Who To Blame

Since I’m an economist, people ask me who to blame for this finance mess.  I’m with Michael Lewis:

Christopher Cox … [is] chairman of the Securities and Exchange Commission, and so has the job of regulating these companies that helped make it possible for every poor American to get a mortgage and are now, as a result, falling apart. … He went as far out of his way as he could to enable the brokerage firms by harassing the small group of informed financial people who have been trying to tell the truth to the markets: the short sellers. They bet against the stock price of a company and so have always had a bad reputation with the public. But in this case, they are the closest thing we have to heroes.

A man named David Einhorn is a case study. He runs a hedge fund called Greenlight Capital, which sells short some stocks and buys others. That is, he doesn’t just bet against companies but for them, too. Still, for some time now, he’s been standing up in front of large audiences, announcing that he was short Lehman Brothers stock, and then explaining in great detail its dubious accounting practices. The SEC responded by demanding to see his firm’s e- mail, hinting darkly that he was part of some conspiracy to drive Lehman Brothers out of business, and generally making him feel that he’d pay a price for telling the truth.

Hat tip to Hopefully Anonymous.

Added: Far from being sorry, they are working hard to make things worse!

Federal regulators yesterday took measures aimed at reining in aggressive forms of short-selling that were blamed in part for the demise of Lehman Brothers and that some feared could be used against other vulnerable companies in a turbulent market. … In a further move, SEC Chairman Christopher Cox said he planned to ask his four fellow commissioners to consider on an emergency basis a new rule that would require hedge funds and other large-scale investors to disclose their short positions … Critics say the SEC action comes too late to stem a tide of short-selling attacks that have felled huge, venerable companies. They want a prohibition on all naked short-selling.

Putting more restrcictions on short than on long trades is trying to shoot the bad-news messenger.  If we had instead been encouraging people to come forward with bad news, maybe we could have dealt with this problem earlier, when it was a smaller. 

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  • D.B. Lambert

    Reduced restrictions on insider trading might have also helped to get more information to the market sooner.

  • Chuck

    On could also point to the systematic dismantling of the Glass-Steagall Act.

    http://www.pbs.org/wgbh/pages/frontline/shows/wallstreet/weill/demise.html

    You might be inclined to say that this kind of failure is inherent in government regulation.

    I would reply by saying that this kind of market failure is inherent in unregulated markets.

    Like so many things in life, it is only through responsible behavior that anything – government, business, personal relationships – works.

  • Chuck

    I think one of the problems with ‘informing the market’ through insider trading is that it is more profitable for the inside trader to keep their info secret until the last minute.

  • Floccina

    The article does not tell us when David Einhorn started warning about Lehman brothers. I did a quick search and the earliest that I see him warning is October 2007, IMO to late to change much.

    For some one to blame how about Alan Greenspan talking up the fact that housing prices were rising faster than inflation like it was a positive (he talked about a wealth effect). Since when is it good to have prices of important things we consume rising faster than inflation? Edward Glaeser warned way back that due to excessive restrictions on building that the benefits of lowering interest rates where almost all being captured by home sellers rather than home buyers. These contributed to the idea that home prices would continue to rise, though perhaps at a slower rate and so that any investment in real-estate was safe.

  • scott clark

    Chuck, saying they keep the info secret until the last minute is like saying its always in the last place you look. its a secret until they act on it, so that is the last minute. the point is that position unwinds. no restrictions on insider trading, then the insider has to act on the info as soon as he/she knows it because he/she has to worry about the other insider(s) acting on the info first. so they race to make the secret unsecret, and its better to know earlier than later for the most part, as Robin was pointing out. Plus, markets don’t fail, some people lose and make choices that turn out not the way they had planned, but thats not a failure, that’s a feature.

  • jobo

    The involvment of the SEC is AIUI not limited to short sellers:
    http://www.nysun.com/business/ex-sec-official-blames-agency-for-blow-up/86130/

  • komponisto

    I would reply by saying that this kind of market failure is inherent in unregulated markets.

    That’s like saying that unwanted offspring are inherent in unregulated sex.

  • Ian C.

    Surely the Federal Reserve is to blame. By keeping interest rates so low they made so much credit available as to encourage all sorts of risky investments. And now today, to solve all these problems they are injecting still more liquidity.

    And what about the few responsible people who actually worked hard, were thrifty, and saved (as old fashion as that idea is). Now their savings are devalued. And for what? So normally non-credit worthy people can get credit. It is like a giant wealth transfer system more powerful than taxes.

  • http://occludedsun.wordpress.com Caledonian

    that helped make it possible for every poor American to get a mortgage

    Isn’t that the problem, right there?

    We’re going to have to get over the idea that everyone is entitled to certain kinds of financial services — and more generally, that everyone is entitled to everything.

