The Astonishing Voice of Albert Hirschman

Albert Hirschman is 95 years old today.

Four decades ago, he published Exit, Voice and Loyalty, a slim volume that contains more insights per page than just about anything else I have read. I consider it to be among the finest books ever written by an economist. For reasons discussed below, it also has enormous contemporary relevance.

The subtitle of the book is "Responses to Decline in Firms, Organizations and States." Hirschman's concern is with "repairable lapses" in organizational performance: declines that could be corrected with the right balance of information, incentives and flexibility of response. This is not a subject to which economists had paid much attention, and he begins by asking why:

While moralists and political scientists have been much concerned with rescuing individuals from immoral behavior, societies from corruption, and governments from decay, economists have paid little attention to repairable lapses of economic actors. There are two reasons for this neglect. First, in economics one assumes either fully and undeviatingly rational behavior, or, at the very least, an unchanging level of rationality... In other words, economists have typically assumed that a firm that falls behind... does so "for a good reason"; the concept... of a... "repairable lapse" has been alien to their reasoning.

The second cause of the economist's unconcern about lapses is related to the first. In the traditional model of the competitive economy, recovery from any lapse is not really essential. As one firm loses out in the struggle, its market share is taken up and its factors are hired by others... in the upshot, total resources may well be better allocated. With this picture in mind, the economist can afford to watch lapses of any one of his patients... with far greater equanimity than either the moralist who is convinced of the intrinsic worth of every one of his patients (individuals) or the political scientist whose patient (the state) is unique and irreplaceable.

But is the neglect justified? Hirschman argues that it is not, because the vision of a "relentlessly taut economy" operating at or close to its productive potential is inapplicable to technologically modern societies capable of producing a substantial surplus relative to the needs of subsistence. The very existence of the surplus implies that considerable slack in the level of efficiency can be tolerated without disastrous consequences. As a result, firms and other organizations are "permanently and randomly subject to decline and decay, that is, to a gradual loss of rationality, efficiency, and surplus-producing energy no matter how well the institutional framework within which they function is designed."

It is critically important, therefore to consider the "countervailing forces" that can arrest and reverse such decline. Hirschman identifies two such forces: desertion and articulation, or exit and voice. Exit refers to the fact that the customers of a firm (or members of an organization) can simply leave and attach themselves to a competing firm or organization. Voice refers to the expression of discontent: the natural human tendency to complain, protest, and generally "kick up a fuss." Each of these mechanisms is interesting in its own right, but it is the interaction of the two (and their connection to loyalty) that gives rise to the most intriguing possibilities.

One of Hirschman's key insights is that exit will not serve as a reliable recuperation mechanism if it occurs too rapidly in the face of organizational decline:

For competition (exit) to work as a mechanism of recuperation from performance lapses, it is generally best for a firm to have a mixture of alert and inert customers. The alert customers provide the firm with a feedback mechanism which starts the effort at recuperation while the inert customers provide it with the time and dollar cushion needed for this effort to come to fruition.

In addition, rapid rates of exit can deprive an organization of precisely those customers (or members) who, had they remained, would be most inclined to utilize voice:

[Those] customers who care most about the quality of the product and who, therefore, are those who would be the most active, reliable, and creative agents of voice are for that very reason also those who are apparently likely to exit first in case of deterioration.

As a result, the "rapid exit of the highly quality conscious customers... paralyzes voice by depriving it of its principal agents."

While it is commonly believed that most organizations would prefer that their customers or members had no exit option at all (as in the case of a monopoly) Hirschman argues, instead, that monopolists would welcome a modest degree of competition in order to shed their most vociferous customers:

[There] are many... cases where competition does not restrain monopoly as it is supposed to, but comforts and bolsters it by unburdening it of its more troublesome customers. As a result, one can define an important and too little noticed type of monopoly-tyranny: a limited type, an oppression of the weak by the incompetent and an exploitation of the poor by the lazy which is the more durable and stifling as it is both unambitious and escapable.

This is why those holding power in dysfunctional states "have long encouraged their political enemies and potential critics to remove themselves from the scene through voluntary exile."

More generally, the performance of near-monopolistic service providers may be worse than that which would prevail if monopoly power were absolute. This has enormous and wide-ranging implications. The poor performance of a national railway system might persist indefinitely if the most demanding customers also have recourse to road transportation. Public schools might deliver worse learning outcomes if private or parochial options are available to the most quality conscious parents. A small decline in neighborhood quality could turn into a precipitous collapse if those most affected by it simply move elsewhere. And the ease with which common stock can be sold implies that the most vigilant shareholders will liquidate their holdings rather than attempt to improve the performance of management.

While most environments are such that either exit or voice is the dominant response to decline, there is one arena, that of political competition, in which both mechanisms are critical. In this setting, taking account of voice leads to sharply different predictions than theories based only on exit. Hirschman's critique of the Hotelling-Downs analysis of political competition (and the median voter theorem it implies) is devastating:

As soon as the Hotelling model had been thus refurbished by Downs, its power to explain reality was again cast into doubt by the undisciplined vagaries of history. The selection by the Republican party of Goldwater in 1964... testified to the extreme reluctance of at least one party to conform to the Hotelling-Downs scenario...

