Exuberant Bulls, Rueful Bears, and Rational Frogs

Yesterday, James Dimon, the CEO of JPMorgan Chase, visited the Bear Stearns headquarters, and met with 400 Bear executives, described in the New York Times this morning as “seething, fearful and to their dismay, far poorer than they were a week ago.” What struck me was the emotional and personal language of the dialogue, something I’m not surprised to hear, but which may take some reconciling for theoretical observers. As this is a blog post, I’ll again offer some not-quite-random thoughts.

1. One of my favorite lines in all of academic writing is Richard Posner’s allusion to the rational actor in neo-classical economic theory. In this variant of consequentialism, reason does not determine ends; the end for any actor is always happiness, measured in units of utility. Reason is instrument and practical – it is a slave to this particular passion. Hence, we assume all actors choose rationally those actions calculated to be most likely to maximize utility. Judge Posner says, therefore, it would not be solecism to speak of a rational frog. We don’t need to dissect it [the frog, get it?] because we can assume it to be a black box whose actions demonstrate, overall, an internal utility calculation consistent with the theory. The model, of course, is simple and useful as a tool, but it has significant limitations as a theory of everything; hence, the rise of behavioral economics to try to explain all choices, even when the frog seems to be acting irrationally. For more on this, see the debate between Judge Posner and Cass Sunstein, et al., in the Stanford Law Review a few years back.

2. So here we have Jamie Dimon (he can’t be James in this context) telling the Bear executives “I don’t think Bear did anything to deserve this. Our hearts go out to you.” Does he really mean that? Do their hearts really go out? Do they have hearts?

3. In response, according to the Times, a Bear executive “with anger in his voice” asks, “In this room are people who have built this firm and lost a lot, our fortunes. What will you do to make us whole?” To which Dimon “gingerly” replies, “You’re acting like it’s our fault, and it’s not. If you stay we will make you happy.”

4. In the Boston Globe this morning, Barney Frank, one of our locals, talks about greater regulation of investment banks. Steven Syre, the Globe business columnist observes there is a gap between conservative banking regulation administered by the Fed and the “heightened risk and reward” environment of Wall Street bankers who underwrite and trade securities. Says Syre, “They made huge fortunes in good times and had every incentive to take big risks, usually by betting with lots of borrowed money.” What he is describing is leverage (or “gearing” for our British readers), and leverage is not strictly a Wall Street phenomenon. Anybody who buys a house with 20% down (i.e. equity) and an 80% mortgage is engaged in financial leverage (and if you buy the house with a subprime mortgage, putting 5% down, you just leverage up more). All companies seek an optimum level of leverage in their capital structure – they are always balancing financial risk with financial reward.

5. Now let’s talk about foresight and hindsight, and particularly what the behavioralists call “hindsight bias.” When you engage in business and take significant risk, and it doesn’t pan out, and you look at the whole mess in retrospect, it may be that you are affected by hindsight bias, which means that the bad result, which may have been a 40-60 shot ex ante, is now 100% certain, and doesn’t feel like a 40-60 shot any more.

6. I spent five years of my career, from 1992 to 1997, at a company called AlliedSignal. It merged with, and took the name, Honeywell. Those were the boom years in the stock market. The level of the ocean was rising, and if you kept your boat from leaking, much less turbocharging it, you tended to rise with the rest of the boats. We did okay (well, maybe more than okay) in stock compensation, but most of us were significantly (by virtue of the stock plan limitations or by unwise lack of diversification) tied to the fortune of the company’s stock as a measure of our personal net worth. We were just like the Bear executives, except we were luckier. We didn’t have to deal with hindsight bias except in this regard, which was just the opposite: if you exercised your options or sold your stock, and then watched the company outperform the market, you had exactly the OPPOSITE hindsight bias.

Larry Bossidy, long-time second in command to Jack Welch at GE, was the CEO of AlliedSignal in those years. I can’t recall how many times, at employee meetings, the rank-and-file white and blue collars would ask why they couldn’t get stock options (they could get stock in their 401(k) plans, and the company’s match was in stock). Bossidy’s response was always the same: you’ll like the stock if it keeps going up, but it’s a risk-reward proposition, and my experience is that rank-and-file like the reward, but don’t like the risk.

6. Finally, there is the quote from Alan Schwartz, Bear’s CEO: “We are a collective victim of violence. It’s natural to be angry, and you’re not sure who to be angry at. But we have to put it behind us.” This is a very interesting statement, because it gets to the heart of a philosophical dilemma that in some areas was resolved 250 years ago, but pops up whenever we again encounter any kind of disaster. Since Rousseau, we have separated the concepts of natural evil and moral evil. We may attribute blame to people for their response, or preparation, or negligence about the safeguards against hurricane damage, but we don’t connect (I suppose except in the global warming sense) natural disaster to human agency anymore. People aren’t to blame for Hurricane Katrina, or the Tsunami, or the Lisbon Earthquake of 1755.

