Archive for the ‘economy’ Category

I ended Friday’s post with the point that, contrary to what John Cassidy and Barry Ritzholtz assume in their arguments, what is rational is not necessarily good. The blurring of the line between reason and goodness comes, ultimately, from the ascendancy of atheism and, hence, materialism among intellectuals. In place of fundamental and eternally-established goods present in a theistic worldview, materialism turns to reason as capable of determining what’s good. I don’t know where Cassidy and Ritzholtz stand on the existence of God, but they both argue from materialist assumptions. To illustrate the difficulty that causes in seeing how to deal with the sources of the financial crisis, let’s take a look at a few quotations from Cassidy’s arguments.

In explaining the problems with getting cooperative behavior in a prisoner’s dilemma, Cassidy writes:

Attempts to act responsibly and achieve a coöperative solution cannot be sustained, because they leave you vulnerable to exploitation by others. If Citigroup had sat out the credit boom while its rivals made huge profits, Prince would probably have been out of a job earlier. The same goes for individual traders at Wall Street firms. If a trader has one bad quarter, perhaps because he refused to participate in a bubble, the results can be career-threatening.

In these two examples, Cassidy assumes that, at base, the good is self-interest. He notes that Prince would have been out of a job if he did not lead Citigroup into the credit boom and that individual traders who do not participate in bubbles stand to lose their job or see their career prospects damaged. All of those things may be true, but we can see fairly easily that, although the decision of a trader to participate in a bubble may be rational if he has the end of keeping his trading job, it would be irrational if he has the goal of only earning a living through activity that did not lead to long-term harm to himself and others. Indeed, if he has the second goal, his behavior in participating in the bubble would be illogical.

Let’s take another example. Writing about the subprime mortgage boom, Cassidy notes that

…many mortgage companies extended home loans to low- and middle-income applicants who couldn’t afford to repay them. In hindsight, that looks like reckless lending. It didn’t at the time. In most cases, lenders had no intention of holding on to the mortgages they issued. After taking a generous fee for originating the loans, they planned to sell them to Wall Street banks, such as Merrill Lynch and Goldman Sachs, which were in the business of pooling mortgages and using the monthly payments they generated to issue mortgage bonds. When a borrower whose home loan has been “securitized” in this way defaults on his payments, it is the buyer of the mortgage bond who suffers a loss, not the issuer of the mortgage.

Here, Cassidy gives the basic logic of companies giving home loans to people who cannot afford them. (For a first-person account of this logic in action, listen to This American Life, Episode #390, Return to the Giant Pool of Money. The whole episode, really the whole series of episodes about the economic crisis, is great, but the relevant section starts at about 17:05 on my podcast version.) Again, we can call the logic rational, but only if the goal of the mortgage company is to make money on a product that doesn’t have intrinsic value. If we assume that a mortgage company’s goal is to make money by providing loans to people who have a good likelihood of paying them back, then the mortgage companies Cassidy describes were acting completely irrationally.

So, if we cannot judge the goodness of an action by its rationality, we need to have another way of determining whether an action is good. This is where externally-established standards come into play. In a column in last Monday’s New York Times, David Brooks wrote about such standards and the role they have played in American national history. After quoting several statistics about ballooning personal and public debt in the U.S., Brooks makes the following observation and recommendation:

These may seem like dry numbers, mostly of concern to budget wonks. But these numbers are the outward sign of a values shift. If there is to be a correction, it will require a moral and cultural movement.

Our current cultural politics are organized by the obsolete culture war, which has put secular liberals on one side and religious conservatives on the other. But the slide in economic morality afflicted Red and Blue America equally.

If there is to be a movement to restore economic values, it will have to cut across the current taxonomies. Its goal will be to make the U.S. again a producer economy, not a consumer economy. It will champion a return to financial self-restraint, large and small.

In the broad strokes, Brooks is exactly right. We do need a “moral and cultural movement” to confront the shift in values away from discipline and rectitude, and it must be broadly-based. Whoever would like to be a part of that movement would do well to consider these two exhortations from The Hidden Words of Baha’u’llah:

O MY SERVANT! The basest of men are they that yield no fruit on earth. Such men are verily counted as among the dead, nay better are the dead in the sight of God than those idle and worthless souls.

