I've been looking forward to Becker's blog posting on sub-prime for a while. I think the current financial crisis will be to economic liberalism what Iraq was to political liberalism: a failure so vast, so shameful, that many will be led to re-assess their world view.
So what does Chicago-school Becker make of it?
He starts with a great piece of fighting rhetoric: The "belief in the beneficial effects of greater knowledge aboutmortgage terms is inconsistent with the evidence that the mostsophisticated banks and investment companies, including Merrill Lynch,Citibank, and Morgan Stanley, have written down their housinginvestments by billions of dollars. No one can reasonably claim that these banks lacked the skills andknowledge to evaluate all the terms of, or the likelihood of repayment,on the subprime and other mortgages that they originated or held asassets."
Don't try to say people were mis-sold mortgages, because that would imply that the financial sophisticates in the banks were also mis-sold mortgage-related products.
Don't be misled by faulty inference in rhetorical clothing. What the pyramid of mis-selling in this crisis shows me is that, for every buyer in the world, there exists a product that is both just beyond their level of comprehension and also incredibly enticing. From a marketing point of view, the financial engineering of the past 10 years can be thought of as an effort to systematically develop products that fit this bill at every level of the financial system. As the fund managers become more sophisticated, so the volatility option swaps become less decypherable.
The NINJA home owner is to their mortgage contract just as the portfolio manager is to the credit derivative. It promises what s/he wants, the sales person is the sort you aspire to become, to marry, to date ... The banks, I am told by a City trader who got stung by the crisis, were very sophisticated at doing psychological profiles of the portfolio managers they were selling to. Should the salesperson be a young intelligent graduate? what gender and sexual orientation? a potential sports partner? should hospitality be for Wimbledon or Covent Garden or something less salubrious altogether? One day we might get a leak of one of the banks' Customer Relationship Management systems to see the trace of these selling techniques.
Put professional pesuasion techniques to the service of huge financial rewards, and the whole system will be shot through with mis-selling. In the case of the financial system, this means that throughout the economy, bad investments, bad allocations of risk and economic decisions with great long term repurcussions will have been encouraged.
The combination of the personal computer, the MBA and the theory of Principal/Agent incentives destroyed an older financial system where technology required a more "craftsman-like" approach. The system is broken. What is Becker's solution? He doesn't think more regulation is the answer: "I am skeptical of additional government interventions into a housing market that already has too much."
In pointing to housing market regulations, Becker ignores the financial market government interventions that are really at stake in creating the pyramid of mis-selling. At the base of this is the "Lender of Last resort" guarantee that we the tax-payers offer banks, as well as the implicit political contract that we won't let a major part of the financial system go bust. All these financial market guarantees worked in the world before the financial system became manipulable by swarms of three-person teams of quant, pockets (deep ones, to seed a fund) and mouth (smooth, to sell the product).
I think there are two paths for financial markets after the crunch: hyper-regulation or radical disengagement. The path to hyper-regulation is quite natural: as we recognise that the old framework pre-supposed behaviour that can no longer be assumed to be generated by the system itself, we impose rules to constrain behaviour to that which is needed. This is the same twist that has led policy in many domains to become increasingly nannyish.
I am disappointed not to see Becker defending the alternative: radical disengagement. To say that once we are through with the credit crisis, lender of last resort will be taken away. Savers will be on their own in storing value; investors will need to convince savers they are doing the real thing. Pulling the "last resort" rug out from under Big Finance's balance sheet would have radical consequences: a whole new generation of institutions will need to develop reputations for trustworthiness, and will do so in completely new ways. Some of those institutions will look like web innovations available today - zopa, or kiva.
Economic liberalism is going to go through a very rough patch because of the foul mess of the system it has championed. The lesson that the Chicago-school of liberalism taught boils down to a trust that decentralisation will guard against the abuse of power by dividing power. In the times ahead, economic liberals should return to this core, even if that means contemplating a greater radicalism than they imagined.
Gary Becker, this is once again a time for radicalism.
