This was not explicity the issue at hand at the conference on Consumer Decisionmaking: Insights from Behavioral Economics I attended recently at the Dallas Fed (cosponsored with UT-Dallas), but it emerged as an issue in the final talk by Christopher Foote of the Boston Fed, who tilted to the bubbles side, drawing on the earlier keynote speech by George Akerlof, although George did not pose it this way. For Foote, even though fraud and corruption increased during the bubble (and Akerlof argued that they tend to generally in bubbles), it was the housing bubble that sent everything over the top to come crashing down so disastrously ultimately.
Most of the other talks tended to focus either on misbehaviors by lenders and how to stop them (many participants among the 250 or so being people from many Feds or other govt agencies such as the FTC), or on the many psychological tendencies and limits that afflict consumers making them prey to such fraudulent and misleading activities. A good summary of these was given by the other keynote speaker, Sendhil Mullainathan. These include failures of perception, failures of analysis even when perception is accurate, and then failures to act even when both perceptions and analysis are accurate. I note a few other things reported including by Eckel and Croson of UTD that women, parents with children, and African Americans are too risk-averse for their own financial well-being, but from Jeff Carpenter of Middlebury, that risk preferences are not in general related to income or social class. Also unsurprisingly, people with low numerical ability tend to get into more trouble with their mortgage payments, all other factors held constant.
I support all the moves to educate people better, to regulate the lenders more to be more transparent in their activities, and so on. But in the end I think I agree with Foote that it was the bubble and the psychological tendencies ("animal spirits") to such that led us into this most recent disaster, not the longrunning exploitation of innocent victims by fraudulent lenders that did so.
14 comments:
Interesting question, Barkley. My hypothesis, for which I have no evidence at all (and how could I?), is that there is always widespread malfeasance in financial markets, but that this is largely invisible as long as prices hold up. During deflations it emerges in all its nasty splendor. Is there any reason to believe this is untrue?
Can you explain how so many liar loans could have been issued without fraud?
Would a bubble have grown so large without so many loans issued to consumers who had no hope of ever paying them back?
How could ratings agencies slap AAA ratings on really terrible financial instruments without some kind of fraud at play?
Outside of the case against the fabulous Fab, what "fraudulent and misleading activities" by lenders, investment banks or ratings agencies are being prosecuted?
With the feds bailing out banks whose terrible business practices left their businesses essentially bankrupt, and no cases being brought against fraudulent lending practices, what will prevent another catastrophe from happening again?
Just wondering!
Peter,
I agree with your position, although I would (and did) argue that fraud tends to increase during bubbles.
anne,
You are right that not much prosecution of the fraud is going on. More folks should go to jail.
That said, and while I respect the stronger position of Bill Black of UMKC, who whistleblew on the Keating Five that fraud is all over the place (which I agree with), I still do not think it was the prime cause of the bubble. It exacerbated it, just as did the overly easy Fed monetary policy, but it got going on its own initially.
Vernon Smith and David Porter and others have been showing in economic experiments going back as far as 1988 that people have strong propensities to speculate on assets, even when they are fully informed on fundamentals, which they are not often in real world asset markets. So, I think that Akerlof and Shiller are right, and in this are following the earlier Minsky and Kindleberger, that the bubbles just get going on their own initially.
That said, again, existing fraud and corruption increase as the bubble proceeds, which further fuels it, as does the general loosening of lending standards that also ensues, with all of this laid out in full detail in the earlier classic works of Minsky and Kindleberger.
You guys talking about Galbraith's bezzle?
Because I'm a sucker for anything that has to do with complexity I like the idea of emergent fraud.
I've been practicing law since 1954 and have had my share of real estate transactions, both residential and commercial, over the years. Representing a purchaser of a residence requires a lot of work to get it right - but it is difficult charging a full fee for the time and effort. A few years back while eating breakfast, I heard a radio commercial for "no documentation" real estate mortgage loans. This sounded implausible to me based upon my experience. By that time in my practice, my residential real estate work was limited to representing wealthy clients who did not need "no documentation" mortgage loans. But I wondered about the role of attorneys involved with such mortgages, those representing the purchaser, the seller, the mortgagee, and the closing attorney. Where was the oversight? It seems that cost/benefit analysis drove these mortgages such that "no documentation" risks were acceptable to lenders. Did these attorneys accommodate the housing bubble? Was there fraud involved on the part of the attorneys? Were these attorneys as gatekeepers no different from firms grading securities for Wall Street? I was told by a person dealing with bundling of mortgages that investors had confidence that a homeowner with a subprime mortgage would do whatever is necessary to avoid foreclosure, to save her home. "Whatever is necessary" can be broadly construed. Such confidence worked for a while. But then the bubble burst. I wonder if bar associations have considered the role of attorneys in this bubble burst? Now it's possible that many of such borrowers did not have their own attorney, relying upon those at the closing. But what if the bar associations had spoken out in the early stages about the risks to such borrowers?
"Were Bubbles Or Fraud More Important In The Crisis?"
Isn't that a false dichotomy? Not that bubbles are impossible without fraud. Experimental bubbles show that they are possible. But in the real world bubbles attract fraud, and are built in part upon it.
Furthermore, fraud is probably easier to identify than bubbles (assuming that you can get the evidence), because there is less room for differences of opinion.
If, in addition, rooting out fraud pops bubbles, then beefing up the investigation and prosecution of fraud can help prevent economic disasters. :)
So how about more financial undercover investigations and sting operations? :)
rosserjb: "Vernon Smith and David Porter and others have been showing in economic experiments going back as far as 1988 that people have strong propensities to speculate on assets, even when they are fully informed on fundamentals, which they are not often in real world asset markets"
Don't experiments also indicate that people can learn through experience with experimental bubbles not to produce them? (How well that learning then carries over to the real world is another question.)