[It was not] Hotelling's original assumption of inelastic demand... that was wrong or unrealistic, but the inference that the "captive" consumer (or voter) who has "nowhere else to go" is the epitome of powerlessness. True, he cannot exit... but just because of that he... will be maximally motivated to bring all sorts of potential influence into play so as to keep... the party from doing things that are highly obnoxious to him... in a two-party system a party will not necessarily behave as the Hotelling-Downs vote-maximizer because "those who have nowhere else to go" are not powerless but influential.

With modern communication technologies able to transmit, coordinate and amplify voice to an unprecedented degree, these insights have more relevance than ever. 

As Hirschman's title suggests, the interplay between exit and voice depends critically on the presence or absence of loyalty:

When loyalty is present exit abruptly changes character: the applauded rational behavior of the alert consumer shifting to a better buy becomes disgraceful defection, desertion, and treason. 

By making exit less appealing, loyalty to an organization can therefore be functional; it can "neutralize within certain limits the tendency of the most quality conscious customers or members to be the first to exit." But since "the effectiveness of the voice mechanism is strengthened by the possibility of exit," too much loyalty will stifle voice. In particular, the active promotion of loyalty by an organization can be detrimental to its own long run functioning:

[Loyalty] promoting institutions and devices are not only uninterested in stimulating voice at the expense of exit: indeed they are often meant to repress voice alongside exit. While feedback through exit or voice is in the long-run interest of organization managers, their short run interest is to entrench themselves and to enhance their freedom to act as they wish, unmolested as far as possible by either desertions or complaints of members.

From this perspective, a key determinant of organizational performance is the price of exit (which may or may not arise from loyalty):

Such a price can range from loss of life-long associations to loss of life, with such intermediate penalties as excommunication, defamation, and deprivation of livelihood. Organizations able to extract these high penalties for exit are the most traditional human groups, such as the family, the tribe, the religious community, and the nation, as well as such more modern inventions as the gang and the totalitarian party... Since the high price of exit does away... with the threat of exit as an effective instrument of voice, these organizations... will often be able to repress both voice and exit. In the process, they will largely deprive themselves of both recuperation mechanisms.

And the absence of recuperation mechanisms can have catastrophic consequences, as the current predicament of the Roman Catholic Church vividly illustrates.

I could go on, but the point has been made. This is a book with dozens of sparking insights tied together by a coherent vision. The vision allows for a broad range of human motivation, encompassing (but not limited to) standard hypotheses regarding rational behavior. Economic actors in Hirschman's world shop for lower prices and higher quality, to be sure, but they also capable of making a nuisance of themselves, engaging in self-deception, and displaying fierce loyalty to organizations with which they are affiliated. This rich, complex conception of human behavior allows for a sweeping analysis that is as penetrating as it is ambitious.

My birthday wish for Albert Hirschman today is nothing less than that which he has long deserved: the Nobel Memorial Prize in Economics.

Norms as a Substitute for Laws

In a fascinating post on joke-theft in the world of stand-up comedy, Kal Raustiala and Chris Sprigman describe the manner in which social norms backed by informal sanctions can accomplish what copyright laws cannot:

Late one Saturday night in February 2007, a stand-up comic named Joe Rogan decided to take the law into his own hands... For weeks, Rogan had been furious over reports from fellow comedians that an even more famous stand-up, Carlos Mencia, had stolen a joke from one of Rogan’s friends... Rogan spotted Mencia in the audience, and he blew up. Slamming Mencia as “Carlos Menstealia,” Rogan accused his rival of joke thievery. Mencia rushed the stage to defend himself, and there began a long, loud, and profane confrontation...

Rogan’s decision to confront Mencia is an example of what stand-up comedians do all the time. Comedians have rules of their own about joke-stealing. And they impose their own punishments on thieves... Why do comedians do this? In part, because they live in a world where intellectual property law – in particular, copyright – does not help them much when a rival comedian steals a joke... lawsuits are simply too expensive and uncertain to work as an effective response... Today’s comics are intent on enforcing ownership rights. Yet they do so via social norms – informal but nonetheless powerful rules enforced by comedians on their peers... Comedians maintain a small list of commandments that every comic must follow – or risk being ostracized, boycotted, and sometimes worse. These norms track copyright law at times... More often than not, however, the norms deviate from copyright: for example, copyright protects expression but not ideas, but comedians’ norms protect expression as well as ideas...

Importantly, comedians’ norms... include informal but powerful punishments. These start with simple badmouthing and ostracism. If that doesn’t work, punishments may escalate to a refusal to work with the offending comedian – which can keep the accused joke-thief off of comedy club rosters. Occasionally, punishments turn violent. None of these sanctions depend on the law – indeed, when comedians resort to threatening or beating up joke thieves, that’s against the law. That said, although both the rules and the punishments are informal, they are effective. Within the community of comedians, it hurts to be accused of stealing a joke. In some cases, repeat accusations may destroy a showbiz career.

