Snake Oil, Humpty Dumpty and Financial Crisis

I was reading this speech from  George Akerlof (read it along with this ppt). He is basically talking about his new book written alongwith Robert Shiller at a Growth Commission meeting.

In his speech (and book) Akerlof (and Shiller) marry macroeconomics to behavioral economics.

Current versions of macroeconomics greatly play down the role of psychology in the macroeconomy. But, as we show in our book, there are at least eight fundamental macroeconomic questions whose answers depend largely, although not entirely, on the role of psychology.

So the first task of the book is to explain the role of psychology in the macroeconomy, and in answering these eight questions. Keynes called this the role of people’s Animal Spirits. The first part of the book describes five different Animal Spirits. They are: confidence, fairness, corruption and bad faith, money illusion and stories. The second part of the book describes how these animal spirits play a key role in the answer to these eight macroeconomic questions. These questions are as fundamental as why the economy fluctuates as much as it does; why and how monetary and fiscal policy affect the economy; and why there is involuntary unemployment.

He says current financial crisis is a result of selling snake oil as real oil:

It is true that capitalism will produce what people really want, as long as firms can make a profit. But, more subtly, and more generally, capitalism also produces what people think they want, as long as firms can make a profit. Unregulated capitalism may produce good medicines that cure our ills.  

 

I believe it will. But unregulated capitalism also produces snake oil that does not cure our ills. It may even find it profitable to produce the desire for the snake oil itself. In fact that is one major reason for the Food and Drug Administration in the United States. It protects us against buying snake oil medicine.

The principal of snake oil has special relevance for asset markets. Assets to most people are only pieces of paper. Most investors surmise the value of financial assets from what others, such as accountants and rating agencies, tell about them. These accounting and rating agencies also have their own incentives. And those incentives are not fully aligned with the public’s interest. And so when people are overconfident, financial markets tend to produce assets that take advantage of that overconfidence. If unprotected by effective regulation, people will be sold snake oil assets. And an industry will arise to produce them.

🙂 Akerlof could have called snake oil assets plain Lemons as well.  Perhaps lemons is too light a term for the kind of assets that were sold.

There is a view that all we need to do now is to give the banks enough capital so they do not go bankrupt. But that view is naïve and wrong. The shadow banking system, securitizations, and derivatives were serving a function for the economy. This was the way in which much of the economy’s credit was being generated. The originators of the loans initiate them. They would not hold the loans themselves, but, instead, would pass them on to be securitized. But with the loss in confidence, the trust in this system collapsed. It cannot be put back together again. It is a case of Humpty Dumpty. Remember who Humpty Dumpty was. Humpty Dumpty was an egg. He was fragile. So when he fell, all the king’s horses and all the king’s men could not put Humpty Dumpty back together again. Our previous financial system depended on confidence that was fragile.

So, how do you restore confidence? He says Govt should have 2 intermediate targets:

The first target is the usual monetary-fiscal target, projected to reach full employment in the absence of a credit crunch. The second target is the level of credit that would be associated with full employment income. These targets should be achieved by the use of methods one, two, and three.

All this is not new for Akerlof readers. He has for a long time suggested that Central banks should pursue a stabilization policy rather than simple inflation management.

I have just picked bits and pieces from his speech. Read it in full to get the full idea. His take on regulation/deregulation is also quite interesting.

One Response to “Snake Oil, Humpty Dumpty and Financial Crisis”

  1. computers discount Free Important Information | Cheapest Laptop Computer Says:

    […] Snake Oil, Humpty Dumpty and Financial Crisis « Mostly Economics […]

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