But we have, and this is part of what Kant brought to the table, a natural inclination, by virtue of our reason, to want to link what is with what ought to be. My simplest illustration of the process by which most of us immediately separate ourselves from random bad consequence by virtue of our agency is how I always wonder, when I hear about a traffic death, whether the people had their seat belts fastened. My friend Susan Neiman uses the example of criminals in the Nazi concentration camps. There is some evidence that they fared better than most because at least they understood why they were there.

Schwartz’s comment suggests that what occurred at Bear was a kind of evil – a violence in the form of a bank run – that might be moral (did somebody trigger it purposely?) or natural (panics are a part, for better or worse, of economic cycles).

7. So the dialogue, Dimon’s comments, the executives’ anger, Schwartz’s shaken explanation of what happened, are indeed typical human reactions to great disaster, and they are attempts, as always, to reconcile what did happen with our ideals of what should have happened. This, it seems to me, is the great challenge of mature and reasoned discussion about economic life, and the balancing of our desire to be happy (materially) with our desire to be fair. When I was just getting started at being an academic, and still flush with the perspective of a corporate executive, I wrote this in a footnote at the end of an article about how lawyers used contracts as one very limited way of dealing with contingency:

I am willing to concede the simultaneous operation of economic laws and moral laws. They are, respectively, the embodiments of the critical distinction in Kant between the nature of instrumentality and the nature of free will or autonomy. Our needs in everyday life are fulfilled by instrumental relationships all the time. Physical and economic laws are discernible that govern the satisfaction of what Kant calls our inclinations (our tangible and intangible needs). The principle of microeconomics that a rational firm shuts down the plant when the marginal cost exceeds the marginal revenue is morally neutral (at least it is to me, but I recognize others, socialist or critical legal theorists, for example, may disagree). The moral question, on the other hand, is: are they people or things to you morally at the time the real world makes you do that? How do you handle the layoffs? Do you provide outplacement? Is the severance sufficient? Have you developed your employees so they have transferable marketable skills?

I’m no “progressive” (in part because I don’t know what it means), but sight unseen, I’ll recommend a piece just recently up on SSRN by Kent Greenfield that seems to want to encourage this kind of discussion. The abstract follows the fold.

Here’s the abstract of Reclaiming Corporate Law in a New Gilded Age:

Corporate law matters. Traditionally seen as the narrow study of the relationship between managers and shareholders, corporate law has frequently been relegated to the margins of legal discussion and political debate. The marginalization of corporate law has been especially prevalent among those who count themselves as progressives. While this has not always been true, in the last generation or so progressives have focused on constitutional law and other areas of so-called public law, and have left corporate law to adherents of neoclassical law and economics. To the extent that the behavior of businesses has been a matter of concern, that concern has been aimed at adjusting the rules of environmental law, administrative law, employment law, and the like.

The time has come to reclaim corporate law as a topic of wide debate and progressive concern. Instead of being a narrow discipline with limited implications, corporate law determines the rules governing the organization, purposes, and limitations of some of the largest and most powerful institutions in the world. By establishing the obligations and priorities of companies and their management, corporate law affects everything from employees’ wage rates, to whether companies will try to skirt environmental laws, to whether they will tend to look the other way when doing business with governments that violate human rights. Corporate law also determines whether corporations will look at the long term or the short term, whether they will see themselves as owing any responsibilities to stakeholders other than shareholders, and indeed whether they consider themselves to be constrained by law at all.

The main thesis of this article is that corporate law is much more important than most progressives realize. Corporate law can be part of the wider task of regulating corporations in particular and business in general. The rules that govern corporations should more expressly take into account the fact that corporations are collective enterprises that demand investment from a number of different sources. These investments come in various forms: inflows of capital from shareholders and creditors; cash inflows from customers; infrastructural support from governments and communities; and effort, intelligence, and direction from employees. Whereas corporate law presently focuses on the financial investments of shareholders only, it could, and should, be adjusted to take into account the contributions of non-equity investors. Adjusted in this way, corporate law will make it more possible for corporations to serve their purpose of facilitating the creation of wealth, broadly defined and distributed.

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6 Responses

  1. Belle Lettre says:

    This is a wonderful post.

  2. not a broker says:

    I guess I don’t understand. This just sounds like a lot of inappropriate whining from people who should know better.

    Bear Stearns made a big financial bet and lost, so they’re being purchased. If anyone should be expected to understand risk and reward and the harsh realities of business, you’d think it would be a bunch of Wall Street brokers.

    “What will you do to make us whole?”

    “galling… to call this a ‘merger'”?

    “victim of violence”?

