco in the United States leaves us with the question, why did the government leave itself so exposed to abuse?”

They then get part of the answer right:

“Part of the answer, of course, is that actions taken by the government are the result of the political process. When regulators hid the extent of the true problem with artificial accounting devices, when congressmen pressured regulators to go easy on favored constituents and political donors, when the largest brokerage firms lobbied to protect their ability to funnel brokered deposits to any thrift in the country, when the lobbyists for the savings and loan industry adopted the strategy of postponing action until industry difficulties were so large that general tax revenue would have to be used to address problems instead of revenue raised from taxes on successful firms in the industry-when these and many other actions were taken, people responded rationally to the incentives they faced within the political process.”

If Akerlof and Romer saw so clearly that looting had taken place because “people responded rationally to the incentives they faced within the political process” did they then recommend a dramatic re-evaluation of the political process to prevent a similar financial catastrophe from happening in the future?  Unfortunately not; rather than question the political process, they succumbed to wishful thinking:

“The S&L crisis, however, was also caused by misunderstanding.  Neither the public nor economists foresaw that the regulations of the 1980s were bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself.”

Here we are, twenty years later, with a much larger and more damaging catastrophe.  Although he was not a regulator, David Andrukonis, Freddie Mac’s chief risk officer, warned of the dangers that Freddie Mac was taking on in 2004 with a remarkable level of detail and foresight:

In an interview, Freddie Mac’s former chief risk officer, David A. Andrukonis, recalled telling Mr. Syron in mid-2004 that the company was buying bad loans that “would likely pose an enormous financial and reputational risk to the company and the country.”

- and support for him was so “lukewarm” that he was let go.  As Arnold Kling points out, Syron, the Freddie Mac CEO, has close ties to Barney Frank, the relevant committee chairman.  Why, exactly, would Akerlof and Romer believe that people like Andrukonis would be treated differently the next time around?  Why should any of us believe that future Andrukonis will be treated differently twenty years from now?

Arnold Kling, Russ Roberts, and other economists are pointing to the government guarantees as the essential problem that must be removed in order to prevent a similar recurrence of financial catastrophe.   Ron Paul promoted such a policy move in 2003, with remarkable foresight and wisdom:

Today, I will introduce the Free Housing Market Enhancement Act, which removes government subsidies from the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the National Home Loan Bank Board. . . . Congress should act to remove taxpayer support from the housing GSEs before the bubble bursts and taxpayers are once again forced to bail out investors who were misled by foolish government interference in the market.

Had Paul’s proposed bill been passed into law, we would still have a reasonably stable economy and those jerks would be having to get along with merely tens of millions rather than hundreds of millions of dollars.  Recently Orin Hatch, joined by several other Republicans, opposed the financial regulation bill because it didn’t address the issue of Fannie Mae and Freddie Mac (which represent only a portion of the government guarantees).  Why is this perceived as a partisan issue?

Public choice theory has been well-known in the economics community for fifty years now, with thousands and thousands of scholarly papers published on it.  At a minimum, the possibility that government will result in outcomes in which “people respond rationally to the incentives they faced within the political process” ought to be taken seriously by all policy makers everywhere.

At what point do we conclude that:

Do we have to wait another twenty years, provide a few thousand more of the richest people in history with more islands and yachts with our tax dollars, and watch the U.S. itself go bankrupt before we take these issues seriously?

If our best economists all acknowledged that moral hazard through government guarantees was a serious problem, would democracy “work” in that a bi-partisan consensus would develop to eliminate government guarantees?

Or is the more likely conclusion that even if a bi-partisan consensus developed that eliminated all government guarantees in 2010 in a high profile demonstration of civic responsibility, a few years later they would sneak back in, one way or another?

Is the ultimate problem majoritarian democracy itself?

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10 Comments
  1. May 20, 2010 4:54 pm

    These are absolutely the right questions. I have the strong sense that Obama’s refusal to give up on health care reform — despite the advice he received to compromise from even his closest allies — had something to do with wanting to prove that we are not beyond our scale, at least not yet.

    I have been reading this blog from the beginning, and I very much appreciate the bracing criticism of our existing institutions. What is conspicuously missing, however, is positive agenda. The success of our Constitution in the face of powerful interest group politics was and is highly contingent. What makes seasteaders think that they can do so much better than Franklin, Hamilton, the Morrises, and even Madison? I would like to see their plan set out in detail so that it can be compared against the butt of all these critiques.

    • May 21, 2010 7:59 am

      I rather think the point of seasteading is that it isn’t supposed to require a Central Constitutional Planning Committee of geniuses who can surpass the US’s Founding Fathers at their own game. Rather, it assumes that smaller-scale and more competitive government will eventually trump their achievements on the global scale – just as the combined efforts of millions of very ordinary businesscritters generally trump the achievements of the brightest and the best in coming up with the Definitive Plan for the National Economy.

      More subtly, a successful seastead constitution doesn’t have to last as long as the US Constitution. If it becomes sclerotic and dysfunctional, its component households can float off to healthier communities – or even re-form intointentional daughter communities founded on a cloned constitution, but with reset institutions.

      The cost of attempting that in the USA might be just a little bit dear for most people’s purses.

      • May 22, 2010 2:16 am

        Exactly! a) Markets produce progress. You don’t have to know how in advance.

        b) seasteads allow bloodless revolutions

      • May 24, 2010 12:15 am

        Hey Patri, Gray, and Michael:

        I too think you are asking “absolutely the right questions.” I am very sympathetic to your assessment of the problems with governance in the status quo, the importance of opening up cheap exit options, as well as the meta-institutional point about discovering better rules through freedom and entrepreneurship, etc.