Raustiala and Sprigman recognize that the prevalence of such phenomena undermines one of the standard arguments for copyright protection:

What does this all mean? The story of stand-up tells us that... the law is not always necessary to foster creativity. Using informal group norms and sanctions, comedians are able to control joke-stealing. Without the intervention of copyright law, comedians are able to assert ownership of jokes, regulate their use and transfer, impose sanctions on joke-thieves, and maintain substantial incentives to invest in new material.

This presents a challenge to the conventional economic rationale for intellectual property rights. Absent legal protection, the usual theory goes, there will be too few creative works produced — authors and inventors would be unlikely to recoup their cost of creation, so they won’t bother creating in the first place. As we have described, there is no effective legal protection against joke theft. Yet thousands of stand-ups keep cranking out new material night after night. In the absence of law, we find anti-theft norms providing comedians with a substantial incentive to innovate. Which leads to an important and fascinating question: Where else might creativity norms effectively stand in for legal rules?

In fact, one could ask an even broader question: in which other areas of economic and social life might norms (backed by decentralized sanctions) operate as effective substitutes for legal institutions?

This question lies at the heart of the lifelong work of Elinor Ostrom, co-recipient of the 2009 Nobel Memorial Prize in Economics, whose contributions I discussed in in a couple of earlier posts. Using an eclectic mix of methodological approaches, including case studies, laboratory experiments, and game theoretic models, Ostrom managed to overturn conventional wisdom regarding the "tragedy of the commons." She demonstrated the possibility of self-governance when a well-defined group of users with collective rights to an economically valuable resource were at liberty to develop their own rules, and to ostracize, expel, or otherwise sanction each other for violations. 

While Ostrom's focus was on natural resources such as forests, fisheries, and pastures, her basic insights have more general relevance. For instance, institutions of self-governance are critically important in the case of urban communities that lie largely outside the reach of the formal legal system in the United States. There are parts of the country where residents do not have recourse to the courts to adjudicate contractual and other disputes. Given the very high costs of violence as an enforcement mechanism, norms backed by limited community sanctions can therefore play a crucial role.

Sudhir Venkatesh provides a number of vivid examples of this phenomenon in Off the Books, his first-hand account of a Chicago community that functions with limited direct reliance on the police, courts, banks or government agencies. In order to do so, it must draw upon on its own informal substitutes for formal institutions. There is extensive use of barter and in-kind payments for wages and debt settlement, reciprocal lending agreements for insurance, and informal mechanisms for the resolution of disputes and the assignment of property rights. As in the local commons studied by Ostrom, norms sustained by the threat of sanctions allow a broad range of mutually beneficial transactions to occur without formal contracts backed by the power of the state.

The kinds of norms and enforcement mechanisms identified by Ruastiala and Sprigman (and Ostrom and Venkatesh) are pervasive. Many more examples may be found in an extraordinary volume edited by Daniel Bromley. Included among these is a study of sea tenure in Bahia by Cordell and McKean in which the authors describe a system of ethical codes "far more binding on individual conscience than government regulations could ever be." Such codes also crop up in James Acheson's work on the lobster gangs of Maine, E. Somanathan's account of forest resource management in Central Himalaya, and literally hundreds of other studies, enough to fill a two volume bibliography and more.

Norms not only accomplish the goals of laws, they can often do so more efficiently. The erosion of norms (or the prohibition of the sanctions that stabilize them) can therefore be costly, even if formal laws are enacted to take their place. Since laws can sometimes undermine and sometimes reinforce informal codes of conduct, finding the right balance between norms and laws is not an easy task. I suspect that legal scholars are acutely aware of such tensions, but (to my knowledge) these trade-offs have received limited attention in economics.

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Update (4/1). In response to a lively discussion of these issues on Mark Thoma's blog, I have posted a few clarifications. Here's a slightly edited version of my comment:

In hierarchical contexts there can be oppressive norms that serve to reinforce and entrench status. Axelrod has a 1986 paper in the APSR with some examples from the Jim Crow period, and many vivid cases can be found in rural parts of South Asia even today, related both to gender and caste. The fact that oppressive norms can be more effective than oppressive laws makes them less rather than more desirable. I should have been more careful on this point.

For norms backed by sanctions to work, group boundaries have to be well-defined, although communities need not be close knit... For example, norms against plagiarism are pretty effective deterrence mechanisms in academic circles.

This is why the distinction between common property and open access is so critical in resource economics. Open access resources would be depleted in no time without laws backed by state power. But a huge number of people living in rural areas of developing countries own little more than the rights to use common pool resources. Privatization or nationalization of these can have massive welfare consequences. So it's important to know whether or not these resources can be managed sustainably by the populations whose livelihood depends on them.

To me, this is the main message emerging from Ostrom's work.