O MY SERVANT! The best of men are they that earn a livelihood by their calling and spend upon themselves and upon their kindred for the love of God, the Lord of all worlds.

Only with such standards in mind can we use rationality to determine which actions are good and which are not.

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John Cassidy at The New Yorker has a post at his new blog, Rational Irrationality, defending his position from an article last week that the financial crisis was caused by individuals making completely rational decisions that, when aggregated at the collective level, turned out to be completely irrational. In the original article, Cassidy explains that the Prisoner’s Dilemma is at the root of the financial crisis, and he’s certainly right about that. Cassidy’s explanation of the basic dynamics of the Prisoner’s Dilemma and their application to business and finance is as good as you’ll find, so I’ll quote it in full here. (Note: Charles Prince was the Citigroup CEO when Citigroup got into the business of CDOs.)

Because financial markets consist of individuals who react to what others are doing, the theories of free-market economics are often less illuminating than the Prisoner’s Dilemma, an analysis of strategic behavior that game theorists associated with the RAND Corporation developed during the early nineteen-fifties. Much of the work done at RAND was initially applied to the logic of nuclear warfare, but it has proved extremely useful in understanding another explosion-prone arena: Wall Street.
Imagine that you and another armed man have been arrested and charged with jointly carrying out a robbery. The two of you are being held and questioned separately, with no means of communicating. You know that, if you both confess, each of you will get ten years in jail, whereas if you both deny the crime you will be charged only with the lesser offense of gun possession, which carries a sentence of just three years in jail. The best scenario for you is if you confess and your partner doesn’t: you’ll be rewarded for your betrayal by being released, and he’ll get a sentence of fifteen years. The worst scenario, accordingly, is if you keep quiet and he confesses.
What should you do? The optimal joint result would require the two of you to keep quiet, so that you both got a light sentence, amounting to a combined six years of jail time. Any other strategy means more collective jail time. But you know that you’re risking the maximum penalty if you keep quiet, because your partner could seize a chance for freedom and betray you. And you know that your partner is bound to be making the same calculation. Hence, the rational strategy, for both of you, is to confess, and serve ten years in jail. In the language of game theory, confessing is a “dominant strategy,” even though it leads to a disastrous outcome.
In a situation like this, what I do affects your welfare; what you do affects mine. The same applies in business…. If Merrill Lynch sets up a hedge fund to invest in collateralized debt obligations, or some other shiny new kind of security, Morgan Stanley will feel obliged to launch a similar fund to keep its wealthy clients from defecting. A hedge fund that eschews an overinflated sector can lag behind its rivals, and lose its major clients. So you can go bust by avoiding a bubble. As Charles Prince and others discovered, there’s no good way out of this dilemma. Attempts to act responsibly and achieve a coöperative solution cannot be sustained, because they leave you vulnerable to exploitation by others. If Citigroup had sat out the credit boom while its rivals made huge profits, Prince would probably have been out of a job earlier. The same goes for individual traders at Wall Street firms. If a trader has one bad quarter, perhaps because he refused to participate in a bubble, the results can be career-threatening.

Following the argument in this last paragraph, Cassidy argues that the situation should be dubbed “rational irrationality,” as the rational behaviors of individual traders or firms leads to irrationality at the collective level. In other words, what’s good for all these individuals ends up being bad for the collective of which they’re a part. In this case, that collective happens to include the rest of us, too.

As Cassidy notes in his follow-up blog post, Barry Ritzholtz disagrees that the individual behavior Cassidy describes is rational. Quoting Cassidy:

Ritholtz writes: “ ‘Rational Irrationality’ asks us to ignore the repercussions of our behaviors. We can rationalize short term gains at the expense of long term losses, because we need to obtain quarterly profits regardless. Apparently, when it bankrupts the company, only then with the benefit of hindsight can we see what went wrong. I am terribly sorry, but that is precisely the sort of thinking that led to the crisis in the first place. Making loans to people who cannot pay them back is not rational when its profitable—its NEVER rational.”