        Even with all the standard public choice arguments about impediments to reform, I am just quixotic enough to think that there are reforms — one reform in particular — that could replace the forces for constitutional decay with forces for constitutional growth/refinement.

        The post above links to a short overview of what I am proposing, called “a way to debug democracy.” I would read that first… I am blogging related stuff at http://spiritofmoderation.com

        I am willing to concede (1) that giving people cheap exit options is the most immediate and most assured way to progress, and (2) that my proposal is conjectural, but I have not given up on “old school” constitutional democracy…

        Any thoughts you have would be helpful to me…

      • May 25, 2010 12:57 am

        How could I disagree that making expatriation easier would put more pressure on governments to be efficient with the resources they appropriate from their citizens?

        But the argument that lower transactions costs must necessarily result in a more efficient market is false. To be very specific, the argument confuses potential with actual pareto efficiency. There are many situations in which private parties will not be able to reallocate resources through voluntary agreements in order to reach a pareto-efficient equilibrium. First, there is the behavioral economics reason that people sometimes don’t act rationally. Ward Farnsworth had a paper years ago about how people won’t bargain their way around injunctions because usually they hate each other too much at that point. Second, and more perniciously, no pareto-efficient equlibirum may exist at the points in time when parties are ready to transact.

        In other words, the answer that lowering transactions costs to competition in government will necessarily lead to better government, much less bloodless transitions in government, is fundamentally flawed. Like I said before, any prospective new government — even on a seastead — should be expected to justify itself by comparison against already existing governments, and their track records of failure as well as success.

        I will have to spend some more time with tcdurant’s work, which I have not seen before. If it were my passion, however, I would begin with a study of the history of communes that have operated in the interstices of more powerful sovereigns, and see which have survived over time, and for what reason. There are several obvious examples of such communes that I can think of off the top of my head, but I cannot imagine myself ever wanting to live in such a commune cutoff from the rest of the world in the middle of an ocean! The survival of these communes seems uniformly to have been a consequence of their symbiotic (if not parasitic) relationship with a geographically coextensive authority.

        This is part of why, incidentally, I said in the first place that I was interested in polycentric authority, but not in secession. The former is a great idea, and deserves a lot more exploration and development. The latter is a disaster that has been tried and failed with nasty consequences too many times to be taken seriously.

        So if we’re seasteading, why not seastead as a joint venture with BP, and under U.S. jurisdiction? Seems obvious that they could use some environmentalists and engineers out there to keep their roughnecks company. Cambrian explosion indeed.

  2. Painesright permalink
    May 20, 2010 8:46 pm

    Seriously? These are still questions worth asking?? I have a question… are the people who are still pondering these issues just too darn book-smart to have a lick of common sense?

    NEWSFLASH! We were not supposed to be a Majoritarian Democracy… aka Mob Rule… in the first place.

    The story does not go “Mr. Franklin what have you given us?” “A Majoritarian Democracy, if you can keep it.”

    No, we were given a Republic… and no, we did not keep it.

    Two words explain the problem.

    Bread and circuses.

    Our Founding Fathers told us, that when the people realize that they have access to the public till, a democracy is done.

    Politicians now give citizens an unlimited amounts of publicly-funded goodies (financed with borrowered money that our kids owe) in exchange for their votes.

    Politicians took over our school system in order to make sure that the citizens are financially and civically illiterate.

    Politicians accept donations from Political Action Committees (still cannot believe that is legal) and vote for laws that favor special interest groups who donate to their campaigns, instead of voting for laws that favor the overall health of our country.

    Politicians crafted a tax code that allows 2 citizens to join together and rob 1 fellow citizen of half of his income. It punishes success, rewards sloth, divides people into a million different deductions, loopholes and brackets. It gives special breaks to anyone who will vote for a politician in exchange for a tax advantage (taxes for thee, taxes for the guy behind the tree, but don’t tax me!)

    We must become a nation of laws again, not of men.

    And by laws, I do not mean monstrosities such as ObamaCare, the Credit CARD Act, Cap and Trade or the impending mother-of-all-unintended-consequences bill, Financial Reform. Those are not laws, those are takeovers of entire sectors of the private economy. Big difference.

    We elect crooks and liars to go to Washington and then we are dumb enough to re-elect those same crooks and liars over and over again.

    We deserve the government we’ve got.

    Until each of us is willing to give up our special “bennies” from our favorite sugar daddy in DC, we will end up right back in the same spot.

    If we are hopelessly addicted to selling our votes in exchange for more and more bread and circuses, then we need laws that restrain our “leaders” (ahem) from over-taxing AND over-spending (Why not? A family that buys a home has to stay within a certain debt-to-income ratio, why not limit DC’s debt-to-income ratio?) and a tax code that treats ALL citizens equally. Throw in vouchers for public school choice and you would be well on your way to getting us out of the deathspiral we are in.

    If we do not, there will come a time when we are so morally and financially bankrupt that nothing will save us from the fate that we will, quite frankly, deserve.

    • Eelco Hoogendoorn permalink
      May 30, 2010 9:56 am

      Im affraid you dont really get the concept of a sovereign. It MAKES the law. Constraining a sovereign by its own law is a contradiction in terms; an excercise in futility.

      Democracy IS an advance auction of stolen goods. No matter how you dress it up, thats how the incentives are structured at a fundamental level.

  3. Painesright permalink
    May 20, 2010 8:48 pm

    Sorry, forgot one…

    Go back to a limited government that follows the Constitution.

    How could I forget that one!?

    A thousand apologies.

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