The Future of Academic Publishing

Theoretical Economics is among the most prestigious journals specializing in economic theory, with a stellar editorial board and high quality submissions. It is also an open access journal: every published article may be viewed, downloaded and printed freely worldwide without subscription. And authors release their work under a creative commons license that allows users to "copy, distribute and transmit" the work provided that this is done with proper attribution, in the "manner specified by the author."

The founders of the journal clearly see this as a template for academic publishing more generally:

The advent of the web has made free dissemination of research feasible and financially viable. Because existing specialty journals obtain revenues from selling subscriptions, primarily to libraries, access to the research they publish is limited. The attractive revenue stream that such subscriptions provide makes it unlikely that these journals will convert to Open Access. Thus a need exists for new refereed Open Access journals to replace existing journals. We believe that the establishment of a major Open Access journal in economic theory will lead others to establish Open Access journals for other fields of economics, reclaiming full control for the profession of its research output. We hope that this will lead the profession to a new norm in which all research is freely available.

Under the open access format the size of the user pool (and the aggregate consumers' surplus) is maximized, but none of the benefits that accrue to readers can be appropriated by publishers. This would ordinarily make financial viability difficult. But in the case of journal articles there is very little value added by the publisher in any case: from the point of view of most readers, a working paper is usually a near perfect substitute for the typeset article. Hence the lion's share of the product's value is created by authors, referees and editors for little or no direct financial compensation. As a result, relatively modest fees for submission or  the processing of accepted papers can be enough to cover the costs of production and online dissemination.

The attractiveness of this business model has not escaped the attention of commercial publishers. Bentham Science, for instance, is already publishing more than 200 open access journals, including one in economics. The Hindawi Publishing Corporation (in collaboration with Sage Publications) also has a portfolio of comparable size, and has just launched Economics Research International. And such initiatives exist side by side with non-commercial ventures such as the e-journal Economics, which operates not only under open access but also uses an innovative public review process involving a large community of registered readers.

So far, the major academic publishers have managed to maintain their lucrative subscription based model, although they now allow articles to be accessed free of charge if the author pays an additional fee (the publisher typically retains copyright and imposes restrictions on redistribution). It is doubtful that this hybrid model can be sustained. For one thing, libraries will be increasingly reluctant to pay for bundled journal subscriptions when much of the content could be accessed freely in any case. More importantly, when given a choice, authors will surely prefer retention of copyright, avoidance of exorbitant fees, and the broadest possible dissemination of their work.

Accordingly, if some of the major economic societies and associations make the transition to open access, the floodgates will open. Traditional publishers will find themselves in a pincer like grip, with highly prestigious society journals weighing down upon them and new entrants nipping at their heels. The giants who currently dominate academic publishing and own vast numbers of important titles will then be faced with a choice. They could themselves fully adopt the open access format and continue to compete effectively (but with diminished profit margins), or watch the value of their holdings gradually decline. Either way, open access seems destined to be the future of academic publishing.

This would be a welcome development. In an earlier post, I claimed that the proliferation of blogs is leading to a democratization of discourse in economics, as non-specialists and autodidacts bring fresh perspectives to bear on theoretical disputes and policy questions. This process depends critically on the ability of outsiders to eavesdrop easily on conversations among economists. Unfettered access to academic research not only increases the visibility of ideas, it also increases the scrutiny to which they are subjected. And this should result in the development of better, more interesting, and more robust ideas in the long run.

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Update (3/29).  Theoretical Economics is now an Econometric Society journal, so its status and survival are both secure. The Society has also launched a more empirically oriented counterpart, Quantitative Economics, that also has a first rate editorial board. I find it puzzling that the American Economic Association did not choose the open access format for its four new journals; this was a wonderful opportunity missed.

For anyone interested in the economics of academic publishing, Ted Bergstom's journal pricing page is a comprehensive source, featuring links to articles, news, comments and data. In an email to me, Ted points out that open access is not without its own problems:

Your mention of Bentham publishing reminds me that there is a "dark side" to open access publishing as well.  There are some slimy types who are trying to profit from open access publishing by spamming for authors and editors and publishing without any form of quality control. Bentham seems to be one of them. 

In support of his claims, Ted points to a couple of revealing interviews by the British journalist Richard Poynder (also discussed here) and an extraordinary post on the acceptance of a meaningless computer generated article by a Bentham journal. Separating the scam from the genuine article is clearly going to be a challenge in the early stages of this transition.

On Hedging, Speculation and Financial Instability

Over on the Aleph Blog, David Merkel has promised a "long set of irregular posts" about what he calls "the rules." Here's an extract from the second in this series:

On to tonight’s rule: Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.  If the speculator is undercapitalized, risks to the financial system rise.

This rule is pretty simple.  There are few places in the financial markets where there are naturally offsetting exposures that have not been remedied by an institution created for that very purpose, such as a bank.  In most cases with derivatives, the one that wants to reduce exposure relies on a speculator.  There are rare cases where the risk of one is the benefit of another, but situations like that tend to create new firms to internalize the trade.

