The Financial Crisis Explained - Gambling With Other People's Money

Russ Roberts has made a career out of explaining difficult economic topics by relating them to ordinary life in a readable manner.  He explained why we should support free trade in The Choice and other economic concepts in several other novels that involve economic themes.

He's just issued a paper that explains the recent financial crisis very well.  You can download it here.

His critique is well balanced and very nuanced.  It covers all the bases to some degree, although it focuses most heavily on the problem he sees at the heart of the matter: government actions created a bailout expectation that led creditors to not act with their usual caution when it came to the housing market.  He partitions blame between the government and private actors who advocated the government's actions for personal gain.  I like that he takes a degree of personal responsibility, acknowledging that he had downplayed concerns about high leverage (ratio of debt to capital).  Most important, he rejects any easy, simplistic answers from the left (Wall Street Greed) or right (all due to Freddie and Fannie).

Here's just a very short "summary of the summary" to give you a taste:

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.

I don't agree with everything he says, this is probably one of the best pieces I've seen for those who aren't financial policy buffs but want to understand the connection between government activity and the economy a little bit better.

The Inmates are Running the Asylum

The Washington Post's editorial page sounds a worried note after a conservative Republican lost his primary bid for not being quite conservative enough (i.e. he had voted for TARP and had co-sponsored a relatively moderate health care reform proposal with a Democrat) and a Democrat from West Virginia who had shown a willingness to compromise on greenhouse gas regulation lost as well.  In short, two fairly well respected Members who were willing to work with others on compromises lost to candidates who made it clear that compromise was not in their vocabulary:

For many party cleansers, working across party lines constitutes treason. We agree that elected officials ought to be guided by principles that they are willing to fight for. But we also see a difference between fidelity to principle and dogmatism. If Republicans cannot accept that Democrats may make some reasonable arguments, and vice versa, then nothing will get done

I normally don't blog on electoral politics, but this trend has obvious implications for governance if Members of Congress believe that the only way to keep their seats is to scream across the aisle rather than actually governing.  In future posts, I hope to look at what institutional reforms can be made to keep parties from becoming hostages to their most extreme elements.

Because, right now, the inmates are running the asylum in both parties.

The New Prime Minister

It hasn't taken as long as some feared for Britain to get a new government.  Conservative leader David Cameron and Liberal Democrat leader Nick Clegg have formed a coalition government (the first since the end of World War II apparently) between the two parties, with the Conservatives getting most of the leading offices given that they won the largest number of votes.  But Clegg will serve as the Deputy Prime Minister and several other top government posts will go to Liberal Democrat MPs.

Interestingly, one of their first moves will be to enact legislation fixing the term of Parliament at 5 years.  Under current law, a Parliament may last up to 5 years, but a Prime Minister may dissolve Parliament, thereby causing an election, earlier if he or she chooses.  The move may help to solidify the coalition (allaying Liberal Democrat fears that the Conservatives would call new elections once their polling looked better, gain a majority, and kick them out) but it also seems like good government (prohibiting a politically motivated call for a new election by the party in power for the purposes of political advantage.

Still, this could have profound effects on the entire British political system, and render it looking much more like that of the U.S. in several ways.

For example, suppose the Prime Minister loses the majority.  Would Britain be stuck with a prime minister who lacks majority support in the Parliament?  If so, it could come to resemble the US system, where the President and Congress frequently do not come from the same party, a little bit more.

More importantly, it would also likely end the tradition of short, inexpensive campaigns because candidates will know exactly when the elections will be and can start campaigning earlier than the usual 30 day window from when the PM announces an election and when it takes place.  Such a change may wind up with very profound effects.  As a result of longer, more expensive campaigns, voters may wind up paying less attention and fewer going to the polls.

Learning the Right Lessons Part II

Learning the right lessons from a failure is the first step towards improving future performance, in life, in business and especially in government.  As we discussed earlier, the most important aspect of the government's oversight of the safety of offshore drilling rigs may have been the merger of two conflicting tasks, safety and revenue collection, in the same agency.

The AP is now reporting that the administration is looking into splitting the Minerals Management Services into two different agencies centered around these very different tasks.  As we learned last week, the British took a similar step years ago, and improved their safety record as well.  Even if the Wall Street Journal didn't seem to get it quite right when it wrote its headline, Department of Interior Ken Salazar seems to understand.

