Outline:

The Encroachment of Fantasy Into the Republican Party's Economic Policy

More on the Psychology of the Individual Real-Estate Broker and Loan Officer

The Theoretical Upward Limit on Wealth Creation: The Denial of Limits in Republican Philosophy

The Growth of Radical Individualism and Its Effects on Our Economic Life

Where Have all the Leaders Gone?

Why did Those in Position of Authority Not do the Right Thing?

The Deeper Moral, Spiritual and Cultural Roots of our Banking Crises (sic)

 

Good questions are as or more important than getting the right answer. Here's a question that I've had for a while concerning the dynamics which led to the breakdown in the housing finance market, a breakdown now spreading to other areas of finance. Keep in mind that the current crises could have been avoided if the Republican Party had not deregulated in the unthoughtful, roughshod manner it has. A simple regulation increasing the standards for those who needed a housing loan would have prevented this. In what follows, I want to go through a thought exercise to try to shed light on the irrationality of recent American economic policy.

The Encroachment of Fantasy Into the Republican Party's Economic Policy

Imagine you are a real-estate broker. You are motivated to sell a house because you make a commission. The money you make is not in the form of a salary. Your income is directly tied to the number of mortgages you sell. You have an incentive to sell as many houses as you can. Note that the rational self-interest of the individual real-estate broker is not connected to the larger picture in any other than a very indirect way. While he may have been told that the likelihood of a housing market crash increases if prices go up too fast and if loan-qualification standards are lowered, this is not something any single individual has any control over.

Imagine as well the individual loan commissioner or other individual who approves the loan on the house the broker has sold. We can repeat the same thing here, while varying the particulars a bit. While the individual loan officer may know that his entire firm will be put at risk if the entire housing market overheats due to undisciplined marketing tactics and lowered loan qualifications, this risk is not something that he as an individual has any control over. The only issue for him is that his income is tied to the total value of mortgages he issues. He thus has an incentive to issue as many loans as he can. Note that it is not in the rational self-interest of either the real-estate broker or the loan officer as single individuals to even think about these issues. Thinking about these kinds of issues is, however, the job of those who are in authority in both banking and politics. Why they did not do their job is a question that needs to be asked.

Are there any other assumptions underlying the business behavior of the real-estate agent and loan-officer? On their own, the individual brokers and mortgage officers who make up the whole class of each in our country will assume that prices will keep going up, even if only very slowly. It is reasonable for both to assume, minimally, that there will be no loss even if your buyer ends up needing to sell. From the perspective of each individual broker and loan officer, it is reasonable to assume that housing prices do not go down. It is not, however, rational for managers and regulators to make the same assumption.

Let's follow up on the issue of the job function of those in positions of authority. Imagine now all of these brokers and loan officers operating together. It is no longer rational to make these assumptions. The disconnect between what is rational from the perspective of any single individual in the market, on the one hand, and what is rational from the perspective of the market as a whole is one, but not the sole reason, for the need for clear business standards, e.g. regulations, in the market-place. In short, countrary to the fantasy world in which Republican policy makers and activists live, it is irrational to not have reasonable regulations in the market place. It is clear upon observation that wherever and whenever reasonable regulations do not exist, chaos ensues. There is no essential difference in spirit between the radical free-market philosophy pushed by those on the right in recent years and Communist ideaologues in Europe in the 20th century. They both attempt to use politics to realize a deep moral ideal, misunderstanding that a stable political program is never supposed to be the way to realize deep moral ideals. The purpose of political-economy is to enable citizens to get their basic needs met. This happens best in a mixed economy, one with reasonable regulations. It does not happen in a highly unregulated or regulated economy. .

More on the psychology of the individual real-estate broker and loan officer.