As I mentioned, Cassidy defends himself against Ritzholtz’s argument, and at the risk of having this post be overly long, I’d like to quote the defense at length.

From a macro point of view, Ritholtz is right. Directing capital to people or firms who can’t afford to service it amounts to misallocating resources, and it is a form of market failure. But from a micro point of view, things are very different. Most of the people issuing sub-prime loans were loan officers at mortgage lending firms, such as Ameriquest and New Century, who were paid on commission. Neither they nor their bosses had much interest in whether the borrowers could repay the loans, and for good reason. They were intending to sell them on to Wall Street firms for securitization. If the default rates turned out to be higher than expected, it was the purchasers of sub-prime securities that stood to lose out, not the loan originators.
Now, this was certainly myopic thinking, but it wasn’t irrational. During the good years, some of these brokers racked up seven-figure commissions and bonuses. (See, for example, the excellent account of subprime and Alt-A lending in “Chain of Blame,” by Paul Muolo and Mathew Padila.) To be sure, some (many) of them ended up losing their jobs when the bubble burst, but that doesn’t invalidate the point: pushing sub-prime mortgages onto folks that couldn’t afford them was a lucrative business, and the people who were involved in it it were simply reacting to the price signals that the market was providing to them.
Ritholtz focuses on the role of the Wall Street firms. He writes: “On a risk adjusted basis, the behaviors of Citi, Bear, Lehman, New Century and others was hardly rational. Call it whatever you want, but do not forget this simple fact: It was the sort of narrow, risk-ignoring thinking that is ALWAYS rewarded in the short term, and ALWAYS punished in the long term.”
Sadly, this isn’t true either. During a bubble, the risks are rarely evident. If they were evident, asset prices would adjust and the bubble would pop. From the point of view of a trader, or a CEO, the bigger risk is missing out on the easy money that is to be made. In such an environment, the rational thing to do is surf the bubble.

After reading through this argument, it becomes clear that, at root, Cassidy and Ritzholtz disagree about what the word “rational” means. It’s here that we should step back. Both Cassidy and Ritzholtz think that, for any individual, “rational” means whatever is in that individual’s interests. It’s just that they apply different time frames to the interest. Cassidy thinks that short-term interests often outweigh long-term interests because a person looking at the long term to determine his short-term actions may guarantee that he’s not around for the long term. Ritzholtz, on the other hand, thinks that long-term interests can be seen, at least if one has a sense of history, and must be taken into account in the short term. Hence they disagree about what’s “rational”.

I’d like to suggest that they’re both missing part of the picture. They both assume that to declare something “rational” is to declare it morally good. Because something is rational, however, does not mean it is good. To determine whether a practice — selling CDOs, say — is good, I must have a set of criteria about what constitutes goodness. I may then use rational thought to determine whether a particular practice meets those criteria. But if the criteria are flawed, the practice may be rational — i.e. it may follow logically from or be consistent with the criteria — but it will not be good.

Rather than stretch your post-length tolerance any further, I’ll turn to this point in my next post. If you’d like a hint of what’s to come, you might like to read this op-ed from David Brooks at The New York Times earlier this week.

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Following from yesterday’s post on the relationship between capital and labor, I want to post today on markets and the role of financial crises. I’ve read Paul Krugman’s piece on the sate of economics from the weekend’s New York Times Magazine and recommend it to you all. (Krugman also has a post on his blog, The Conscience of a Liberal, responding to a few criticisms that came up, and Andrew Leonard has his take over at Salon’s How the World Works.)

In the Magazine article, Krugman lays out a narrative that attempts to explain the trends in the academic study of economics since its inception. He then uses that narrative to make the case that the current recession, sparked by the crisis of 2008, must in turn spark a re-evaluation of dominant economic theory. He focuses most of his attention on developments of the 20th century, specifically the response of John Maynard Keynes to the Great Depression and the later resistance to Keynes, led by Milton Friedman. Krugman, in response to the current situation at least, is an unabashed Keynesian, believing that governments must drive demand through spending in times of severe recession.

