The campaign to crack down on Wall Street bonuses was dealt a serious intellectual blow today when the winner of the 2006 Nobel prize in economics described attempts to blame misaligned compensation incentives for the financial crisis as “the most profound fallacy.”
Edmund Phelps wrote a piece critical of neoclassical and Keynesian responses to the financial crisis for the Financial Times today. It’s a great takedown of both schools from a Hayekian perspective. But it concludes by delivering a hammer blow to those who want to blame the financial disaster on bonuses.
The most profound fallacy is the newfangled idea that misalignment of incentives in banks caused the housing bubble – a bubble that, when it burst, shook the economy to its foundations. All can agree that increased lending and building ran into the awkward fact that costs increase when production is stepped up. On that account, prices sought a higher level. But that analysis does not capture the steep four-year climb in housing prices, which rose by more than 60 per cent.
To account for so large an increase, we have to recognise that expectations played a role. Speculators appear to have expected that housing prices would go sky-high, so prices took off and then went on climbing in anticipation that those high prices were getting closer. The banks, seeing the houses offered as collateral were worth more and more, responded by supplying an increasing flow of mortgage loans.
From this viewpoint, speculation drove the crisis. Misaligned incentives were not sufficient to do it – and not necessary either. Bubbles long predate bonuses. The crisis could have happened with a 1950s financial sector. The lesson the crisis teaches, though it is not yet grasped, is that there is no magic in the market: the expectations underlying asset prices cannot be “rational” relative to some known and agreed model since there is no such model.