  • http://profile.typekey.com/aroneus/ Aron

    I’m disappointed with the attribution of restrictions on naked short sellers. First, you’d have to demonstrate that there was insufficient opportunity to short sell the normal way. Second, you’d have to somehow tie the stock values of these companies (which is a 2nd order measurement) to the underlying fundamental problem of bad loans and bubbley housing prices.

    I blame greenspan.

  • eric falkenstein

    This is a common problem. Many are blaming the symptoms, such as ‘derivatives’, a word that covers so many products it is almost meaningless (eg, ‘we need to regulate derivatives’). Derivatives basically allow one to create ‘complete markets’, and bet on all sorts of things that are unavailable when products do not have these things. But this is the tail, not the dog.

    The problem, the subtlety, of the current crisis is int the complex set of incentives that led to new underwriting standards in an effort to increase home ownership, especially for minorities, and indeed home ownership increased significantly over the past 10 years, something the government and regulators thought was a good thing. To cry wolf in 1995 when policies were just being created, would have been ‘proven’ false by 2000 at least.

    I suppose one could argue derivatives exacerbated this overshoot, but one could also say derivatives highlighted this overinvestment into homes earlier than would have otherwise been (note first signs were really signaled by the ABX subprime indices in early 2007).

  • Aaron

    One theory for the restrictions on short selling is that regulators are embarrassed by successful short sellers because the latter often reveal fraud that the regulators missed (or hid).

  • http://www.allancrossman.com Allan Crossman

    Britain too has apparently “banned short-selling” if the AP is to be believed:
    AP: UK puts ban on short-selling of financial shares

  • a nonie mouse

    look for people (economists (UBS), politicians) who say ‘have to return to normal conditions, normal growth conditions’. these are the people to blame, in this case almost everybody. who says growth is the normal condition?

  • http://michaelgr.com/ Michael G.R.

    “Surely the Federal Reserve is to blame. By keeping interest rates so low they made so much credit available as to encourage all sorts of risky investments. And now today, to solve all these problems they are injecting still more liquidity.”

    Yep. They’re basically printing inflation.

  • http://evtujo.blogspot.com evtujo

    For what it’s worth the second half of TAL last weekend was about Cox and naked short selling among other things. Enforcers

  • mjgeddes

    The blame for the crises is squarely with Libertarian ideologues, and Libertarian economists, and Libertarian blog commentators. Thanks to their propoganda the US financial sector did not implement regulations needed for the complexities of modern operations.

    There were extreme booms and busts long before there was much governemnt regulation (as records prior to the 1930s clearly show). In fact, as James Hughes just pointed out, this was a clear weakness of unregulated markets. As more government regulations were implemented, the extremes were mitigated. This is clearly seen in the current big US government bail-outs, (nationalization of these business is good old fashioned socialism) without which world markets would have totally implored.

  • http://neuraltransmissions.wordpress.com MZ

    SEC puts a 10-day ban on short selling.

  • http://hanson.gmu.edu Robin Hanson

    Thanks for the link MZ; I just blogged it.

  • Brian Macker

    “Since I’m an economist, people ask me who to blame for this finance mess.”

    Alan Greenspan, mostly. Stock jobbing, manias, “episodes of greed”, asset bubbles, are effects that generally follow from excess monetary inflation.

    This is mostly about lowering the interest rates to absurdly low levels, a history of bailouts, etc.

    I’m going with the theories of those who predicted this finance mess prior to it happening. The William Fleckensteins of the world, the people over at mises.org. Austrian theory, not Monetarist theory or whatever the hell Greenspan specifically believes that lead him to pump and pump the money supply.

  • Wei Dai

    The “market” bought trillions of dollars of mortgage-backed securities without noticing that:

    a. mortgage loan standards were going down the drain because loan originators weren’t risking any of their own money
    b. housing prices were rising at an unsustainable rate
    c. the companies that sold insurance (i.e. credit default swaps) on those mortgage-backed securities couldn’t possibly pay off on claims if housing prices stopped rising and defaults occurred on a large scale,

    none of which were exactly secret information. Is it Michael Lewis and Robin’s position that this happened mainly because the S.E.C. made some vague treats against short sellers and demanded to see their emails?

    It seems like we have much better candidates to assign the blame:

    – rationality: some people buying mortgage-backed securities knew what they were getting into, but didn’t care because they were playing with other people’s money and were in a “heads I win, tails someone else loses” situation
    – irrationality: those playing with their own money failed to properly account for risks

    Maybe short selling can be a cure for both of these problems, but if so we’d need to figure out how to encourage it to occur on a much bigger scale, because the natural market incentives don’t seem to be enough.

  • http://hanson.gmu.edu Robin Hanson

    Wei, I didn’t say they were the only people to blame.

  • Tim Tyler

    Didn’t short selling help finance 9-11?

    “ISRAELIS were 9-11 short sale stock buyers, betting on WTC terror strikes”

    http://portland.indymedia.org/en/2005/04/315296.shtml

    It’s easier to blow things up rather than build things – and short selling makes it easier to profit from the misfortune of others.