One element in the creation of bubble is people's willingness to believe that this time is different. In the present case, this time was different because of financial innovation, better monetary policy, better technology to manage shocks (e.g. digital technology reducing supply bottlenecks), and so on leading to a (supposed) reduction in overall financial risk without a corresponding reduction in returns.
But this time wasn't different, it was in many ways a rerun of the dot.com bubble, and Shane Greenstein says people are finally starting to notice. In fact, according to the argument below, the effort to address problems on Wall Street has passed the "Russ Roberts test":
This just in, something is wrong with Wall Street, by Shane Greenstein [Note: original post replaced with an updated version at the author's request]:
Please forgive the irony in the title. But I just felt like expressing sarcasm because – Ha! — many professional economists have begun to notice something is wrong with Wall Street.
Better late than never, I guess.
This recent essay/podcast from Russell Roberts is a good indication that just about everyone has noticed that Wall Street has a tin ear for its public standing, which has sunk quite low due to self-serving behavior.
In case you have not noticed what Roberts has noticed, then let me remind you. Just recently the management at Goldman Sachs announced that the firm had a very profitable quarter, which, of course, resulted in very high pay for their executives.
That is where it gets interesting. Roberts points out (correctly, IMHO) that had the government not stepped in at AIG, etc., Goldman would have gone down with everyone else. Ergo, their executives should recognize that they have a connection to taxpayer money as much as any other firm, and they should, therefore, eschew blatantly selfish and observable behavior, such as paying themselves high salaries.
Russ Roberts is normally a free market economist, but in his essay he sounds like an old fashioned populist. When a firm does something to turn Russell Roberts into a populist then — perhaps — something is actually amiss with attitudes on Wall Street.
Alright, then, so what? Well, take this observation another step or two…
What Roberts did not say
Here is what Roberts did not say, so I will. Goldman displayed a tin ear by not making any gesture at the same time they announced their profitable earnings.
What do I mean by tin ear? Here is an example. They did not announce the hiring of many (otherwise) laid off workers — as sort of a political gesture to address the need to do something about the high unemployment rate around the country.
Here is another idea. Why stop with hiring a few more employees? How about making an unusually big (I mean VERY BIG) donation to a soup kitchen — once again, as a gesture to suffering of others in these hard time.
Hmmm, here is another idea. How about doing anything mildly publicly-spirited, like buying a new fire truck for the New York city Fire Department, because the whole city is having a bad budget year? Why the New York city Fire Department? Because nobody ever has anything bad to say about firefighters in most cities, and certainly not in New York City after their sacrifice during 9/11.
Heck, once you start thinking this way, it is quite easy to find a way to spend a half billion dollars in unexpectedly large profits. But if you have a tin ear for this sort of non-selfish gesture, then the thought might never have surfaced.
And now to the point of this rant…
For those of us who live in the land of high tech, these type of observations are nothing new. The self-serving and otherwise destructive behavior of some Wall Street managers is well known…
Look, I have been around the block enough to understand that sometimes financial managers have something useful to say to high tech firms. But there is also something wrong. For example, the short-termism of Wall Street managers is legendary among high tech managers who have a long term vision for their firm but are asked to deliver revenue tomorrow. The self-serving decision making of managers who give IPOs to friends is another well known behavior (and most young firms and VCs would love to eliminate it). Another common complaint concerns the unwillingness of IPO managers to change the system if it meant a loss of control. For example, remember this? Wall Street was unwilling to conduct any IPO as an auction until Google insisted — insisted! — that the old system would not apply to them.
Enough is enough. Even guys like Roberts can see that something is amiss.
Remember the dot com madness?
It is really nothing new. Really.
Back in the late 1990s — more than a decade ago — Wall Street cheered on one of the goofiest investment bubbles I have ever seen in my lifetime (and hopefully I ever will see). It was called the dot-com boom, and, frankly, it was nuts from any rational perspective.
Yes, there are lots of explanations for the boom. There was a social dimension: Plenty of observers tried to say it was nuts. They were drowned out by crazy evangelists who ignored basic finance and who argued that price earnings ratios could be way out of whack. And it sold copy: the business media loves of a sensational story, and that did not help.
But that is why adult supervision is required in high tech. The financial professionals and auditors of this country had a professional obligation to say sober things, to ask — perhaps, insist! — that revenues align with expenses, and advise investors when such alignment has little chance of appearing. And in the late 1990s, what did the professionals do? Well, it is complicated, but, suffice to say, few of them said no to the nuttiness.
Why not? Here is a good clue in an essay by Henry Blodget.
You may recall that Blodget was a wunderkindt cheer leader for dot coms. How did he get there? Basically, he made a bold call, got himself some attention, and kept making more bold calls. His bosses saw an opportunity and replaced someone else who had the good sense to point out that the promises had considerably risk. Blodgett instead went full steam ahead because — he fully admits it — he was hired to do just that.
I do not know this fellow, nor have we ever met. I have read some of his writing. As best I can tell, Blodgett actually has a pretty smart head on his shoulders. He writes well and has the capacity to make some intelligent and deep observations.
Anyway, Blodgett eventually got himself into trouble. While I understand how someone with those sort of smarts can delude themselves enough to tempt fate for a short while — he is human, after all — nonetheless, it is beyond my capacity as a psychologist to explain how someone can do it for a long time. And he did. For several years. Until the dot com crashed, and a scandal broke, and he got banned.
There is a deeper question behind that run of several years. How did his bosses allow Blodgett to ply this trade for so long even though the wiser adults among them surely must have suspected/concluded/known that much of it was a financial charade?
The answer, of course is quite simple: they made so much money during that time. Blodgett’s bosses had no reason to change anything.
Many years later Blodgett wrote about his time in this essay. He finds many reasons for explaining his own behavior. Blodget says he did it because if he did not others would. He did it because his bosses wanted him to do it. He did because everyone was making huge amounts of money from focusing on the short term benefits to their firm. All in all, he did it because it seemed like a good idea at the time.
In economics-speak, all those explanations add up to the following. Henry and his bosses simply ignored the consequences for the prudent investor or for the country as a whole — even though it had occurred to them that there was a chance that something might have gone wrong.
Let’s say this in general terms. Wall Street firms had no reason to internalize the issues with systemic risk — that is, they each ignored the downside to the entire system from all of them taking on too much risk, because each of them only contributed a small amount to it. Instead, each of them pursued their own selfish interests, and made out well in the short run, sacrificing system-wide long run stability.
Those of us who live in high tech land noticed the odd behavior of Wall Street a while ago. Finally, it seems, the macroeconomics policy crowd has started to notice the same issues, and has started to argue that — perhaps — it is time to reign this in a bit. When a free market guy like Roberts notices, you know that the sensible people are finally thinking this one through.
Like I said, better late than never.
Now, on to the serious conversation: what to do about it….I am not sure what the right answers are, but limits on executive bonuses seems like a band-aid for a systemic issue. It is too much to ask a manager who makes several million dollars a year to stop gaming the system, but it might be reasonable to ask for better auditing, more transparency for investors, tighter capital requirements for firms taking risky actions, and a few others unpleasant measures that might help us all avoid these system-wide problems.
Oh yes… until then, the executives at Goldman might consider a public spirited gesture or two, such as — I dunno’ — donating a fraction of their recent profits to the New York Fire Department.
"Even guys like Roberts can see that something is amiss." So this time is different?
I want to believe that, I really do.