Let's return to the multiplication of the number of brokers and loan officers. Imagine again all the brokers and loan officers in the United States. When we look at these brokers and loan officers as a group, one simple fact immediately becomes obvious to the business person: Once all the individuals in this group make the same assumptions discussed above, the assumptions can no longer be valid. For example, once all the individual players act on the assumption that real-estate values will "keep going up", and more particularly, once this assumption becomes a basis of a business-wide practice, it must self-negate. The more individuals are in on a game of making money from buying and selling a particular asset in a particular market, the value that each can gain in this game must decline as more attempt to get in on the action. This is realized by combining simple facts of economic life and basic math. One reason players in this market told themselves that this market was exempt from the normal rules of economics was because housing is always necessary. But this simply allowed for a kind of "Emperor's New Clothes" fantasy to get deeper instilled in the culture at large. It allowed all the concrete individuals who make up the group as a whole to hide behind the other individuals. The game of buying and selling on the assumption of ever-increasing housing prices could only be maintained as long as everyone continued to believe in the same thing. Ultimately, the market participants set themselves up for big losses by their reject ion of basic economic reality and mathematics.

The crisis being brewed by Republican Party policy is such that it cannot be explained by simple misunderstandings of basic economic facts of life or bad business practices in banking and housing. At the first level, this bad policy can be explained to be what happens when we as a society allow the most selfish among us to gain too much power and influence in setting policy. But we can't just blame "them". Given that the United States has an explicit philosophy which is supposed to prevent the very selfish from gaining too much influence and power, we need another explanation for this ongoing crisis. I have argued that the most important explanation for this crisis of politics and leadership in the United States is the deep relativism pervaded the society as a whole. This deep relativism has ended up infecting an area of our civilization we would least expect it to: the free market which is assumed to be guided by sound economic principles and rational self-interest.

Because an ultimately moral, spiritual and philosophical crisis plays out in foggy thinking and poor decision making in both business and govermental policy making, let me tack back to discussing some basic economic principles and math again. My purpose at this point is to shine a light on the particular nature of the "foggy thinking" going on.

The Theoretical Upward Limit on Wealth Creation: The Denial of Limits in Republican Philosophy

The reason why the amount of wealth available to any single buyer or seller must decline as more try to get in on the act is because there is only so much wealth that all the players together can claim within any one time period. While conservatives like to say that wealth is not fixed; that wealth levels respond to various changes in incentives, the fact remains that there is a theoretical upward limit to how much aggregate wealth can increase within any given market per time period. The failure to be clear about the distinction between a) the fact that more wealth is created when incentives are maximized and b) the fact that there is a theoretical upward limit to the total amount of housing value in any given time period, is one contributing factor to the run-away euphoria that lead to our current housing and finance crisis. Moreover, I would bet that the same individuals who sing the praises of the free market and who argue that there should be no regulations or minimal regulation of the housing finance industry also fail to see that incentive effects have a limit as well: It is not possible to get continual increases in wealth creation by continuing to lower various tax rates and/or regulatory standards. For example, while it made sense to lower the upper tax rates in the Reagan Administration, since they have been lowered quite a bit since this time, it is no longer rational or ethical to make the same argument: that lowering taxes on the wealthy will give them an incentive to work more. Lowering marginal tax rates below a certain level has been shown to have no effect on economic activity, and that rate was passed a long time ago! The same general claim can be made about deregulation. The limits of the incentive effects in the banking industry is known as the liquidity trap. Lowering interest rates below a certain theoretical point will not elicit more borrowing. It does not take a rocket scientist to grasp the relevant intuitions behind these facts of economic life, and the fact of the matter is that anyone with a high paying job in these industries knows and understands these principles. This means that it is not stupidity or ignorance that drives the bad business practices we keep seeing repeated in our nation. At some point, arguments for lower taxes and more deregulation become a way for those addicted to unlimited wealth to simply get more of their fix. To claim that the wealthy in America should get more is irrational from any perspective. It is also highly unpatriotic. These argument carries about as much moral seriousness as an alcoholic arguing that they should get more alcohol because it makes them more agreeable..

The Growth of Radical Individualism and Its Effects on Our Economic Life

I want to repeat my argument that the standard left-ish claim that we can explain bad policy and business practice by "greed" misses key points. References to and attributions of greed also trivializes the matter. No political philosopher of repute basis their arguments on the claim that people should not be greedy. This argument misses factors that are much more relevant and influential. Ultimately we require a deeper explanation of our crisis, for reasons touched on agove. The following is one such example.

