Bad rules produce bad outcomes: underlying public-policy causes of the U.S. financial crisis.

• Author: Ely, Bert
• Position: Report

The current global financial crisis is the worst economic crisis since the Great Depression, with no end in sight. Already, much political finger pointing has occurred, with most of those fingers pointed at supposedly greedy bankers, investors, and hedge-fund managers as well as the financial deregulation of recent decades. Governments everywhere are rushing to enact new regulatory protections to prevent another crisis of this magnitude. Yet if history is any guide, these new regulations will set up the global economy for yet another financial crisis, perhaps worse than the present one, or create regulatory straitjackets that will greatly impede economic growth.

This article will first explore the interactions between finance and human nature, for public policymaking--enacting laws and adopting regulations--that ignores or misinterprets those interactions, is doomed to fail. Indeed, policymaking that responds to symptoms and consequences of perceived problems, rather than forthrightly addressing the underlying causes of real problems, will introduce greater fragility into the financial system.

After drawing observations from an analysis of interactions between finance and human behavior, I will then examine 11 underlying public-policy causes of the financial crisis and offer recommendations for addressing those causes, or at least ameliorating their deleterious effects.

Interactions between Finance and Human Nature

The current financial crisis represents a collision between finance and human nature. The consequences of this collision are as a predictable as the consequences of a collision between human nature and the physics of the real world. Unfortunately, politicians either seem oblivious to or deliberately ignore the interactions between finance and human nature when enacting laws and regulations affecting financial activities.

Behavioral economics seeks to explain the role of human behavior in economic decisionmaking. That is, certain aspects of human nature, of how human beings approach financial decisionmaking, are extremely critical in understanding the underlying causes of the current financial crisis. Misunderstanding how humans approach financial decisionmaking leads to policymaking that creates a frequently refreshed hothouse environment in which financial crises flower every decade or so.

To put this point another way, most people make financial decisions that seem rational to them at the time even though the aggregate effect over time of thousands or millions of similar decisions may have disastrous macroeconomic or social consequences. In particular, if people, as individuals or as managers of organizations, make decisions that appear to them to be in their self-interest under the laws and regulations in effect at that time ("the rules of the game"), but the product of those decisions, when viewed after the fact, is not desirable, then clearly the rules of the game had a negative impact on that decisionmaking. Hence, bad rules produce bad outcomes.

The following is a discussion of five aspects of human behavior that relate to finance and therefore must be taken into account when establishing the rules of the game as they apply to financial transactions and outcomes. Alter the rules of any game--baseball, football, basketball, or finance--and the players will alter the way they play the game. Key to improving the game is to give players an incentive to act in their own self-interest while also maximizing the outcome of the game for all concerned.

Arbitraging the Rules of the Game in an Attempt to Gain an Advantage

Trying to arbitrage the rules of the game--interpreting the rules in a manner that seems to favor the decisionmaker--is a very understandable human trait. After all, successful, lawful arbitrages reduce costs, which in turn increases the profits, or capital, created by the transaction. Lawfully arbitraging the Internal Revenue Code and other tax laws is so widespread, and readily accepted, that insufficient thought is given to the distorting effect on economic decisionmaking of those arbitraging activities.

Laws and regulations governing financial activities and institutions present another significant arbitraging opportunity. It is nearly certain that in the aftermath of the current crisis Congress will enact new laws intended to prevent another crisis, financial "reforms" that most likely will contain the seeds of the next financial crisis.

Attempting to Profit from a Positive-Sloping Yield Curve

One aspect of interest rates is that much of the time short-term interest rates are lower than long-term interest rates--that is, most of the time, the interest-rate yield curve has a positive, or upward, slope from left to right, from short term to long term. Hence, an investor, when financing a long-term financial asset, such as a 30-year home mortgage, will often earn a higher profit by financing that asset with short-term funds that are frequently rolled over or refinanced during the life of the asset than by financing the asset with equity capital or with debt carrying a maturity comparable to the maturity of the asset. Financing long-term financial assets with short-term debt is called "maturity mismatching." While seemingly more profitable, maturity inismatching is quite risky because short-term interest rates sometimes rise above long-term rates.

The savings-and-loan (S&L) crisis of the early 1980s represents a classic example of the dangers of maturity mismatching, yet its lessons seem to have been quickly forgotten, for widespread maturity mismatching has occurred in recent years, as evidenced by the liquidity squeezes many investors and financial institutions have experienced, notably in auction-rate securities and structured investment vehicles (SIVs). Despite the readily evident dangers of maturity mismatching, there is good reason to believe that future financial players will ignore history, again, and try to profit from maturity mismatching.

Overextrapolating Trends

One widespread aspect of human nature is to overextrapolate trends, especially when the trend is wealth enhancing. This tendency is especially evident with regard to asset prices--stock prices and the value of homes. People like good news because that usually means their income and wealth are rising. Consequently, most people tend to tune out bad news and contrarian points of view during good times and good news and contrarian points of view during bad times. This tendency to overextrapolate magnifies swings in economic activity.

While the tendency to overextrapolate is quite evident among individuals in making personal financial decisions, it also occurs in businesses and other organizations. It is difficult for people within organizations, and especially those in niddle management or in riskmanagement positions, to counter conventional thinking about current market trends. For example, news accounts have reported on how senior management at Fannie Mae and Freddie Mac ignored warnings from lower-level personnel that home prices had become overinflated. Fannie and Freddie are now in government conservatorship, similar to Chapter 11 bankruptcy.

Getting Caught Up in Herd Behavior

Overextrapolating trends leads to another aspect of human behavior--herd behavior, which seems to become more intense the further a trend goes without reversing. Charles Mackay was an early observer of this behavior in his 1841 book, Extraordinary Popular Delusions and the Madness of Crowds. Many of Mackay's observations are still highly relevant today.

Interestingly, it appears that herd behavior is quite prevalent among more financially sophisticated folks, if not more so, than it is among the less sophisticated financially. Arguably, herd behavior among financial sophisticates has been strengthened by financial engineering since rigid mathematical formulae often are premised on simplistic, untested, yet widely held assumptions about what happens at the extremes of statistical distributions. Despite numerous financial explosions rooted in financial engineering, such as the popularity of portfolio insurance prior to the stock-market crash of 1987, the meltdown of Long-Term Capital Management in 1998, and the more recent failure of credit-rating models, rapid increases in computing power and seemingly more powerful quantitative techniques suggest that computer-driven herd behavior is alive and well and perhaps nore dangerous than ever.

Placing Excessive Reliance on Expert Opinions

Another aspect of human behavior that bears on financial decisionmaking is extensive reliance on expert opinions, specifically accounting opinions rendered by government-certified public accountants (CPAs) and government-endorsed credit rating agencies, notably the Big Three--Moody's, Standard & Poors, and Fitch.

The concept of the division of labor, while quite valid, by its very nature fosters the creation of highly specialized expertise, such as judging the reasonableness and fairness of financial statements or likelihood that principal and interest on a particular debt security will be paid when contractually due. In an increasingly complex financial world, investors and financial managers place much greater reliance on the valuations and evaluations of experts and unrelated third parties than was the case in earlier, simpler days.

While the division of labor can justify much of today's reliance on expert opinion, some of that reliance stems from two other human characteristics--laziness and the power of endorsement. Financial and legal analysis of complex financial transactions is hard...