In the days and weeks that followed the government’s decision to bail out troubled banks, Paul Krugman was a reliable guide to the problem of socializing financial losses and the dangers of creating zombie banks.
These days, however, Krugman has departed from the reality-based community in favour of the banker pay myth of the financial crisis.
Fortunately, there are powerful voices of reason now speaking up against the the idea that bankers knowingly took on too much risk because they were rewarded with short term profits.
The journal Critical Review has started a “Causes of the Crisis” blog that nicely deals with how the theory, which they call “the executive compensation thesis,” doesn’t jibe with the facts.
The evidence that has been produced suggests that it is false.
For one thing, bankers were often compensated in stock as well as with bonuses, and the value of this stock was wiped out because of the investments in question. Richard Fuld of Lehman Brothers lost $1 billion this way; Sanford Weill of Citigroup lost half that amount. A study by Rüdiger Fahlenbrach and René Stulz  showed that banks with CEOs who held a lot of stock in the bank did worse than banks with CEOs who held less stock, suggesting that the bankers were simply ignorant of the risks their institutions were taking. Journalists’ and insiders’ books about individual banks bear out this hypothesis: At Bear Stearns and Lehman Brothers, for example, the decision makers did not recognise the risks until it was too late, despite their personal investments in the banks’ stock.
Perhaps the most powerful evidence against the executive-compensation thesis, however, is that 81 per cent of the mortgage-backed tranches purchased by banks were rated AAA, and thus produced lower returns than the double-A and lower-rated tranches of the same mortgage-backed securities that were available. Bankers who were indifferent to risk because they were seeking higher return, hence higher bonuses, should have bought the lower-rated tranches universally, but they did so only 19 per cent of the time. And most of those purchases were of double-A rather than A, BBB, or lower-rated, more-lucrative tranches.
Tyler Cowen at Marginal Revolution agrees that “the evidence isn’t there — at least not yet — that executive pay was in fact the big problem.”
Over that The Atlantic, Megan McArdle explains what’s wrong with the myth:
There are two basic narratives of what happened. The first is that bankers had bad incentives: they took massive risks because the profits were so good in the up years that it was worth the risk of the bad, or because they could pass the risks onto some other sucker, or they thought Uncle Sugar would bail them out. The other narrative is that bankers had bad information: they didn’t understand the risks they were taking.
I’ve always preferred narrative B, because Narrative A doesn’t make much sense. The CEOs of big banks lost vast sums of money, and their jobs, most of their social status, and so forth…
I find it vastly more plausible, if not so comforting, to believe that systems can occasionally produce bad results even if the incentives basically point in the right direction. The FICO score revolution was valuable, but we took it too far. The money sloshing around US markets disguised the problems, because people who got into trouble tapped their home equity, or in a pinch, sold the house at a tidy profit. Everyone from borrowers to regulators was getting the same bad signal, that their behaviour was much less risky than it actually was.
Notice that Krugman tells the story of banker bonuses without feeling the need to present any evidence whatsoever. This is a good indication that we’re dealing with a myth, a just-so story, rather than an argument rooted in facts, evidence and economics. And it’s especially surprising from Krugman, who is normally so resistant to making policy based on lies, myths or factual error.
If Krugman were simply advocating lower pay at financial firms out of a sense of distributive justice (the idea people just shouldn’t be allowed to earn that much more money than the rest of us) or partisan politics (campaigning against Wall Street, an ever popular stance, is probably a sure winner these days), we could understand his mythologizing. And, at times, he sounds like these might be his reasons for taking this stance.
- “Even as the rest of the nation continues to suffer from rising unemployment and severe hardship, Wall Street paychecks are heading back to pre-crisis levels,” Krugman writes in his New York Times column today. That’s almost a pure statement of either envy or distributive justice (take your pick) as imaginable. It is almost entirely a normative complaint: it’s not right these guys are making so much money while so many others are out of work.
- Krugman also notes that Obama should take a strand against big pay days for bonuses because “the administration has suffered more than it seems to realise from the perception that it’s giving taxpayers’ hard-earned money away to Wall Street, and it should welcome the chance to portray the G.O.P. as the party of obscene bonuses.” That’s the political angle in a very pure form.
But Krugman is a Nobel prize winning economist rather than a professional moralist or political adviser. So he wants to claim that there are economics behind the myth of banker pay. Unfortunately, presenting it as economics rather than politics or morality makes Krugman’s banker pay mythologizing not only wrong-headed. It makes it actually dangerous.
The problem is that Krugman wants regulators to focus on this issue, calling it “the single best thing we can do to prevent another financial crisis.” But policy making based on a mistaken mythology is unlikely to prevent another financial crisis. Indeed, it is likely to encourage the next crisis by diverting regulatory attention and creating a false sense of confidence in the stability of our system. We may not get around to adopting more effective policies because we are so eager to put our boots into the teeth of greedy bankers.