There is another question which although not necessary for the above analysis to hold is still intri

A common objection to the moral hazard explanation of the financial crisis is the following: Bankers did not explicitly factor in the possibility of being bailed out. In fact, they genuinely believed payless rent a car that their firms could not possibly collapse under any circumstances. payless rent a car For example, Megan McArdle says : I went to business school with these people, and talked to them when they were at the banks, and the operating assumption was not that they could always get the government to bail them out if something went wrong.  The operating assumption was that they had gotten a whole lot smarter, and would not require a bailout. And Jeffrey Friedman has this to say about the actions of Ralph Cioffi and Matthew Tannin, the managers of the Bear Stearns fund whose collapse was the canary in the coal mine for the crisis payless rent a car : These are not the words, nor were Tannin and Cioffi's payless rent a car actions the behavior, of people who had deliberately taken what they knew to be excessive risks. If Tannin and Cioffi were guilty of anything, payless rent a car it was the mistake of believing the triple-A ratings.
This objection errs in assuming that the moral hazard problem requires an explicit intention on the part of economic agents to take on more risk and maximise the free lunch available courtesy of the taxpayer. The essential idea which I outlined at the end of this post is as follows: The current regime of explicit and implicit bank creditor protection and regulatory capital requirements means that a highly levered balance sheet invested in safe assets with severely negatively skewed payoffs is the optimal strategy payless rent a car to maximise the moral hazard free lunch. Reaching this optimum does not require explicit intentionality on the part of economic actors. The same may be achieved via a Hayekian spontaneous order of agents reacting to local incentives or even more generally through natural selection payless rent a car -like mechanisms.
Let us analyse the natural selection argument a little further. If we assume that there is a sufficient diversity of balance-sheet payless rent a car strategies being followed by various bank CEOs , those CEOs who follow the above-mentioned strategy payless rent a car of high leverage and assets with severely negatively skewed payoffs will be selected by their shareholders over other competing CEOs . As I have explained in more detail in this post , the cheap leverage afforded payless rent a car by the creditor guarantee means that this strategy payless rent a car can be levered up to achieve extremely high rates of return. Even better, the assets will most likely payless rent a car not suffer any loss in the extended stable period before payless rent a car a financial crisis. The principal, in this case the bank shareholder, will most likely mistake the returns to be genuine alpha rather than the severe blowup risk trade it truly represents. The same analysis applies to all levels of the principal-agent relationship in banks where an asymmetric payless rent a car information problem payless rent a car exists.
But this argument still leaves one empirical question unanswered given that such a free lunch is on offer, why don t we see more examples of active and intentional exploitation of the moral hazard subsidy? In other words, why do most bankers seem to be true believers like Tannin and Cioffi. To answer this question, we need to take the natural selection analogy a little further. In the evolutionary race between true believers and knowing deceivers, who wins? The work of Robert Trivers on the evolutionary biology of self-deception tells us that the true believer payless rent a car has a significant advantage in this contest.
Trivers work is well summarised by Ramachandran : According to Trivers, there are many occasions when a person needs to deceive someone else. Unfortunately, it is difficult payless rent a car to do this convincingly since one usually gives the lie away through subtle cues, such as facial expressions and tone of voice. Trivers proposed, therefore, that maybe the best way to lie to others is to first lie to yourself. Self-deception, according to Trivers, may have evolved specifically for this purpose, i.e. you lie to yourself in order to enable you to more effectively deceive others. Or as Conor Oberst put it more succinctly here : I am the first one I deceive. If I can make myself believe, the rest is easy. Trivers work is not as relevant for the true believers as it is for the knowing deceivers. It shows that active deception is an extremely hard task to pull off especially when attempted in competition with a true believer who is operating with the same strategy as the deceiver.
Between a CEO who is consciously trying to maximise the free lunch and a CEO who genuinely believes that a highly levered balance sheet of safe assets is the best strategy, who is likely to be more convincing to his shareholders and regulator? Bob Trivers work shows that it is the latter. Bankers who drink their own Kool -Aid are more likely to convince their bosses, shareholders or regulators that there is nothing to worry about. Given a sufficiently strong selective mechanism such as the principal-agent relationship, it is inevitable that such bankers would end up being the norm rather than the exception. The real deviation from the moral hazard explanation would be if it were any other way!