The trouble occurs when the speculator can’t make good on his obligations.  As with many speculators, he overcommits.  He is short of funds because many trades are going against him at the same time.  It is in these cases that those who hedge learn to evaluate counterparties for their riskiness.

That is why it is worth knowing who is at the end of the chain in this financial game of crack-the-whip.  The status of the ultimate speculators, and whether they can make good on promises or not is a huge thing.

There are really two separate points here: (i) hedging is generally possible only if speculation also occurs, and (ii) if speculators do not have adequate capital reserves, then the stability of the system is at risk.

The first point is worth keeping in mind when thinking about the regulation of derivatives. For every bondholder who purchased credit default swaps as protection, there was a counterparty betting against default. Hedging by the former would not have been possible without speculation by the latter. This kind of transaction involves the transfer of credit risk from one party to another at a price that is agreeable to both. If such transactions were not possible, then those who have the capital to buy the underlying bonds would be forced also to bear the credit risk, possibly resulting in a thinner market and increased costs of borrowing. This is the usual economic argument against curtailing the use of such instruments.

In thinking about the costs and benefits of speculation, however, it is equally important to keep in mind that the converse of David's rule does not hold: it is clearly not the case that someone must hedge in order to allow you to speculate. Two parties can enter a contract in which they are both making directional bets. Naked credit default swaps (where the buyer does not hold the underlying bond) are contracts with this character, as are put options purchased (or call options written) without ownership of the underlying stock. 

Hence, while some degree of speculation is necessary to make hedging possible, there is essentially no limit on the volume of purely speculative transactions that can be sustained by any given quantity of underlying assets. The fact that the sum total of such side bets must net to zero does not mean that the scale of this activity has no effect on prices, volatility, or financial instability. Richard Portes (via Mark Thoma) explains why:

Naked CDS, as a speculative instrument, may be a key link in a vicious chain. Buy CDS low, push down the underlying (e.g., short it), and take a profit from both. Meanwhile, the rise in CDS prices will raise the cost of funding of the reference entity – it normally cannot issue at a rate that won’t cover the cost of insuring the exposure. That will harm its fiscal or cash flow position. Then there will be more bets on default, or at least on a further rise in the CDS price. If market participants believe that others will bet similarly, then we have the equivalent of a ‘run’. And the downward spiral is amplified by the credit rating agencies, which follow rather than lead. There is clearly an incentive for coordinated manipulation, and anyone familiar with the markets can cite examples which look very much like this. The probability of default is not independent of the cost of borrowing – hence there may be multiple equilibria, with self-fulfilling expectations, as Daniel Cohen and I have argued.

In addition to the multiple equilibrium issue (previously discussed on this blog here and here), there is the problem of counterparty risk:

The mechanism of CDS is like that of reinsurance. The fees are received up front, the risks are long-term, with fat tails. There are chains of risk transfer – a CDS seller will then hedge its position by buying CDS. So the net is much less than the gross, but the chain is based on the view that each party can and will make good on its contract. If there is a failure, the rest of the chain is exposed, and fears of counterparty risk can cause a drying up of liquidity. The long chains may create large and obscure concentration risks as well as volatility, since uncertainty about any firm echoes through the system.

Naked CDS increase leverage to the default of the reference entity. They can thereby substantially increase the losses that come from defaults. And the leverage comes at low cost – nothing equivalent to capital requirements, no reserve requirement of the kind insurers must satisfy.

This brings us full circle to the second part of David's rule: the dangers of undercapitalized speculation. AIG was able to sell credit default swaps without posting collateral as long as it maintained its AAA credit rating. When the Lehman bankruptcy simultaneously triggered both higher CDS spreads and a downgrade of AIGs rating, the company faced major collateral calls that it could not meet. Had it not been for an $85 billion line of credit from the Federal Reserve (acting in concert with the Treasury) AIG would have entered bankruptcy and its counterparties, despite having correctly predicted the movement in CDS spreads, would themselves have taken major losses. They either failed to fully appreciate this risk, or anticipated (correctly as it turned out) that the government would not allow a failure on this scale.

That $85 billion investment has now swollen to more than $180 billion and there is a great deal of public outrage and incomprehension concerning the need for taxpayer funded payouts on privately negotiated speculative bets. William Dudley, in a speech at Columbia University last December, defended the actions taken by his employer but acknowledged that the situation was "unfair on its face... galling in an environment in which the unemployment rate is 10 percent and many people are struggling to make ends meet... deeply offensive to Americans" and "counter to basic notions of justice and fairness."

These decisions were made under enormous pressure with little time for reflection, and mistakes made in such circumstances would ordinarily be forgivable. But Dudley, as well as Bernanke and Geithner in their congressional testimony, continue to insist that the best available course of action was taken, and that any alternative would have had devastating economic costs. Even if they are correct on this point (and I have my doubts), the fact that it came to this surely reflects one of the most staggering failures of regulatory oversight in recent history.

Selection into and within Occupations

A recent report by Max Abelson contains some choice statements by a couple of former Lehman executives:

There are two ways to react to the biblically proportioned report that Lehman Brothers’ bankruptcy examiner released last Friday... The first is to lose faith in man...

