April 28, 2010

Gambling with Other People's Money

How Perverted Incentives Caused the Financial Crisis
  • Russell Roberts

    Affiliated Senior Scholar
Summary

“If you don’t know who the sucker is at the table, it’s probably you,” runs an old poker saying. At the poker table of the current financial crisis, “We are the suckers,” opines Professor Russ Roberts as he makes the case that public-policy decisions have perverted the incentives that naturally create stability in financial markets and the market for housing.

Executive Summary

Beginning in the mid-1990s, home prices in many American cities began a decade-long climb that proved to be an irresistible opportunity for investors. Along the way, a lot of people made a great deal of money. But by the end of the first decade of the twenty-first century, too many of these investments turned out to be much riskier than many people had thought. Homeowners lost their houses, financial institutions imploded, and the entire financial system was in turmoil.

How did this happen? Whose fault was it? Some blame capitalism for being inherently unstable. Some blame Wall Street for its greed, hubris, and stupidity. But greed, hubris, and stupidity are always with us. What changed in recent years that created such a destructive set of decisions that culminated in the collapse of the housing market and the financial system?

In this paper, I argue that public-policy decisions have perverted the incentives that naturally create stability in financial markets and the market for housing. Over the last three decades, government policy has coddled creditors, reducing the risk they face from financing bad investments. Not surprisingly, this encouraged risky investments financed by borrowed money. The increasing use of debt mixed with housing policy, monetary policy, and tax policy crippled the housing market and the financial sector. Wall Street is not blameless in this debacle. It lobbied for the policy decisions that created the mess.

In the United States we like to believe we are a capitalist society based on individual responsibility. But we are what we do. Not what we say we are. Not what we wish to be. But what we do. And what we do in the United States is make it easy to gamble with other people’s money—particularly borrowed money—by making sure that almost everybody who makes bad loans gets his money back anyway. The financial crisis of 2008 was a natural result of these perverse incentives. We must return to the natural incentives of profit and loss if we want to prevent future crises.

My understanding of the issues in this paper was greatly enhanced and influenced by numerous conversations with Sam Eddins, Dino Falaschetti, Arnold Kling, and Paul Romer. I am grateful to them for their time and patience. I also wish to thank Mark Adelson, Karl Case, Guy Cecala, William Cohan, Stephan Cost, Amy Fontinelle, Zev Fredman, Paul Glashofer, David Gould, Daniel Gressel, Heather Hambleton, Avi Hofman, Brian Hooks, Michael Jamroz, James Kennedy, Robert McDonald, Forrest Pafenberg, Ed Pinto, Rob Raffety, Daniel Rebibo, Gary Stern, John Taylor, Jeffrey Weiss, and Jennifer Zambone for their comments and helpful conversations on various aspects of financial and monetary policy. I received helpful feedback from presentations to the Hoover Institution’s Working Group on Global Markets, George Mason University’s Department of Economics, and the Mercatus Center’s Financial Markets Working Group. I am grateful for research assistance from Benjamin Klutsey and Ryan Langrill. None of the above bears any responsibility for any errors in this paper. In writing this paper, I’ve learned a little too much about how our financial system works. Unfortunately, I’m sure I still have much to learn. And as more of the facts come to light about the behavior of key players in the crisis, I’ll be commenting at my blog, Cafe Hayek, under the category “Gambling with Other People’s Money.”

Continue reading