“If there is a single episode in this entire 18 months that has made me more angry, I can’t think of one other than AIG. AIG exploited a huge gap in the regulatory system.”
These words were spoken by Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System in testimony on Tuesday, March 3, 2009 before the Senate Banking Committee. Bernanke expressed further anguish at the behavior of AIG on Sixty Minutes Sunday evening.
Professor, welcome to the real world!
Treasury Secretary Timothy Geithner echoed some of the same feelings in testimony on the same day before the House Ways and Means Committee when he stated that some areas of AIG were not under “adult supervision.”
Come on, Timmy, I try and stop people from making the same claim about the bank bailout plans of the Treasury Department.
Is the Obama team becoming so defensive about their program that they are beginning to resort to name calling to deflect criticism?
Did AIG exploit a huge gap in the regulatory system? Yes, they did. And that is what people do over and over again in the real world. It is called “responding to incentives.” The world is full of incentives…some positive incentives…some negative incentives…and so on. That is what the study of economics is all about! Give the people in the Obama administration a copy of “Freakonomics”!
I have been in the Federal Reserve System…I have worked for a cabinet Secretary in Washington, D. C….and I have run publically traded financial institutions…and one thing is especially clear…people respond to incentives.
Some of those incentives are to innovate in products and markets. And, what do economists tell potential innovators to look for? Missing markets. Incomplete Markets. Places that are not being served or regulated.
Why do you look in these areas? Well, because that is where a person…or a business…can find a place to achieve a competitive advantage. Being a “first-mover” or a “second-mover” into a market is a way to achieve exceptional returns…at least for a short time period. And, this is plenty of incentive to draw people into the effort.
It is a highly risky effort and a lot of people and businesses fail because it is so risky. But, the incentives are substantial enough that people are continually drawn into the exercise.
A competitive advantage may not last for a very long time. People that find opportunities to arbitrage markets…traders…may find segments in a market place to exploit for a period of time…but, over time competitive advantage does not seem to last for specific trading schemes…see Enron and Long Term Capital Management. In such cases, you need to keep coming up with something new. That is what businesses producing Information Goods do.
One of the games played in the financial services area…and I have experienced this in my professional life beginning in the 1960s…is to find the hole in the regulatory structure. It is a game that the regulators are always behind in. The private sector does something…the regulators close the gap with new regulations…the private sector finds a way around this…and the regulators have to close the gap again. And, the game goes on and on because the incentives are such that it is still worthwhile to the private sector to continue to innovate.
Furthermore, anything the government does sets up incentives. And that is why the Obama “recovery plan” is so important…it changes a lot of the incentives that exist within the economy…for better or for worse. Notice the long, long lines of governors, mayors, and other officials that have gathered with their hands out for funds from the “recovery plan”. I am not going to comment any further on the “recovery plan” at this time other than to just highlight the fact that this plan changes incentives…regardless of how much stimulus it provides.
But, to be an equal-opportunity critic, I must mention that the previous administration created incentives that resulted in the present financial crisis. Maintaining negative real rates of interest for at least 18 months created plenty of incentive to leverage and innovate in financial structures and instruments. This period of innovation has created a massive crisis with respect to asset values. (For more on this see my blog post “AIG and Our Core Economic Issue: Unknown Asset Values” http://seekingalpha.com/article/123867-aig-and-our-core-economic-issue-unknown-asset-values.) In my mind, there is going to have to be a resolution to the asset value problem before any stimulus package is going to have much of an effect on the economy.
Anytime the government attempts to impose its hand on the private sector “things happen.” The government is just not attuned to enter the very complex tangled web of the real world with simplistic plans to “set things straight.” Even within the government public officials have started pointing fingers at each other when events don’t go as desired. Last night I saw Barney Frank interviewed by Rachael Maddow. Frank made it very clear that we got into the AIG mess because “the Fed”, without coming to Congress, gave AIG $85 billion last September and this started off all the mess. And, the reason why this bonus thing and other events have occurred is that “the Fed” without the advice or consultation of Congress gave AIG the $85 billion with “no strings attached”!
Wow! Go figur’ that, will ya!
Now, the Wall Street Journal has the headline this morning…”Obama to Avoid Auto Bankruptcies.” The “experts” in the government, we are told, are going to restructure General Motors Corp. and Chrysler LLC outside of the bankruptcy courts. This, we are expected to believe, will give the taxpayers a better and more protected solution than will a court solution. We wait the conclusion…
The real world is tough. People don’t always do what you want them to do. Incentives matter. We must be careful about the incentives we are creating for the future, for one other fact from the field of economics is very clear: sometimes it takes a long time for the full effect of incentives to work their way through an economy. As a consequence, we can often lose sight of the cause of a problem because the incentives that created the problem are embedded somewhere in the distant past.