The second reaction is to shrug... Two former senior Lehman executives did just that this week, telling The Observer that the examiner’s autopsy... was simply not a big deal... “It’s just not that big of an event... They just want to be mad and don’t know what they’re talking about and want to be outraged...”

“When I read this, I giggle a little bit. Because $50 billion is a shitload of money, but in the grand scheme of things... $50 billion is a drop in the ocean.”

The former managing director in London said that Repo 105 was an open secret there, if it was a secret at all. “Yeah, yeah, yeah. In Europe, people just generically talk about it. It’s funny, for nonprofessionals, you can try to make it a smoking gun,” the source said, “I’m like, whatever.”

The only people who would worry about using an old trick to reduce leverage from 13.9 to 12.1, the second executive said, are “yappers who don’t know anything.”

Stacy-Marie Ishmael at FT Alphaville is rendered speechless by this. Felix Salmon, however, is not lost for words:

[It’s] important not to lose sight of the fact that what we’re seeing here is a corporate failing to an even greater degree than it is an individual one, and that it infects investment banks generally, not just Lehman Brothers. These shops deliberately go out to hire psychopaths, and then they fire the ones who go soft, while promoting the most aggressive assholes, keeping a few smooth-talking client-relationship types on hand to preserve some semblance of a respectable public face.

I prefer to think in terms of preferences over risk and reward rather than psychological pathologies, but behind the strong language his point still stands: human behavior differs substantially across career paths because of selection both into and within occupations. This is what I was trying to get at in an earlier post in which I argued that behavioral economics, despite its many successes, was going to be of limited use in understanding the determinants of financial instability:

[Regularities] identified in controlled laboratory experiments with standard subject pools have limited application to environments in which the distribution of behavioral propensities is both endogenous and psychologically rare. This is the case in financial markets, which are subject to selection at a number of levels. Those who enter the profession are unlikely to be psychologically typical, and market conditions determine which behavioral propensities survive and thrive at any point in historical time.

This calls for an ecological approach to understanding financial market behavior, focused on behavioral heterogeneity and selection pressures. The argument is not by any means new; it is a critical component of Minsky's financial instability hypothesis, and has been articulated recently in the following terms by Macroeconomic Resilience:

If we assume that there is a sufficient diversity of balance-sheet strategies being followed by various bank CEOs, those... who follow the... strategy of high leverage and assets with severely negatively skewed payoffs will be “selected” by their shareholders over other competing CEOs... cheap leverage afforded by the creditor guarantee means that this strategy can be levered up to achieve extremely high rates of return. Even better, the assets will most likely not suffer any loss in the extended stable period before a financial crisis. The principal, in this case the bank shareholder, will most likely mistake the returns to be genuine alpha rather than the severe blowup risk trade it truly represents.

Selection of strategies necessarily implies selection of people, since individuals are not infinitely flexible with respect to the range of behavior that they can exhibit. Hence any incentive structure will elevate certain types of individuals at the expense of others. As Felix notes, this is "something that regulatory reform can’t even come close to addressing, unless it deals head-on with the question of compensation."

An Ecological Perspective on Financial Market Reform

Financial practices such as leverage and maturity transformation have been getting a lot of attention in the aftermath of the recent crisis. Consider, for instance, the following comments by William Dudley from a speech he gave in November:

Turning [to] inherent sources of instability, there are at least two that are worthy of mention. The first instability stems from the fact that most financial firms engage in maturity transformation — the maturity of their assets is longer than the maturity of their liabilities. The need for maturity transformation arises from the fact that the preferred habitat of borrowers tends toward longer-term maturities used to finance long-lived assets such as a house or a manufacturing plant, compared with the preferred habitat of investors, who generally have a preference to be able to access their funds quickly. Financial intermediaries act to span these preferences, earning profits by engaging in maturity transformation — borrowing shorter-term in order to finance longer-term lending.

If a firm engages in maturity transformation so that its assets mature more slowly than its liabilities, it does not have the option of simply allowing its assets to mature when funding dries up. If the liabilities cannot be rolled over, liquidity buffers will soon be weakened. Maturity transformation means that if funding is not forthcoming, the firm will have to sell assets. Although this is easy if the assets are high-quality and liquid, it is hard if the assets are lower quality. In that case, the forced asset sales are likely to lead to losses, which deplete capital and raise concerns about insolvency.

The second inherent source of instability stems from the fact that firms are typically worth much more as going concerns than in liquidation. This loss of value in liquidation helps to explain why liquidity crises can happen so suddenly. Initially, no one is worried about liquidation. The firm is well understood to be solvent... But once counterparties start to worry about liquidation, the probability distribution can shift very quickly toward the insolvency line... because the liquidation value is lower than the firm’s value as a going concern...

These sources of instability create the risk of a cascade... Once the firm’s viability is in question and it is does not have access to an insured deposit funding base, the next stop is often a full-scale liquidity crisis that often cannot be stopped without massive government intervention.

