Rational Actors and the Economic Crisis
I missed this when it originally happened, but you should read Richard Posner’s take on the financial crisis, as delivered to Columbia law students.
Posner devoted the bulk of his presentation to outlining the myriad motivations behind the excessive risks. What disturbs him most, he said, is that all of the risk-takers – from CEOs to the day traders to home buyers – were behaving rationally, which free-marketers such as Posner generally believe should act as a bulwark to protect against such catastrophes.
The bankers, for example, were rational in betting on mortgage-backed securities and other housing-related investments, even long after they recognized that their entire industry was, in fact, standing deeply inside an enormous, overstretched bubble. “Even if you know you’re in a bubble, it’s extremely difficult to get out,” said Posner. Pulling up stakes before the bubble explodes means telling investors to expect smaller short-terms rewards. “I think that is a very hard sell,” he said.
Besides, Posner added, when investors want to balance their portfolios, they will do it themselves with, say, bonds or treasuries. The purpose of the high-risk funds is to take the high risks necessary to generate the outsized profits.
Posner also cited the win-win structure of most top executives’ contracts: If their high-risk decisions result in big gains they receive huge bonuses, and if the gambles fail they result in huge severance packages. He noted the $161.5 million awarded last year to outgoing Merrill Lynch chief Stanley O’Neil. “Very, very generous compensation incentivizes executives to maximize their short-term profits,” he added.
Boards of directors, Posner lamented, are hardly “reliable agents of shareholders.” With compensation in the high six-figures for positions that require them to attend only a few meetings per year, board members would need to act against their own self-interest to contest a CEO’s plus-size salary – which wouldn’t exactly be rational.
“This is rational behavior. This is troublesome for economists,” Posner said. “You can have rationality and you can have competition, and you can still have disasters.”
Though he said he wanted to end the presentation on a high note, Posner seemed to have trouble finding one.
There is much here to agree with, particular Judge Posner’s skepticism about the efficacy of regulation. But I’m not as convinced (as he is) that this story is best explained as a failure of perfectly maximizing actors. Indeed, as the story describes his position, it sounds like many of the agents were not maximizing at all. Why, for instance, could bankers not convince (purported) rational investors that we were in a bubble? The best reason, which Posner hints at, is overoptimism bias. Why aren’t executives’ contracts structured for long-term return instead of short-term profit taking? Wouldn’t rational boards and rational executives prefer a smooth future income stream? I’ve got to think that a rich account of compensation behavior would take into account both the tournament effect and risk aversion. And why isn’t there a better market for board members? Could it be some kind of bias against out-groups?