Since the 1980's, a philosophy has grown up in our society that tells us that we should all be able to make a lot of money easily and fast. While it may be possible for a very small percentage of individuals within any economy to do this, there is a theoretical upward limit to the percentage of any given market participants who can make a lot of money easily and fast. While the very desire to do this is fraught with moral, spiritual and practical problems, the fact remains that it is possible for a small percentage to make money easily and fast. But again, there is a limit on the percentage of market players who can do this within any given time period. If this desire is allowed to instill itself into business practices and governmental policy making, this particular society will set itself up for a lot of practical economic pain and heartbreak.

Here's my question: Why is it that those who approve the loans in the banking industry did not see the obvious? Or if they did, why did they not act on it by raising loan qualifications on potential home buyers? Why did they not say to themselves and each other, "Hey, wait a minute. If the entire industry gets caught up in a kind of frenzy of selling houses in the assumption that the values will always go up, or even more moderately, not go down, our confidence in both assumptions must go down. In other words, risk rises as the housing market is more and more influenced by these two assumptions. Risk rises even more if a philosophy takes hold that treats as a principle the notion that values will always go up or at least not go down." I'm curious as hell to know if anyone verbalized this obvious thought in any meetings in the housing or banking industry in the last ten years within American borders. This is the question I want those in the banking industry to answer: "Why did you allow an obviously self-contracting assumption to become the guiding principle of housing finance in the last few years?" Did you talk about the possibility that a bubble would have to occur, with its attendant crash? Again, this is not rocket science, but basic economic psychology and math.

Where have all the leaders gone?

If economic actors are rational, then we would have expected some individuals in the banking industry and Congress to argue the above and put a break on market exuberance before we reached the crisis point. I believe Alan Greenspan has done our business culture a great disservice. I believe he has contributed to an increased desire in our managerials class to hide behind the group. I never heard Greenspan make a statement in public that suggested we really need to get serious about respecting limits in our economy, and do so in a way that if acted upon would have cost someone something. It was as if each time he made a public pronouncement, he made sure that it did not imply anything that would cost anyone of any influence anything significant. Why for all our pride in our independence does it seem that those in positions of authority in America are terrified of saying something that no one else is saying; that might require someone to give up something for the common good, even when these individuals know in their heart of hearts that such is just what is required? Again, these individuals cannot all be stupid or mean-spirited or merely selfish. So why are they not leading? Why do they not speak in public in a way which calls out for the best in our society? Why, that is, do they so often simply say what the audience wants to hear? ... I merely pose these questions and don't mean to offer any deep answers. But let us call this phenomenon in our society the "Emperor's New Clothes in America" phenomenon. Instead of seeing individual decision makers in business today who are confident that they are able to recognized and grasp economic truth when it happens and to respond to that with intellectual and moral clarity, we seem to have a culture in which most of those in positions of authority say nothing that might cost someone something or seem to be "different." As in the above Grimm's Fairy tale, it is as if we tell ourselves:   "As long as no one else says that prices can't go up forever, they will go up forever. ". In this case, what the Wizard tells us not to pull the curtain back on is the obvious fact that if everyone is trying to make money on rising housing prices, the prices must stop rising and eventually come down. It is also obvious that a lot of home buyers given housing loans would not be able to afford to pay them back. What confuses me is the fact that I have not heard of anyone in the relevant journalistic or business fields making these simple observations. Finance Managers and other leaders in the field of housing finance seem not to have made them or act on them by putting the breaks on irrational business decisions. Why does such irrationality keep repeating in America?

Once again imagine all those finance managers in the bank. They are in the midst of a rise in real-estate values. They have to know in some way that if the rise continues and more and more try to get in on the action, the risk rises that there will be a correction. The longer the finance managers - the loan officers - resist taking responsible action by raising the qualifications for mortgage lending, the more the market will have to correct itself later. Since the entire economy is based on confidence and trust, it is not only harmful to their own businesses to allow this kind of irrational behavior to go on, but it is harmful to all others in our society since our economy depends on liquidity in the loan industry.

Why did Those in Position of Authority Not do the Right Thing?