    I could understand these sorts of remarks from simpler people or from people who don’t work in the finance world, but coming from brokers, this is more than a little rich. I’d say that this is lovely schadenfreude material, but they’re probably all still quite well off. I’m left with a foul taste in my mouth and more than a little hope that the whiny ones suffer further.

    Am I missing something?

  3. A.J. Sutter says:

    Not a broker: if you’re missing something, you’ve got company. I think the point of this post is a bit too pointillistically expressed; for me the colors are not merging.

    Starting from the last point first, I don’t think it’s too controversial that “corporate law matters.” Nonetheless, it will wind up being no more than a very general framework, whatever its configuration. Nor will it govern all the stakeholder relationships that are relevant in situations like the one we’re in now. Corporate law doesn’t deal with the issues between predatory lenders and desperate borrowers, for example, or even between management and employees. In any case, one shouldn’t expect any body of law to address all the moral concerns raised in Jeff’s footnote. It’s still up to each individual whether he or she is going to be a mensch or not.

    As for all the highfalutin’ talk about hindsight bias, I’m reminded of all the dinner panel post-mortems of the dot-com boom with titles like “What Happened?”. It was obvious while they were being done that most of the deals were crappy, and based on ridiculous assumptions. Similarly, that the sub-prime implosion was written on the wall was obvious even in 2003 to a commercial bank branch manager of my acquaintance. She successfully persuaded her institution to stay away from these loans.

    Are we meant to believe the MBAs and financial whizzes at Bear couldn’t see it coming because their rational faculties were slaves of their desire for happiness? I’m not sure what is the point of the rational frog story in this context. But I don’t buy the psychological excuses. I think this is more simple Sophocles than Kahneman & Tversky or Kant: your head gets too big, you get knocked down. The reported speech of the folks at Bear tends to make me feel all the more that they’re getting what they deserve.

    So Jeff, please connect the dots — what is it that you are you so delicately suggesting?

  4. Jeff Lipshaw says:

    Andy, I said it would be kind of random. My guess is that there were a lot of Bear executives who had no control over this – and out of the blue a tsunami hits them. The closest equivalent in my experience would be – you are working for a service business in a large conglomerate, and the stock tanks because of a huge liability in the chemical business. It ought not to happen to you, but it does. But you go down with the ship just like everybody else.

    The question for me arose because of the emotive language. I think people are trying to reason their way to an explanation of something that may be the economic equivalent of saying “why did a bridge happen to fall on me?” There’s only so much we control.

    I don’t mind being pointillistic occasionally.

  5. A.J. Sutter says:

    Thanks for the reply. And I appreciate your stylistic virtuosity, unless it’s simply a glitch in the blog engine that’s caused you to shift unwittingly into the repetitive groove of Sol LeWitt and Philip Glass.

    I can understand your conglomerate analogy. But I think most of us in that situation would find it pretty obvious why the bridge fell: because of the morons in the chemical division. The analogy doesn’t explain Dimon’s remark that no one at Bear had done anything wrong, nor the Bear exec’s demand that JPMC make them whole, nor the shameless victim discourse of Schwartz. I suggest that rather than reasoning his way to an explanation, each of these guys was just being self-serving in his own way. No doubt there are some at Bear who merit your philosophical musings, but probably they’re in the support staff and about to get laid off for their bosses’ sins. None of the people you quote is exactly a poster boy for sympathetic pondering.

    But perhaps the point of your original post was those who experience such calamities should regard their predicament with an air of detachment, viz., que Seurat Seurat?

  6. Jeff Lipshaw says:

    I’m migrating from an old Dell to a new MacBook, so I have had some glitches. I have access to delete comments, but like the guy in Annie Hall, I forgot my password mantra, and it took awhile to straighten it out.

    You may be attributing to me more sympathy for the Bear execs than I feel. My point, even in the conglomerate example, is that bad things happening aren’t always the result of somebody’s fault. Shit happens. That was one of the myths of GE and AlliedSignal culture – a great leader could stand in the way of, and push back, a market tsunami. Or in other words, if a business didn’t perform, somebody was at fault. Sometimes that’s true; sometimes it’s not.

    So I’m not big on either fault-finding or whining, both of which are attempts to deal with the gap between the “ought” and the “is.” The ought for which fault-finding is the response is “people shouldn’t screw up,” and the ought for which whining is the response is “the natural or economic world ought not to impose disaster on us exogenously.” I still don’t know enough about the Bear Stearns implosion to know how those two causes of disaster contributed, although there are people in the world (see Ben Stein’s column in the NYT Sunday Business section today) who think that Bear collapsed because of a whisper and gossip campaign begun by hedge funds with substantial short positions.

    Finally, not an air of detachment, no. When you are fighting a natural disaster, like a tornado, you are committed and resolute and not detached. Somewhere north of detached and somewhere south of “oh God why hast thou forsaken me?”, I would think.