Sunday, November 16, 2008

The Mathematics of the Blame Game

I recently received a survey of economists on the subject of the financial crisis. The primary goal is to find out what economists believe caused the crisis. The various contributing factors fall into two basic categories, which I will call “government failure” and “market failure.” (Those aren’t the terms used in the survey, but that’s essentially what they are.) At one point, the survey asks the respondent to assign each category a percentage score for its contribution to the crisis, with the percentages adding up to 100%. For instance, you could say government factors were responsible for 60%, market factors for 40%.

The thing is, it should be possible for the percentages to add up to more than 100%. Why? Because some part of the crisis cannot be attributed to one category or the other; it can only be attributed to both.

An analogy. Say your spending on Coke has risen from $20/month to $45/month. This is because the price has risen (from $2 to $3) and also because your consumption has gone up (from 10 to 15 bottles). The total change is $25/month. How much of the increase is attributable to higher price, and how much to higher quantity? Well, if the price hadn’t increased, you’d be spending $15/month less. If the quantity hadn’t increased, you’d be spending $15/month less. As a percentage of the total $25 increase, each factor is responsible for 60% of the total effect, for a combined percentage of 120%. How is that possible? Because $5 of the increase resulted from both price and quantity having gone up; that is, $1 more per bottle multiplied by 5 more bottles.

Okay, so that example was probably too obvious. But I think that’s exactly what we have in the financial crisis. Some amount of the crisis is attributable solely to bad government behavior (like the Community Reinvestment Act and easy credit from the Fed). Some is attributable solely to bad market behavior (like excessive optimism and lying on credit applications). And some portion of the crisis is attributable to bad government policies having exacerbated bad market behavior. For instance, Fannie Mae and Freddie Mac – government-created entities with implicit government backing – helped to inflate the housing bubble.

No, I don’t know what percentage should be attributed to both categories. But I think it’s probably large.

If we must lump the combined effect into one of the other two for “blame game” purposes, there is an interesting philosophical question about where to put it. It depends a lot on what you take as given. My instinct, for instance, is to lump the combined effect into the government failure effect. Why? Because I largely take the propensities of market actors as given. Yes, people are greedy and overoptimistic and dishonest. But it was always thus. I don’t see basic human nature as fundamentally alterable. What matters, then, is whether government policy channels human nature in good or bad directions. On the other hand, if you start with government policy as given, then you’ll end up lumping the combined effect into the market failure effect. Which is the more reasonable assumption?

In addition, at least in the government category, there are two kinds of potential failure – broadly, “too much government” and “too little government.” And that’s actually where a lot of the debate is taking place, since liberals seem to think the main problem was that we needed more regulations, while market-types (like me) think a large part of the problem was too many (bad) regulations in the first place. Should lack-of-regulations be considered a market failure because regulations are supposed to rein in the market, or a government failure because government actors failed to enact them? (For what it’s worth, the survey includes “regulatory and surveillance policy” in what I’ve called the government category.)

5 comments:

Anonymous said...

Yes, the big problem with trying to pinpoint the blame is that it's a false dichotomy. Big business basically dominates government today. The federal and state governments are controlled by the corporations that they are supposed to regulate. The last 8 years of Bush were especially the case of the foxes running the chicken coops on Wall St. Although Phil Gramm basically got his way regarding legislation designed to deregulate business during the Clinton Administration. Part of the deregulation was a purposeful attempt to keep the regulating agencies from getting a full picture of what was going on with the financial markets, etc. - keeping them mostly in the dark. Every time businesses were deregulated it was at the behest of those very same businesses. So the blame is closer to 200 percent - 100 percent for each actor to undo the protections created during FDR's administration. This government has been bought and paid for by the greediest, most corrupt people you can imagine. Their world of malign mischief is collapsing around them and they are killing us in the process. If these culprits cause a 2nd Great Depression resulting in the the pain and suffering of millions, will they get off scot- free? Mostly, others will be left to pick op the pieces for their folly, while they continue to live the life of Riley. Revolutions and civil wars have been fought over such things in the past, in various countries around the globe, usually resulting in death and destruction on a wide scale.

Tim2208 said...
This comment has been removed by the author.
Tim2208 said...

I wonder, would the financial industry be in the state it's in today if there was never the prospect of government intervention?

CB said...

The question goes back to one of the foundational arguments that established this experiment. The slimy Alexander Hamilton (he Aaron Burr and others started the Bank of New York with what was supposed to money from residents for the plague) wanted to replicate the mercantilist system of England here in America whereby a central bank would favor those industries believed to be necessary for the development of the nation and its long term prosperity, meaning, it was going to personally benefit Hamilton and others on board with him to use public funds to establish and grow their businesses.

John Locke and Adam Smith decried the folly of mercantilism, Smith more forcefully. Jefferson and Madison were also opposed.

Mercantilism is different than market organization of economic activity. The government picks winners and losers and since Wilson revived the concept of a central bank after Jackson killed it by not renewing the charter of the 2nd National bank, we've been more mercantilist and less capitalist.

Mercantilism is insidious. If you think of economic/political systems on a continuum, mercantilism is a bridge from capitalism to socialism. Government initially only intervenes with capital, then with regulation, then by regulators manipulating, then through direct participation, socialization of losses and maybe nationalization of industries.

It still comes down to government that distorts market decisions through either artificially high available money which places some otherwise unprofitable ventures in the black long enough for private actors to take the risk or through the false security of regulation that gives investors confidence or through the imprimatur of government agency and the cascade of confidence failure that follows incompetent government actors who, without the authority of their office would not be in the game (fannie, freddie) but have taken everyone down with them in the name of fairness, equity, goodness and light.

Robert said...

Hi, the blame game is something that the working class will always lose because of how the banks have such power with the media.

Check out this article that goes in depth into the lies pushed out:
http://www.sott.net/articles/show/176841-Rescuing-Capitalism-or-Grand-Theft-Military-Dictatorship-