The relentless witch hunt for those culpable of our current economic ills has me a little perplexed. I am constantly amazed by how coverage of this event has failed to enlighten us on the real root of the problem. As we all learned at SOM, economics is the study of incentives. And thus if we examine the real estate bust, which has resulted in a financial crisis, ultimately leading to consumer led recession without parallel in the post WW2 era, we will find incentives embedded in the tax code and US law. Let's take for example, the deductability of mortgage interest, which is a clear incentive for home ownership and high levels of indebtedness (interesting that this only happen in Anglo Saxon countries, and not in nations where these incentives do not exist), and most recently the law Clinton signed in 1999 (Community Reinvestment Act Part Deux) broadening incentives for home ownership. Furthermore, the alchemists in Wall Street created "securitization" which although a good idea, had many perverse incentives they didn't foresee, i.e. originators didn't scrutinize borrowers as if the loan was going to remain on their portfolio till maturity. Then there was the Basel 2 accord with respect to the treatment of these toxic pieces of paper (they never contemplated volatility in home prices). So this was a crisis in the making for decades, with the decline in the savings rate during this time as clear evidence.

So as the media has fun blaming Wall Steet, Hedge Funds, greedy banks, we really know who the culprit is, government. How about also blaming ourselves, yes the public. After all, why are we blaming those that handed all of us easy money. Think about it, who is the fool, the guy who gives you money on a non recourse basis when there is a low probability he will get it back, or the guy that takes it, buys a house with it, and makes a profit with it (if he or she bought the property in the early 2000's and sold it now...yes even now)? Seems to me like the borrower got a free call option (well at a cost of 200 points on your FICO score if you mail the keys back).

So why the outrage? Everyone is to blame here, the general public who didn't learn their lesson (about there being no free lunch) after the dot com bubble and thought this asset class was somehow different (They should have all read Irrational Exuberance like me in 2002), the extinct wall street investment banks, who deluded themselves into believing they had found the alchemist's dream in securitization and further compounded the mistake by levering in some cases up to 40 to 1, and finally government who provided the incentives for the whole mess in the first place.

Free markets work, contrary to what you read in the papers, and so would government if it was responsible (please read Alan Smith to understand how government can work hand in hand with free markets for our collective good). Let's also give Hedge Funds and short sellers a break as well. They have done us a favor by bringing these problems to light much quicker than otherwise would have happened, thus aiding the price discovery process. They first put everyone on notice during the sub-prime crisis of August 2007. What might have been if we would have listened to Ackman and Paulson back then. But no, we demonized them, and failed to heed the message they were sending us, with the conviction of their pocket books. Short sellers have now put corporate America on notice that stupidity will no longer be tolerated and for that we should be thankful, Hayek and Von Mises would be proud. They are to some extent the ultimate regulator, with the benefit of aligned incentives.

Finally, it is unfortunate how this has all worked out. To make matters worse, we now live in a world of the Phillips Curve and the Keynsian Liquidity, where deflation threatens to end our way of life (deflation is kryptonite to a highly levered economy). We are in what in physics is called the event horizon, and if the fed doesn't go to ZIRP, quantitatively eases , starts buying assets, provides more unemployment relief and food stamps, I fear we shall fall into the black whole. The sad thing is that government who planted the seeds for all of this initially is now who we must rely on in order to save us. Perverse indeed.

I want to thank Yale SOM for providing me with the skill set necessary to successfully navigate these very troubled waters. Professors Lamont and Shiller through their behavioral finance class and writings were instrumental in shaping my thinking about markets and asset prices. There can be no better testament to the value of Yale's education than for one of its students to so clearly see in the last 2 years what so many out there where so blatantly oblivious to.

Posted by Paul Tweddle 2004 on December 2, 2008

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