More recently, David Merkel has discussed the issue as follows:

If the money markets get too large relative to the economy on the whole, that means there is possibly an asset/liability mismatch in the economy, where too many are financing long assets short.  It costs more in the short run to finance long-life assets with long debt or equity, but in the short run you make a lot more if you finance short… do you take the risk or not?

GE Capital nearly bought the farm in early 2009 from doing that.  CIT did die.  Mexico in 1994.  When you can’t roll over your short term debts, it gets really ugly, and fast... The phrase, “You can always refinance,” is a lie... Long-dated assets should be financed by non-putable long-dated liabilities or equity.  Don’t cheat and finance shorter than the life of the assets involved.  There is never an assurance that you will be able to get financing on terms that you will like later.

In his report on the Lehman bankruptcy, the court-appointed examiner Anton Valukas observed that "demands for collateral by [its] lenders had direct impact on Lehman’s liquidity" and that the resulting inability to obtain short-term financing "is central to the question of why Lehman failed." As Barry Ritholtz points out, however, this was a proximate rather than ultimate cause of the bankruptcy:

So what actually kills the patient — the disease that ravages the body, destroys its naturally ability to fight off invaders, and leaves it totally vulnerable? Or whichever random infection finally does them in?

In the case of Lehman Brothers, the disease that left them vulnerable was a mad embracing of risk, the excess use of leverage, an extensive exposure to mortgage and real estate, and the enormous usage of derivatives — concurrent with a lack of intelligent risk management.

Citi and JPM were merely the opportunistic infections that came along at when Lehman’s immune system was compromised. That is why you never want to allow yourself to become that vulnerable on Wall Street.

Note that if Lehman were the only firm engaged in such practices, we would probably have had a contained bankruptcy rather than a full-fledged financial crisis:

On Monday September 15, Lehman Brothers... was allowed to go into bankruptcy... It was a game-changing event with catastrophic consequences... the price of credit default swaps... went through the roof as investors took cover. AIG, the insurance giant, was carrying a large short position in CDS and faced imminent default. By the next day Hank Paulson, then US Treasury secretary, had to reverse himself and come to the rescue of AIG.

But worse was to come. Lehman was one of the main market-makers in commercial paper and a large issuer of these short-term obligations to boot. Reserve Primary, an independent money market fund, held Lehman paper and, since it had no deep pocket to turn to, it had to “break the buck” – stop redeeming its shares at par. That caused panic among depositors: by Thursday a run on money market funds was in full swing.

The panic then spread to the stock market. The financial system suffered cardiac arrest and had to be put on artificial life support.

None of this would have been possible without extensive maturity transformation and high levels of leverage across a broad range of financial institutions, making them all simultaneously vulnerable to a liquidity shock. But how did this level of fragility arise in the first place?

As far as I am aware, there are few economists who have attempted to shed light on the process that gives rise to changes over time in systemic financial fragility. An important exception is the late Hyman Minsky, who developed what might be interpreted as an ecological theory of financial practices. I have discussed his ideas at length in a previous post, but they are worth revisiting in light of the Lehman report. 

Central to Minsky's theory is the idea that at any point in time there is a distribution of financial practices in the economy, ranging from prudent debt structures with ample margins of safely to highly aggressive positions involving significant leverage and maturity transformation. In particular, Minsky draws a distinction between hedge financing and speculative financing. The former refers to a debt structure in which expected cash flows in all future periods are large enough to meet contractual debt commitments. Unless revenues are unexpectedly low, therefore, there will be no need for such a firm to roll over its debt. Speculative financing refers to a debt structure in which cash flows are expected to lie below debt commitments in some periods. In this case the firm anticipates that it will need to refinance, and is therefore vulnerable to changes in interest rates and the availability of credit.

Minsky is interested in the manner in which the distribution of financial practices -- the extent of hedge relative to speculative financing in the economy --  changes over time. The proximate determinants of such changes are differential rewards: those practices associated with the highest realized returns will tend to proliferate through reinforcement, imitation, and flows of capital to successful firms. As long as a liquidity crisis is averted, the prevalence of speculative financing will therefore increase. This effect is amplified by the fact that speculative financing results in faster economic expansion and asset appreciation:

The natural starting place for analyzing the relation between debt and income is to take an economy with a cyclical past that is now doing well. The inherited debt reflects the history of the economy, which includes a period in the not too distant past in which the economy did not do well. Acceptable liability structures are based upon some margin of safety, so that expected cash flows, even in periods when the economy is not doing well, will cover contractual debt payments. As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever. After the event it becomes apparent that the margins of safety built into debt structures were too great. As a result, over a period in which the economy does well, views about acceptable debt structure change. In the deal making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activity and positions increases. This increase in the weight of debt financing raises the market price for capital assets and increases investment. As this continues, the economy is transformed into a boom economy." (Minsky, 1982)

The inevitable result of a progressive shift towards increasingly aggressive financial practices is a rise in system fragility. When a liquidity crisis eventually arrives, it is the most highly leveraged firms that face bankruptcy. I summarized this process in a 2002 review as follows:

During stable expansions, profits accrue disproportionately to firms with the most aggressive financial practices, resulting in an erosion of margins of safety. This raises the probability that a major default will trigger a widespread crisis. When a crisis does eventually occur, its most devastating impact is on the highly indebted firms that prospered during the expansion. Balance sheets are purged of debt, margins of safety rise, and the stage is set for the process to begin anew. From this perspective, expectations of financial tranquility are self-falsifying. Stability, as Minsky liked to put it, is itself destabilizing.

