Tuesday, April 21, 2009

Incentives matter

I had a minor epiphany yesterday, which is to say that what I epiphanized was entirely obvious.  We still cling to a belief that somehow this crisis will "teach people a lesson" or something like that -- we still believe that the question is one of moral and ethical failures.  And if we continue to believe this, we continue to be unable to solve the problems of mechanism that led to this crisis.  We continue to imagine that somehow, the same people running the same banks will magically feel chastized and begin behaving in a more upright manner.  This is the very definition of insanity -- repeating an action and expecting a different outcome. 

So no one should be at all surprised to discover that the banks are gaming their earnings:

"Although perfectly legal, this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won't be pretty."

-Steven Roth, professor of management at the Tuck School of Business at Dartmouth College, on Bank of America's earnings fraud

We been discussing how many of the recent profits were not "real" — i.e., based on one time sleights of hands — losing a losing month, AIG flow throughs, bailout monies, etc.

Thus, it is gratifying to see on the front page of the NYT Business section, Andrew Ross Sorkin's article with the provocative but accurate title, Bank Profits Appear Out of Thin Air.

The quote above comes via this same article. It refers to Bank of America's fraudulent earnings scheme of booking a $2.2 billion gain that falsely increases value of the  Merrill Lynch's assets recently acquired. BofA decided to give themselves a phony profit bump by raising the value of Merrill assets to prices significantly higher than Merrill kept them.

The banksters who have emptied the US Treasury of its money continue the same games of accounting sleight of hand, finacial engineering, and other tricks of the trade that helped caudse the mewltdown in the first place.

... to discover that they are gaming the bailout:

The Treasury Department's most ambitious plans to rescue troubled banks — partnerships between the government and private investors, backed by the Federal Reserve — are inherently vulnerable to fraud and should not be started without stronger safeguards, a top government investigator warned in a report to be released Tuesday.

The report also warned that the Treasury's $700 billion Troubled Asset Relief Program has evolved into a $3 trillion effort of "unprecedented scope, scale and complexity" and comes with too little oversight and too little information about what companies are doing with the taxpayer money they are getting.

... and to discover that in general, nothing has changed about the behavior of the principal actors, because the same actors are sitting in the same places with the same incentives.  In fact, the truth is that the incentives to roll the dice have increased dramatically for these guys.  With government assitance they have much less to lose and much more to gain.

Thus, the most dangerous sentiment out there is stuff like this WSJ op-ed:

What's to be done? We must work to establish a "fiduciary society," where manager/agents entrusted with managing other people's money are required -- by federal statute -- to place front and center the interests of the owners they are duty-bound to serve. The focus needs to be on long-term investment (rather than short-term speculation), appropriate due diligence in security selection, and ensuring that corporations are run in the interest of their owners. Manager/agents need to act in a way that reflects their ethical responsibilities to society. Making that happen will be no easy task.

Bogle is good guy, a smart guy, and the head of a very respectable and ethical organization ... and the most dangerous fucking man in America (unless this is Obama, who maybe represents the most perfect incarnation of this problem).  It's wonderful to think that people should be more ethical.  I fully agree.  They should.  However, at this point I think it is delusional to expect this little piece of monkey code to hold our society and economy together.  Monkeys respond to incentives.  This is the deepest and most valid thing that economics can teach us.  Money is not the only incentive, but it is a damn strong one.  Expecting some sort of exaggerated ethical and fiduciary duty to generate the counter-incentive necessary to overcome this is completely insane. 

I'm not saying that we shouldn't consider using the monkey ethical hack as part of our new system.  I'm just saying that somebody has already hacked the hack, so we need to develop some more clever version of it.  I would love for everyone to walk away from this crisis with a lesson I feel like I have learned, a lesson JP morgan summed up so well:

Asked: "Is not commercial credit based primarily upon money or property?"
"No sir," replied Morgan. "The first thing is character."
"Before money or property?"
"Before money or anything else. Money cannot buy it...Because a man I do not trust could not get money from me on all the bonds in Christendom."

While it's lovely to think that one should only go into business with people one trusts, that is not a solution to this crisis unless that trust is backed up by a mechanism, the very simplest version of which has a failure of trust resulting in a loss of capital.

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