Maybe it is an upward spiral? Bubbles increase the opportunity for fraud. Fraud fuels the bubbles to greater heights. Bubbles expand to consumer larger swaths of the financial landscape. Fraud spreads as the bubble spreads.
From Jan 2004:
"In a bid to boost minority homeownership, President Bush will ask Congress for authority to eliminate the down-payment requirement for Federal Housing Administration loans."
Both fraud and bubbles were encouraged at the highest levels of the Bush Administration, possibly the most corrupt administration ever.
jonny bakho
I agree with anne and jonny bakho and Bill Black and others that there should be more vigorous ongoing efforts to reduce both fraud and discrimination in financial markets, even if these efforts do not completely end bubbles.
Yes, people can learn to avoid bubbles, but in the real world there are always new suckers lining up to be fleeced.
The analysis of the recent downturn is rife with bias. The Repubs need as much blame as possible to fall on the Dems, and of course the reverse is also true. Then the USA must protect its reputation... so there is an underlying need to blame something outside of what might have been controlled, or what might have been taken responsibility for, something such as 'animal spirits', or an explanation that includes a 'few bad apples' is always evasive and easy.
Then to make the analysis efforts even more complicated, there is the ever present conflict between the socio-economic classes and in this case... one of those two classes has complete control of the media, and of the rewards for those who provide the least revealing analysis, so of course an inordinate amount of the blame must be placed on those who, conveniently... have no influence at all. That is not to say that that this voice-less sect is entirely innocent of any malice here, that is of course not the case. But what is most interesting in their behavioral shortcomings is that which is all too often absent from consideration: that being the fact that all other available opportunities for those at the low end of the workforce, opportunities other than upward mobility via real-estate gains, had all but disappeared for these people. So they were put in a situation where they had nothing to lose, and so, their propensity for excessive risk-taking should have been easily predictable. But any analysis focusing too much on that aspect leads to a conclusion that casts blame on the collective shortcomings of our entire democracy, with most of blame falling upon the vast number of people who benefit from exploitive wages, and of course that type of analysis is hard to sell.
'Bubbles' though are not possible without there being too much investment capital flowing through the system. If this obvious fact receives its due focus in the analysis though the conclusion becomes unacceptable (worthless). A telling clue to this is again that which is being ignored, and in this instance, increasingly so: Equity values actually fell faster and further than housing values, and more in terms of money, if measured globally. But, as expressed in this post, "...people" who get into..."trouble with their mortgage payments" are given far more consideration than anything (total investment flows etc.) that might suggest that wealth distribution factors might be at fault. Or, if that implication is traced back to the where the blame applies the most accurately, that leads to the investment-class. But of course that group is almost never mentioned while the no-other-mobility-options sect is quite prevalent when it comes to blame.
The question presented by this post though:"Were Bubbles or Fraud More Important to the Crises, would be better posed as: What Could Have Caused Asset Values and Fraud to Spike Simultaneously?
Ray
I've been taking it as given that the bubble was causing a lot of the fraud: a seemingly bottomless demand for the underlying mortgages from the successive levels of securitization and derivatives investors created an environment where the fraud wasn't just a profitable scam in and of itself, but necessary to meet demand.
And then you finally get the things like the SEC case against Goldman where the shorts were contributing to that demand by defrauding the securities and derivatives investors, pushing the bubble up one last leg before it all crashes and burns.
I think the fraud was largely by intermediaries of lenders, so I would say it was lenders dumb beliefs (housing always goes up) and non dumb beliefs (government will always bail us out) that were to blame. Both are intimately related to bubbles whether to believe in them or to ignore any downside of them even if you don't.
r l love said lots of stuff that seems to matter here. At the bottom of this deal were people who were not at risk and who could have seen clear rewards in a society that has been moralized to worship successful deal making. To turn down an opportunity at the land rent escalator would have been really stupid and demoralizing. I can remember talking to one of my acquaintances in 2003 and telling him that he was a damned fool if he didn't buy a house. He didn't do it and he got left behind. He could have made out very well indeed with a 2 year tax free investment.
And that is how it is in REPUBLICAN America. You either take advantage of the rules or you lose. I do not _BLAME_ people for buying homes or even using houses for poker chips, It was no different than commodities or stocks as far as "investing for appreciation" but for the fact that the rewards were greater and the risks were less. If you lost you walked away because you had no skin in the game and if you won you did not have to pay taxes on the winnings.
On the part of the people on the bottom there was no fraud going on at all. It was join the herd or be crushed by it. There comes a time when you are bereft of choice. The real crime was committed by the Republicans in their lust to stay in power at the cost of the American dollar, or more pointedly, in their lust to destroy the American government by destroying the American dollar. I am ever amazed at how otherwise intelligent people can avert their eyes from this reality. The bubble and the collapse were the objective as opposed to an unintended consequence.
REPUBLICANS have a religious fixation on bubbles to separate the fools from the sharpies and government is the only thing that stops this. The idea of Keynesianism is sacrilege. Neoclassical economics purposefully divides the economy between producers and consumers and all evaluation is based thereon. You will not see evaluations of the interaction of owners and producers. We note that natural resources are no part of the production function and considered to be a constant. All of this is designed to hide economic rent and to divert attention from the fact that ownership plays no part in production whatsoever. Payments to ownership are a dead weight loss.
The prime proximate cause of the blowing of the housing bubble IMHO was the build up, to unprecedented levels, of the Wall St. machinery of structured finance, in which profits and bonuses were recorded in advance and risks passed on through subsequent re-securitizations. It wasn't a ponzi scheme in any narrow sense, but it definitely was ponzi finance in Minsky's sense.
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