Recall that we are not focusing so much here on individual brokers and loan-officers, but rather those in positions of authority in both business and government. Why did our managers and political leaders not respond appropriately to this problem, one in which timing is everything? One reason owes to what we might loosely refer to as a "veil of ignorance". This "veil" is that which hides the facts discussed above from any single loan officer and manager of mortgage funds. I believe that the basis of this "veil" is the radical individualism in the wider culture which prevents each particular individual from always remembering that all other players are doing the same thing. The radical individualism of our society inclines each particular mortgage officer and all other players in the business to believe in their gut that they as individuals can somehow game the system longer and better than all the other players. But of course, this gets us back to the very elementary scenario I drew above: While any single player might be able to game the system better than all the other players, once this assumption spreads to all or most players in the particular business market in question, and once this becomes a "business principle", the risk that gets incurred by allowing this assumption to be the basis of business decision making - from granting loans through to the act of selling houses - rises dramatically. Those in authority - managers and political leaders and regulators - know this.

A bit more needs to be said here about the factors leading to the irrational business practices we see given the "okay" in American culture. Note again that from the perspective of any individual, these practices will seem rational. It is from the perspective of leadership or managment that they must be viewed as irrational and harmful to the longer term economic well being of the firm and economy as a whole. Some will argue that greed on the part of individual bankers and brokers feeds this cycle so that the rise in values goes on too long, leading to a crises that would have been avoidable if we preserve business confidence and trust in the system as a whole. I want to repeat that this is not a helpful explanation, but rather a trivially true one. Rather, let us name the error in collective thinking, an error which I have argued effectively conceals true risk from business decision makers, "the broker's fantasy". The gist of this fantasy was outlined above: Each individual as such assumes he can make a profit or at least not lose. Once this assumption is itself transformed into a business principle, it must self-negate. I call it a fantasy because the assumption itself denies reality.

The deeper moral, spiritual and cultural roots of our banking crises.

It is reasonable to argue that there is a significant degree of pathology in the commercial culture of the US today. In short, the pathology is the widespread desire to make a lot of money easily and fast. When this desire gets inculcated by the business culture at large, I believe it begins to display traits we normally see in addictive behavior. We can define insanity as a behavior that is repeated over and over again in spite of the fact that we rationally know it will lead to a particular result. In this case, the irrational behavior has been outlined above, with its attendant economic crises at the micro and then, inevitably, macro level. The fact of repetition of this kind of collective behavior must be explained. It will not do to say that the individuals in positions of ‘ok'ing loans are greedy, or that brokers are greedy, or that home buyers are ignorant. In the final analysis, in addition to being enabled by what I called "the broker's fantasy", the problem is cultural and systemic and grounded in a philosophical problem. I believe that the crisis which has lead American civilization as a whole and in particular its government into increasingly irrational behavior in the last couple of decades is the instillation of deep moral and intellectual relativism in the educated class in American society.

We today live in a culture whose most educated citizens seriously believe in their heart of heart that there is no truth and goodness, and that everything is relative. Interestingly, I believe this relativism is more prevalent in those who would define themselves to be on the right of center than in those on the left of center. I base this claim on my interactions with conservatives of all stripes as well as secular and religious liberals. I know no hard leftists. While conservatives claim that they stand for morality and principle, if we are to judge them by their political choices and what I see as a latent cynicism, I would bet that they don't really expect businesses to be run on the basis of a code of ethics. When the American conservative is not cynical, he is a radical individualist. In short, I believe that American conservatives, generally speaking, are excessively under the influence of the social, economic and religious thought of John Locke, Hobbes and Calvin.  Each of these thinkers is highly influential in American civilization, no more so than among our conservatives. Each of these thinkers in their own way teach that we are all just individuals who must make it completely on our own; that money is the only thing that we really do or should care about, and that we are all sinful and can do nothing about it. Until this deeper moral and spiritual problem is effectively responded to by our artists and intellectual class, and likewise, until it depletes itself from our educated conservatives, the federal government can bail out as many banks as it wants, but we will continue to repeat the same behavior over and over again. Until then, I worry that we baby-boomers and those who follow will not let go of the collective insanity that we have been increasingly displaying for some time now.

The First Step is to admit the problem and stop electing governments which feed off of the worst qualities in us; leaders who are anti-intellectual and themselves addicted to manic money-seeking, status and power. Let us embrace the courage to have hope, and know that no society can endure on the basis of the private profit motive alone. Let us act on our own care about our own good and the good of all others in our society.

Terence Hoyt

New Orleans, September 20, 2008