Most interesting to me, though, is Krugman’s analysis of the shortcomings of economics:

Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system. If the profession is to redeem itself, it will have to reconcile itself to a less alluring vision — that of a market economy that has many virtues but that is also shot through with flaws and frictions.

Krugman goes on to suggest how he thinks economics ought to develop:

There’s already a fairly well developed example of the kind of economics I have in mind: the school of thought known as behavioral finance. Practitioners of this approach emphasize two things. First, many real-world investors bear little resemblance to the cool calculators of efficient-market theory: they’re all too subject to herd behavior, to bouts of irrational exuberance and unwarranted panic. Second, even those who try to base their decisions on cool calculation often find that they can’t, that problems of trust, credibility and limited collateral force them to run with the herd.

So, Krugman wants an economics that acknowledges people’s irrationality and the dynamics of group behavior. That seems reasonable enough. What Krugman doesn’t seem to want, though, is an economics that considers that people might not be entirely self-seeking, either. On this point, I think, a Baha’i view can be helpful.

In his letter of 1931, know to us now as The Goal of a New World Order, Shoghi Effendi made the following comments about the forces contributing to the upheaval of the present-day world order:

The disquieting influence of over thirty million souls living under minority conditions throughout the continent of Europe; the vast and ever-swelling army of the unemployed with its crushing burden and demoralizing influence on governments and peoples; the wicked, unbridled race of armaments swallowing an ever-increasing share of the substance of already impoverished nations; the utter demoralization from which the international financial markets are now increasingly suffering; the onslaught of secularism invading what has hitherto been regarded as the impregnable strongholds of Christian and Muslim orthodoxy—these stand out as the gravest symptoms that bode ill for the future stability of the structure of modern civilization. Little wonder if one of Europe’s préeminent thinkers, honored for his wisdom and restraint, should have been forced to make so bold an assertion: “The world is passing through the gravest crisis in the history of civilization.” “We stand,” writes another, “before either a world catastrophe, or perhaps before the dawn of a greater era of truth and wisdom.” “It is in such times,” he adds, “that religions have perished and are born.”

Shoghi Effendi attends to the spiritual elements of a financial crisis – in this case, the Great Depression – and considers the wider effects such crises may have on people’s fundamental views of themselves and the world around them. While I doubt the current recession will be strong enough to spark such a change, there is no doubt that the continued upheaval of the world’s systems leads an increasing number of people open to the possibility that fundamental change is necessary. Such fundamental change requires us to reconsider economics in light not just of such factors as human irrationality and group dynamics, but also of human qualities such as a desire for unity and justice.

Writing in The Prosperity of Humankind in 1995 about the need for women to be accorded their rightful equal place in society, the Baha’i International Community had the following analysis:

The classical economic models of impersonal markets in which human beings act as autonomous makers of self-regarding choices will not serve the needs of a world motivated by ideals of unity and justice. Society will find itself increasingly challenged to develop new economic models shaped by insights that arise from a sympathetic understanding of shared experience, from viewing human beings in relation to others, and from a recognition of the centrality to social well-being of the role of the family and the community. Such an intellectual breakthrough—strongly altruistic rather than self-centered in focus—must draw heavily on both the spiritual and scientific sensibilities of the race.

Only when we are able to embrace both the scientific and the spiritual sides of our reality in shaping our economic analyses will our crises finally result in the victories for which we are destined.

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Yesterday was Labor Day in the U.S., and Michael Lind used the occasion to post an interesting article at Salon: “Who are the wealth creators?” In the piece, Lind argues against what he calls the libertarian right position that “economic growth is almost exclusively the result of investment decisions by a small number of rich individuals.” After quoting from Lincoln to show that Republicans have not always held such a view (nor do all now, I would say), Lind argues for another theory of the origins of economic growth, which states that

the true creator of wealth is, ultimately, the commonwealth – not only the political community, but the civilization that it shares with other nations. No technical invention or business innovation is a creation of something from nothing. All depend on the intellectual capital that the human race has accumulated since the Paleolithic period.

