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?

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3 Responses

  1. Frank says:

    I wonder if he still doubts the “efficacy” of high taxation of windfalls like “the $161.5 million awarded last year to outgoing Merrill Lynch chief Stanley O’Neil.” His views in 2006 were not encouraging, as I discussed in this post:


  2. A.J. Sutter says:

    Another reason for Posner’s distress is a fallacy of composition. He implicitly believes that if all actors act rationally, the system should behave predictably. A nice discussion of this fallacy in the financial meltdown context appears in George Cooper’s recent The Origin of Financial Crises. The fallacy is also rife throughout neoclassical economics, most significantly in the formation of demand curves. The result is the ambiguous situation captured by the Sonnenschein-Mantel-Debreu Theorem, which shows that microeconomic rationality doesn’t entail anything about the macroeconomy. SMD is a critique of neoclassical economics from within (you can’t get more neoclassical than Debreu), but I’ve never seen it mentioned in any law&econ texts. For more on SMD, see esp. the articles in Part 2 of Mirowski & Hands, eds., Agreement on Demand: Consumer Theory in the Twentieth Century (Duke UP 2006).

  3. bob mccue says:

    Nice blog. I am a first time visitor. I found you while looking for critiques of George Cooper’s recent book, cited above.

    Quickly before moving on, I will note that while I agree with Posner’s comments to a degree, I like to start trying to understand micro behaviour by understanding macro conditions, since behaviour (and in particular the perception of rationality) is dependent on premises and certain other conditions. That is, our behaviour tends to be boundedly rational (see http://en.wikipedia.org/wiki/Bounded_rationality). As an aside, I note that Nate Oman and I have conversed a bit about Mormonism, where I apply the same kind of analysis to explain what is by many standards irrational behaviour. Nate and I, however, politely disagree regarding the utility of the Mormon institution. Hello Nate. I hope you are well.

    Cooper’s key point is that the Efficient Markets Hypothesis, on which the behaviour Posner decries is mostly based, is flawed as a result of its refusal to acknowledge the presence of memory and feedback loops in market behaviour. EMH hence misses the opportunity to use complex adaptive systems theory to understand market behaviour (see http://www.santafe.edu/research/topics-dynamics-human-behavior-institutions.php). Acknowledging and attempting to model these feedback loops should allow us to more accurately estimate system risk, and better avoid (or reduce the effect of) future meltdowns of the type we are now experiencing. Proceeding in this direction would extend the economic theories of Keynes, Minsky and others to the detriment of neocon economic theory, and the EMH.

    The forest management analogy may be apt. For decades the objective of the forest service was to minimize the impact of all forest fires. This made sense as a result of the destruction they caused. However, the absence of forest fires allowed the undergrowth to become heavy enough that when fires finally got going, they tended to leap to the canopy as never before, creating uncontrollable infernos more massively destructive than anything before seen. That is, the sensible (from a short term point of view) impulse to avoid forest fires eliminated an important pruning mechanism that kept the forests in long term balance. This pattern – eliminate what appear to us to be manageable, short term problems and cause far larger (or unmanageable) long term problems – is a feature of many physical systems (see Philip Ball – “Critical Mass”), from avalanches to traffic jams to various kinds of social disruption. Democracy may be a mechanism for institutionalizing regular small disruptions while avoiding the much more destructive and occasional revolutions that convulsed human society for eons. The “power law” distribution is a characteristic of these systems, and has been found in many aspects of market and economic behaviour (see http://www.nature.com/nature/journal/v415/n6867/full/415010a.html as well as “Critical Mass”). An important hypothesis currently being tested is that the avoidance of recession through the kind of monetary and fiscal policy that dominated the Greenspan years plays a role in economics similar to that of avoiding forest fires – short term gain (and complacency) in exchange for long term disaster.

    Risk assessment systems that are based on the EMH tend to both dramatically under and overestimate risk in different conditions, and justify the extreme (and mostly unconscious) risk taking that has caused our current financial mess. Cooper elegantly explains the cracks in the free market systems that after the introduction of banks and leverage, cause bank runs, and how central banks attempt to regulate this. Better regulation of banks is required in this regard, as well as similar regulation of bank-like behaviour elsewhere in the economy that allows credit to unduly expand and to contribute to asset price inflation and the creation of investment bubbles of various kinds. The advent of derivatives and other useful market innovations (like the securitization of residential mortgages and household debt) caused this behaviour to spring up in new unregulated places, and grow to potentially catastrophic size before its nature was appreciated.

    Should we be surprised that rational bankers and other business executives would facilitate this? Not if we use history as our guide. These same folks consistently walked into bank runs for how long? How many serious asset bubbles have we had, and how many recently?

    Our limited ability to understand cause and effect relationships over large time scales and through numerous linkages is well known. That is one of the reasons for which EMH believers accept that we need central banks to regulate our efficient markets. I am therefore not in the camp that wrings hands over the behaviour Posner describes. It is a function of the system we had in place. Change the system and the behaviour will change.

    But in any event, back to Cooper. If anyone can point to a cogent critique of his recent book (The Origins of Financial Crises) I would appreciate hearing about it (rmccue@mccarthy.ca). I am passingly familiar with the arguments EMH advocates make against the position Cooper takes. He gives these short shrift, and I would like to find those arguments collected in one place, and well made.