…Some agents are more rational than others?
I’m reading through 13 Bankers, Johnson and Kwak’s excellent treatment of the rise of the American financial oligarchy and the current economic crisis. In addition to being well-written and comprehensive, the book also adds a much longer historical narrative to the current conjuncture. Rather than beginning with the 1970s or 1980s, as do most accounts that have much history, or even the Great Depression, 13 Bankers goes all the way back to early debates in the late 18th and early 19th century about the role and power of banks. And unlike other accounts, 13 Bankers includes a section on the various financial crises of the 1980s and 1990s that affected other countries. Johnson, who worked at the IMF for years, draws insights from those crises and in particular the importance that various oligarchs (people who trade economic power for political power to in turn make more money) had. Finance, Johnson and Kwak argue, constitutes the American oligarchy.
While the account is excellent, as a longtime reader of their blog, and a current consumer of all kinds of narratives about the crisis, I haven’t seen a ton that’s absolutely new (just changed in focus, given the emphasis on political economy rather than technical and mathematical wizardry or pure fraud). One set of stories did interest me though: the decisions not to regulate complex financial derivatives. At various points in the 1990s, federal regulators contemplated regulating derivatives. Brooksley Born, then head of the Commodity Futures Trading Corporation (a federal regulator in charge of old-school derivatives that were traded on exchanges, like agricultural futures) fought Greenspan, Rubin and others who thought that new derivatives did not need regulation. Born lost, and so did we all – eventually Born left the CFTC, and in the last moments of Clinton’s 2nd term, he signed the Commodity Futures Modernization Act which enshrined the non-regulation of derivatives (and preempted state regulators who might have thought about taking a shot at it).
The rationale for this preemption interests me because it connects closely to a key kind of assumption in economic theory: rationality. In general, economics assumes that agents are rational. Minimally, that means that agents have consistent preferences (preferring A to B, B to C and thus A to C). Maximally, rationality is taken to mean that agents have a full understanding of all choices available to them, all potential outcomes, and the probability of each choice leading to each outcome, along with a set of preferences that emphasizes narrow self-interest (i.e. maximizing profits or utility). Many modern economic models relax or eliminate some parts of these assumptions – such as Nobel-prize winning attempts to grapple with incomplete information (Akerlof, Stiglitz), or the persistent risk aversion observed in people’s behavior (Kahneman and Tversky).
One of the presumptions of the sort of economic sociology I find most helpful is that rationality is not a fixed aspect of human nature, but a product of social and technical arrangements. That is, rather than debating whether or not people are “really” like what economic models say they are, economic sociologists have focused on how people actually make the calculative decisions that their life demands – from finding a job (Granovetter’s early work) to calculating the value of stock options (MacKenzie and Millo). More traditional economic sociology focused on the social and institutional contexts of economic decision-making (like networks of friends, or board interlocks diffusing information), while one branch of newer work has focused on the material and theoretical tools for calculation (calculators, computers, economic models).
So what’s this got to do with the financial crisis and the regulation of derivatives? The interesting problem facing Greenspan and Rubin in arguing that derivatives should be let free was how to claim that regulators could ignore a certain kind of activity. Rather than seeking to expand their domain, they wanted to limit it. The answer was to split up the world of economic actors into different classes of rationality. Individuals – depositors, mortgage-seekers, credit card holders – might need protection (the FDIC, for example, which protects deposits) but sophisticated investors do not. On page 136, Johnson and Kwak quote Greenspan’s testimony before a House committee:
Greenspan said, “professional counterparties to privately negotiated contracts also have demonstrated their ability to protect themselves from losses, from fraud, and counterparty insolvencies”; he concluded, “aside from safety and soundness regulation of derivative dealers under the banking or securities laws, regulation of derivatives transactions that are privately negotiated by professionals is unnecessary. Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living.”
In other words, professional investors are far too rational to need the government’s help deciding how risky derivative transactions are. And a market populated by large, professionals transacting with each other doesn’t need any enforced transparency or clearing mechanism that would result from forcing such transaction to be standardized on an exchange rather than over-the-counter. Combine a belief that professional investors are best at looking out for their own interests, and a strong belief that individuals pursuing their self-interest wisely always leads to socially good outcomes (i.e. the shoddy, modern version of the invisible hand argument which ignores the possibility of systemic risk), and you get a rationale not to regulate a crazy, complicated, and potentially massive new kind of market.
“I made a mistake in presuming that the self-interest of organizations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms.”
In other words, Greenspan thought of financial firms as unitary, rational actors, not complex coalitions of potentially fallible micro-actors with diverse interests, information, capacities and the like. When the ties that held such combinations together – ties like Value-At-Risk and Gaussian Copula models, as much as personal and financial ties – started to fall apart, macro-actors ended up looking like really big micro-actors. Instead of a hyper-rational and super-safe investor, big firms started to look like highly leveraged individuals who’d made a single kind of bet – that home prices wouldn’t fall, that similar securitized assets rated AAA would not lose their value, that super-senior tranches could never fail. Whoops.