Calling this the commonwealth theory, Lind goes on to say that it

defines wealth broadly, as everything that conduces to the well-being of a community. Material production is only one of many activities that enrich a society. Public goods like safety and utilities and infrastructure and parks are part of the wealth that we share in common. So are many private goods that sometimes are best provided by the public, like public education and inexpensive healthcare.

Lind advances a wise view of wealth, taking into consideration the many ways in which a society develops, rather than just the monetary. Indeed, it conceptualizes wealth in a way that might help us practice Baha’u’llah’s admonition in the Gleanings: “All men have been created to carry forward an ever-advancing civilization.”

‘Abdu’l-Baha’s comments on the causes of and remedies for strikes give credence to this notion:

You have questioned me about strikes. This question is and will be for a long time the subject of great difficulties. Strikes are due to two causes. One is the extreme greed and rapacity of the manufacturers and industrialists; the other, the excesses, the avidity and intransigence of the workmen and artisans. It is, therefore, necessary to remedy these two causes.

It is, therefore, preferable for moderation to be established by means of laws and regulations to hinder the constitution of the excessive fortunes of certain individuals, and to protect the essential needs of the masses. For instance, the manufacturers and the industrialists heap up a treasure each day, and the poor artisans do not gain their daily sustenance: that is the height of iniquity, and no just man can accept it. Therefore, laws and regulations should be established which would permit the workmen to receive from the factory owner their wages and a share in the fourth or the fifth part of the profits, according to the capacity of the factory; or in some other way the body of workmen and the manufacturers should share equitably the profits and advantages. Indeed, the capital and management come from the owner of the factory, and the work and labor, from the body of the workmen. (Some Answered Questions, pp. 273-4)

In casting blame for strikes on both owners and laborers and in explaining that both owners and workers earn the profits of the company and thus generate wealth, ‘Abdu’l-Baha anticipates Lind’s commonwealth theory. In recognizing the role of both owners and workers and calling for profit-sharing, though, ‘Abdu’l-Baha does not advocate equality of distribution. He goes so far as to say that enforced equality would be to the detriment of society:

rules and laws should be established to regulate the excessive fortunes of certain private individuals and meet the needs of millions of the poor masses; thus a certain moderation would be obtained. However, absolute equality is just as impossible, for absolute equality in fortunes, honors, commerce, agriculture, industry would end in disorderliness, in chaos, in disorganization of the means of existence, and in universal disappointment: the order of the community would be quite destroyed. Thus difficulties will also arise when unjustified equality is imposed.

Perhaps instead of celebrating Labor, then, we should celebrate our common wealth, created from all our diversity of fortunes and honors.

(For an interesting look at the dangers of gross accumulation of wealth among a small minority in a society, see Luigi Zingales’s “Capitalism After the Crisis” at National Affairs. Thanks to David Brooks in today’s New York Times for the pointer.)

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Simon Johnson has an excellent post over at the New York Times’ Economix Blog, explaining that the recent financial disaster in the U.S. stems from three “pathologies” endemic to finance: (1) “the financial sector often acquires or aspires to political power”; (2) “the financial sector can obtain disproportionate power over industry”; and (3) “finance can also go crazy, running up speculative frenzies.” Johnson also shows the work of Presidents Andrew Jackson, Theodore Roosevelt, and Franklin Roosevelt in providing regulation to overcome those pathologies in previous eras.

I quoted a lengthy excerpt from The World Order of Baha’u’llah in a previous post, one sentence of which (p. 204) will suffice here:

The economic resources of the world will be organized, its sources of raw materials will be tapped and fully utilized, its markets will be cöordinated and developed, and the distribution of its products will be equitably regulated.

We’ve had a lot of market cöordination and development in recent years. There’s been so much, in fact, that we face the difficulty, as Johnson notes, of the financial sector being too large a proportion of the economy. What we could use more of now is equitable regulation. Such is the prescription of the Divine Physician.

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