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Error vs. Fraud

Monday, January 4, 2010

How do groups of intelligent, sophisticated bankers, investors, borrowers, entrepreneurs, and traders find themselves caught together in the recurring bubbles and busts?

The reason I entered banking 40 years ago was that I thought, as I still think, that financial systems and their relationship to the real economy, politics, and group psychology are philosophically intriguing. In my opinion, there is no doubt that financial busts and crashes and crises are natural occurrences. However, we have to be more sophisticated than the usual ex post facto explanations, such as that bankers are stupid, greedy, fraudulent, or “fat cats”—these are uninteresting hypotheses and dull rhetoric.

The interesting question is: How do groups of intelligent, sophisticated bankers, investors, borrowers, entrepreneurs, and traders (not to mention central bankers and regulators) find themselves caught together in the recurring bubbles and busts? At Continental Illinois in 1984, I lived through a bank run. Continental Illinois was filled with smart, competent people—yet it failed. So was Bear Stearns in 2008, and so did it. Walter Bagehot observed that in the excitement phase of a financial expansion, the ablest and cleverest leverage the most. So how is it that intelligent, hard-working, competent, analytical bankers, investors, and entrepreneurs end up in financial collapses?

We have to be more sophisticated than the usual ex post facto explanations, such as that bankers are stupid, greedy, fraudulent, or ‘fat cats’—these are uninteresting hypotheses and dull rhetoric.

The explanation often offered by economists is one of incentives. It is said that if we only had better incentives—if banks, for example, had more capital, more management ownership, better governance by boards of directors, or more involvement by the at-risk shareholders—you would not have these crises. I am not much impressed by this argument. History is full of private banks that were not only owned by the bankers but where the banker himself had his total personal wealth committed to the liabilities of the bank; those private banks got involved in financial bubbles and the subsequent busting, just like banks and other financial companies do today.

I do not think the fundamental problem is incentives. I believe the essential question is one of knowledge and inevitable ignorance of the future, or knowledge and error, or what we may call the doctrine of plausible mistakes. As the witty observer Don Schackelford said about the savings and loan collapse of the 1980s, “the unintended folly of the reasonably decent was far more costly than the contrived villainy of the corrupted few.”

This is a fine phrase. In the same vein, here is Bagehot, writing in 1873, in one of my favorite passages of Lombard Street:

A manager sometimes committed frauds which were dangerous and still oftener made mistakes that were ruinous … Error is far more formidable than fraud: the mistakes of a sanguine manager are far more to be dreaded than the theft of a dishonest manager … The losses to which an adventurous and plausible manager, in complete good faith, will readily commit a bank, are beyond comparison greater than any which a fraudulent manager would be able to conceal.

How do ex ante credible and intelligent actors come to make such momentous mistakes? Well: “Many things which were considered impossible nevertheless came to pass.” For example, it was generally considered impossible for U.S. national average house prices to fall, let alone to fall by 30 percent, but they did.

I believe the essential question is one of knowledge and inevitable ignorance of the future, or knowledge and error, or what we may call the doctrine of plausible mistakes.

The key question is not why such things came to pass, but why they were considered impossible by all of those well-educated, hard-working financial professionals.

Part of the explanation is that, for practical purposes, risk is a feeling. When something ceases to feel risky, you go ahead. Very risky things are done because one gets used to doing them. Feelings of riskiness fade when practice changes step by step over time. We are great comparers of this year with last year, but as things keep drifting, step by step, we get used to it. So we might slightly alter some couplets of Alexander Pope. In the original, the first word is “vice”; the bankers’ version begins with “risk”:

Risk is a creature of such frightful mien
That to be hated needs but to be seen,
Yet seen too oft, familiar with her face,
We first endure, then pity, then embrace.

We may think of this as “how to boil a frog.” You may remember the old story that to boil a frog, put him in very comfortable warm water so he relaxes. Then you turn up the heat 1 degree at a time, and before he realizes it, he is cooked. So in the banking system, one degree at a time, as the bubble grew, financial relationships shifted, leverage at all levels increased, and the margin for error shrank, but feelings of risk did not keep up with how much all this was shifting.

When all the risk becomes manifest, and the uncertainty about who is broke and who isn’t is intense, the feelings of risk catch up and overreact: we have the panic and the crisis as the now-obvious errors come home to roost.

This gives politicians, who in the case of the mortgage bust had a big hand in promoting the errors, the chance to make another error by blaming the problems on fraud, greed, and stupidity. This recurring political phase of financial cycles is not pretty, but it is completely predictable.

Alex J. Pollock is a resident fellow at the American Enterprise Institute. From 1991 to 2004, he was president and CEO of the Federal Home Loan Bank of Chicago.

FURTHER READING: Pollock recently asked, in “TARP and Leviathan,” how the United States can move back towards reprivatization after the financial crisis, and says of the housing bubble, “It Wasn’t a Bubble—It was a Double Bubble.” He also testified before Congress on running “TARP on a Businesslike Basis.”

Image by Dianna Ingram/Bergman Group.

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