Wednesday, October 6, 2010

Hatchet Job

. Wednesday, October 6, 2010

Charles Ferguson, the maker of Inside Job, is losing credibility almost by the day. I previously discussed here and here how he's got the history of the U.S. economy, financial crises, and regulation wrong. But those mistakes are at least somewhat academic, if pretty basic. In his anti-Summers companion piece, however, Ferguson reveals that he is simply not a reliable source:

In 2005, at the annual Jackson Hole, Wyo., conference of the world's leading central bankers, the chief economist of the International Monetary Fund, Raghuram Rajan, presented a brilliant paper that constituted the first prominent warning of the coming crisis. Rajan pointed out that the structure of financial-sector compensation, in combination with complex financial products, gave bankers huge cash incentives to take risks with other people's money, while imposing no penalties for any subsequent losses. Rajan warned that this bonus culture rewarded bankers for actions that could destroy their own institutions, or even the entire system, and that this could generate a "full-blown financial crisis" and a "catastrophic meltdown."

When Rajan finished speaking, Summers rose up from the audience and attacked him, calling him a "Luddite," dismissing his concerns, and warning that increased regulation would reduce the productivity of the financial sector.


Brad DeLong digs up this "attack":

I speak as a repentant, brief Tobin tax advocate, and someone who has learned a great deal about the subject, like Don Kohn, from Alan Greenspan, and someone who finds the basic, slightly Luddite premise of this paper to be largely misguided. I want to use an analogy, not unlike the one Hyun Song Shin did, but to a rather different conclusion.

One can think of the history of transportation over the last two centuries as reflecting a gradual and determined move away from arm’s length transactions. People once supplied their own power. Then, they started carrying on transportation using tools that they owned. Then, they increasingly relied on tools that other people owned that were provided by intermediaries.

In that process, the volume of transportation activity increased very substantially. Over time, people became almost entirely complacent about the safety of the transportation arrangements on which they relied. Large sectors of the economy came to be organized in reliance on the capacity of planes to fly and trains to move. The degree of dependence on individual hubs—like O’Hare Airport—increased substantially. The worst accidents came to be substantially greater conflagrations than they had ever been in an earlier era.

Yet, we all would say almost certainly that something very positive and overwhelmingly positive has taken place through this process. Something that is overwhelmingly positive for individuals is that the number of people who die in transportation-related episodes is substantially smaller than it was in an earlier era.

The best single way to think about the process of financial innovation is as representing a similar process of movement across spaces, spanned not by physical space, but by different states of nature. It seems to me that the overwhelming preponderance of what has taken place has been positive. It is probably true that—as we didn’t use to have transportation safety regulation and we do now—an evolving system does require an evolving regulatory response.

But it seems to me that one needs to be very careful about stressing the negative aspects of the evolution, relative to the positive aspects of the evolution. I was going to make the same point that Don Kohn made about the Japanese financial system and the Scandinavian financial system standing out for the magnitude of damage done and the reliance on vanilla banking, relative to other activities.

Something similar could be said about the history of U.S. business cycles. The history of the business cycles prior to 1970 would place very substantial reliance on problems that came out of the financial sector and the regulation of the financial sector.

I was surprised by the tone of the recommendation around the incentives because it seems that if you take what is the central, most plausible area of concern that is suggested by what takes place in the paper, it is the notion that speculation involves negative feedback over a certain range, then positive feedback once you get outside of that corridor, and that process is very substantially exacerbated by hedge fund phenomena. Indeed, if one looks at the Shleifer-Vishny paper that Mr. Rajan refers to, hedge funds and the behavior induced by hedge funds and hedge fund liquidations are the central example. Yet, hedge funds would be the primary example we have of a financial institution where those who were running it did in fact have, as Raghu Rajan recognized in his comment on Long-Term Capital Management, very substantial wealth that was involved.

While I think the paper is right to warn us of the possibility of positive feedback and the dangers that it can bring about in financial markets, the tendency toward restriction that runs through the tone of the presentation seems to me to be quite problematic. It seems to me to support a wide variety of misguided policy impulses in many countries.

I would say as a final example of what has come out of the discussion for the 1987 crisis is that if those who wish to protect their assets had bought explicit puts rather than portfolio insurance, the situation would have been substantially more stable. That also argues for the benefits of more open and free financial markets, rather than for the concerns they bring.


Summers' critique is not dismissive at all. He deals with Rajan's argument with respect and interest. He acknowledges the strengths of it (as he sees them), and clearly expresses where and why he disagrees.

DeLong says that, despite Ferguson's mischaracterization, Rajan was right and Summers was wrong. If you take a short view (i.e. 2005-2010), Rajan clearly is right and Summers clearly is wrong. But if you take a long view, as Summers is obviously trying to do, it's not so clear. Has the "increased transportation" of finance really hurt the global economy over the past 50 years? 150 years? There have been a multitude of booms and busts during that span, but in the end it's hard to argue that we should entirely forego checking accounts and ATMs and electronic transactions and futures contracts and etc. These innovations have added an enormous amount of value to society, and in general has made the economy much safer and secure than it would otherwise be.

I still want to see Inside Job. But I'll be watching with a more skeptical eye now.

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