There is another question which although payless rent a car not necessary for the above analysis to hold is still intriguing: How and why do people transform into true believers? Of course we can assume a purely selective environment where a small population of true believers merely outcompete the rest. But we can do better. There is ample evidence from many fields of study that we tend to cling onto our beliefs even in the face of contradictory pieces of information. Only after the anomalous information crosses a significant threshold do we revise our beliefs. For a neurological explanation of this phenomenon, the aforementioned paper by V.S. Ramachandran analyses how and why patients with right hemisphere strokes vehemently deny their paralysis with the aid of numerous self-deceiving defence payless rent a car mechanisms.
Jeffrey Friedman s analysis of how Cioffi and Tannin clung to their beliefs in the face of mounting evidence to the contrary until the threshold was cleared and they finally threw in the towel is a perfect example of this phenomenon. payless rent a car In Ramachandran s words, At any given moment payless rent a car in our waking lives, our brains are flooded with a bewildering variety of sensory inputs, all of which have to be incorporated into a coherent perspective based on what stored memories already tell us is true about ourselves and the world. In order to act, the brain must have some way of selecting from this superabundance of detail and ordering it into a consistent belief system , a story that makes sense of the available evidence. When something doesn t quite fit the script, however, you very rarely tear up the entire story and start from scratch. payless rent a car What you do, instead, is to deny or confabulate in order to make the information fit the big picture. Far from being maladaptive, such everyday defense mechanisms keep the brain from being hounded into directionless indecision by the combinational explosion of possible stories that might be written from the material available to the senses. payless rent a car However, once a threshold payless rent a car is passed, the brain finds a way to revise the model completely. Ramachandran s analysis also provides a neurological explanation for Thomas Kuhn s phases of science where the normal period is overturned once anomalies accumulate beyond a threshold. It also provides further backing for the thesis that we follow simple rules and heuristics in the face of significant uncertainty which I discussed here .
The selection argument provides the rationale for how the the extraction of the moral hazard subsidy can be maximised despite the lack of any active deception on the part of economic agents. Therefore, as I have asserted before , we need to fix the system rather than blaming the individuals. This does not mean that we should not pursue payless rent a car those guilty of fraud. But merely pursuing instances of fraud without fixing the incentive system payless rent a car in place will get us nowhere.
payless rent a car Thanks David I hadn t heard that acronym either! But it does ring true. Shifting potential losses into the future is a popular strategy for many agents, not least politicians Greece probably being the best example.
Thanks Michael your idea in the linked post of better disclosure mitigating the principal-agent problem is valid. At the very least, we need to enforce strict mark-to-market payless rent a car in as many cases as we can a point I have argued in an earlier post.
Moreover, claiming Ramachandran provides a neurological explanation for Kuhnian payless rent a car paradigm shifts is over the edge. In the first place, I spent about three years of my life studying those issues, payless rent a car coming to the conclusion that, on the whole, the less said about Kuhnian payless rent a car paradigm shifts the better. More directly, Ramachandran s work would lead one to believe that after a certain point scientists payless rent a car should shift paradigms. In fact, as Kuhn documents, what happens is that the new paradigm wins when believers in the old one die off. It s the young, who have less invested in the old way, who make the shift. See Night Thoughts of a Classical Physicist.
I should add that I agree with your main point; several lines of argument show that the assumption of deliberate exploitation of the value of the implicit government guarantee is not necessary to explain that guarantee s role in the mess.
You re right. I thought of mentioning Ramachandran s critique of Trivers but decided against it because I wasn t leaning on a strict interpretation of Trivers conclusion. As Ramachandran mentions, self-deception has maladaptive consequences. But its not clear to me that the true believer banker is engaging in true self-deception given that he benefits in the short run. As I see it, the conclusion is more relevant for the knowing deceiver who has an uphill payless rent a car task competing with a true believer.
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