The Federal Workforce - Faster Hiring

Federal employment rules are an embarrassing anachronism.  They were created for a time when the government was smaller, its duties much more limited, and the typical functions were routinized ones, such as typing and filing.  One aspect of this is the incredibly long time it takes to hire anyone.  A short summary of the issue can be found here.

At least one aspect of this operation appears headed for improvement.  Today's Washington Post reports that President Obama is ordering the feds to step up hiring.

This is welcome news.  The federal government needs to replace a lot of workers who are scheduled to retire soon.  In 2008 the Partnership for Public Service projects over one-third of the Senior Executive Service (SES), which constitutes the core leadership of the civil service will retire.  We need to keep a steady flow of quality candidates coming through the pipeline merely to maintain the government's capacity.  Whether you're a fan of "big government" or not, a government with big responsibilities but without the resources to carry them out is a failed government, and something that would benefit no one.  A long, complicated hiring process deters people from entering the pool, reducing the overall quality of the federal workforce.

Some of the changes include ditching government - only forms and requirements (a problem not only in hiring but many other aspects of government such as contracting) in lieu of more traditional applications and resumes and allowing agencies to hire someone who had applied for a position at another one in the same department (but not across departments, which would require an Act of Congress).

Now, let's talk about (a) making promotions and salary increases based more on merit and less on seniority and (b) getting rid of poor performers.

Regulatory Incentives: A Case Study

A Wall Street Journal (subscription) story caught my eye, "Oil Regulator Ceded Oversight to Drillers":

The small U.S. agency that oversees offshore drilling doesn't write or implement most safety regulations, having gradually shifted such responsibilities to the oil industry itself for more than a decade.

Instead, the Minerals Management Service—now caught up in the crisis of the Deepwater Horizon rig that for weeks has sent crude oil gushing into the Gulf of Mexico—sets broad performance goals for the industry. Oil producers and drilling companies are then free to decide for themselves how to meet those goals, industry executives and former regulators say.

 Let's break this down.  What does it mean, exactly, to say that the agency has ceded its regulatory authority?


In short, it's something called "performance based" regulation.  The agency, in this case something called the Mineral Management Service (MMS), sets performance expectations, but doesn't tell the agency HOW it must reach the performance expectations.  In theory, this should allow for less expensive regulations than the traditional "prescriptive" model (where I tell you HOW you must do something, but generally absolve you from the results if you comply).


MMS has now made clear it will be shifting away from a performance based system to a more prescriptive based one soon after last week's disaster in the Gulf.


I'm not so sure it was the model of regulation, or the fact that industry practices were adopted as the standards rather than rules written by federal regulators, that caused the problems MMS faces.  In fact, the Journal appears to have "buried the lede" (i.e. put the most important part of the story in the middle rather than up front).


Some interesting facts emerge about MMS (which is an agency within the US Department of the Interior): Enforcement of safety rules isn't MMS's "primary responsibility" although it does inspect rigs.  Instead, its to "verify how much oil is being pumped, which is key to another MMS duty, maximizing payments the government receives for oil and gas rights from energy producers."  As a result, the agency, which is funded by fees and rental receipts, faces a "conflict of interest" according to former MMS employees.


Does this make a difference in safety?  Very possibly.


Consider this: fatalities on oil rigs is four times higher in the US than in Europe.  The UK had a similar model, but recently separated its safety function from its revenue collection function.  The result has been an improved safety record.


The story goes on to detail how the MMS failed to follow-up on instances where the industry had failed to meet safety standards, etc.  In short, poor enforcement rather than poor regulations may have been at fault here.


Note: this is not the first time in recent years MMS has come under fire.  In 2008 it was cited for "a lack of ethical culture" after fairly shocking evidence of misbehavior occurred.

A minority government for Her Majesty...

The British people have spoken...now the politicians will decide what they said.  No party received a majority in the House of Commons, so now a coalition will need to be formed - something that country hasn't dealt with since the 1970s.  In the US, of course, we've had divided government with one party controlling Congress and another the White House.

Will be interesting to see how this all plays out...