May 24, 2011
Note that ratings were crucial to both these operations – the banks could only reduce required capital if the securities received high ratings from those ratings agencies that held a U.S. government-conferred designation as Nationally Recognized Statistical Rating Organizations (NRSROs); basically, Moody’s, S&P and Fitch.
This put overwhelming pressure on ratings agencies to produce AAA ratings to feed ballooning demand for asset-backed securities, whose quality was actually declining fast as the best pickings were snapped up. The ratings agencies complied, using ratings models that claimed support from economic theory.
Two of the essayists, Friedman and American Enterprise Institute Fellow Peter Wallison, argue that the ratings agencies didn’t produce more-accurate ratings because they had been granted an oligopoly and were thus shielded from market competition by the government NRSRO designation; Posner debunks this however with a nice bon mot, “But what would have been the market for such wet-blanket raters?” The raters were competing in a market not to produce accurate ratings, but ratings favorable to the issuers; if investors wanted more accurate ratings, they could have paid independent advisors for them.
The economists dunnit
As you may have noticed, the foregoing does not make accusations against bankers, or even ratings agencies. (Only one author, Nobelist economist Joseph Stiglitz, points fingers, but he spreads the blame widely.) It’s all about the structure of the containment vehicles and conduits – that is, the regulations and government policies. The bankers and raters will follow the laws governing them, just as the laws of fluid dynamics govern fluids, which then do what the containment structures make them do.
So who is to blame for the mess? Steered away from blaming others by journal style guidelines, several of the economists place the blame squarely in the only place they are allowed – on themselves.
Two articles advance this nostra culpa, one by MIT economist Daren Acemoglu, and a yet stronger one by a group of David Colander, a Distinguished Professor of economics at Middlebury College, and six other economists.
One notion that Acemoglu says was held by economists (and many others) is a notion that I have tried to debunk numerous times. Acemoglu himself says that “It is also one that I strongly believed in.” This now-refuted idea is that “we could trust the long-lived large firms – the Bear Stearnses, the Merrill Lynches, the Lehman Brothers of the world – to monitor themselves, because they had accumulated sufficient ‘reputation capital’ that they would not want to waste it.” In other words, we could trust their brand. “We should not have put our faith in individuals monitoring others simply because they were part of larger organizations,” Acemoglu added.
I believe this should have been obvious, particularly to an economist. I’ll come back to this, but first let’s go on to the more sweeping indictment in the essay by Colander et al, titled “The Financial Crisis and the Systemic Failure of the Economics Profession.”
I find this article deeply satisfying because what it says is precisely what I thought when I first went to an economics conference many years ago. At the time, I was a newly minted Ph.D. in mathematics who happened to have joined a brokerage firm, knowing exactly zero about economics.
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