Those who recognize that such a process is underway can make a killing when the crisis eventually erupts, but will make steady losses in the interim and must have deep enough pockets to hold on. If they are managing other people's money, they may face major withdrawals of cash precisely when their expected returns are highest (this is the central insight in Shleifer and Vishny's analysis of the limits of arbitrage).

One cannot, therefore, simply rely on self-correcting market mechanisms to keep such crises at bay. What should one do instead? The ecological perspective suggests that static approaches to financial sector reform (such as curtailing the use of certain types of contracts or shifting over-the-counter transactions to exchanges) may not be enough. What is required is a more dynamic policy response that makes aggressive financial practices more costly at precisely those points in time when fragility is greatest. As long as prudence doesn't pay, the injunction that "long-dated assets should be financed by non-putable long-dated liabilities or equity" will surely continue to fall on deaf ears.

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Update (3/18). For anyone interested in reading more about the ecological approach to financial market behavior, Macroeconomic Resilience has a number of posts on the topic; see especially this one on parallels and complementarities between Minsky's ideas and those of the Canadian ecologist Buzz Holling.

On Asymmetry, Reflexivity and Sovereign Default

One of the most rewarding aspects of blogging is that it gives me the opportunity learn from those who read and comment on the ideas expressed here. I have had the good fortune of being visited by a number of informed and thoughtful readers, whose remarks have often been of greater quality than the posts to which they were responding. Among those for whom I have developed the greatest respect is the anonymous author of Macroeconomic Resilience, who left a couple of very helpful comments in response to my recent post on credit default swaps.

MR pointed out that the idea of multiple self-fulfilling default probabilities plays a key role in George Soros' theory of reflexivity, and linked to an article in which Soros interpreted the Lehman bankruptcy in precisely these terms. In fact, it is a combination of reflexivity and a particular kind of risk/reward asymmetry that gives rise to what Soros calls self-validating bear raids:

First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market... Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one’s risk exposure while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short-selling of stocks.

The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract...

The third step is to recognise reflexivity – that is to say, the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust. That means that “bear raids” to drive down the share prices of these institutions can be self-validating. That is in direct contradiction to the efficient market hypothesis.

Putting these three considerations together leads to the conclusion that Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other. Unlimited shorting was made possible by the 2007 abolition of the uptick rule (which hindered bear raids by allowing short-selling only when prices were rising). The unlimited selling of bonds was facilitated by the CDS market. Together, the two made a lethal combination.

Soros' point about risk/reward asymmetry directly answers one objection to curtailing purchases of naked credit default swaps, namely that such contracts "provide identical leverage both to the optimistic and the pessimistic side of the transaction." Leverage may be considerable on both sides of the contract but this does not mean that market clearing prices reflect optimistic and pessimistic beliefs in equal measure, because the spreads at which sellers are willing to enter the contract must offer them adequate compensation for the significant downside risk that they face.

MR does not consider reflexivity to be a routine problem in credit markets, arguing that "only when the entity is in a state of low resilience that markets are sufficiently reflexive to push it over the edge." This is also David Merkel's view of the matter:

... if a company or government has a strong balance sheet, and has a lot of cash or borrowing power, there is nothing that speculators can do to harm you.  You have the upper hand.  But, if you have a weak balance sheet, I am sorry, you are subject to the whims of the market, including those that like to prey on weak entities.  Even without derivatives, that is a tough place to be.

But what causes a balance sheet to become weak? In the case of sovereign states, it could be widespread tax avoidance and excessive spending relative to revenues, as has been alleged in the case of Greece. But it could also be a significant decline in economic activity that reduces the tax base and triggers automatic stabilizers. This is how Paul Krugman interprets the experience of Spain, which had a budget surplus three years ago, but "is running huge deficits now [as] a consequence, not a cause, of the crisis: revenue has plunged, and the government has spent some money trying to alleviate unemployment."

Any attempt to raise taxes or cut spending in this environment could make it even harder for the country to meet its near term debt obligations. For this reason, Felix Salmon's claim that countries "have essentially no limit on how much they can tax or cut spending in order to make their debt repayments" cannot possibly be correct as a general principle. A government can change expenditure policies and tax rates, but has no direct control over realized revenues and outlays. As a result, raising tax rates or trimming expenditures (such as unemployment benefits) in the face of severe deficiencies in aggregate demand can worsen rather than improve its balance sheet position.

Under such circumstances, it is terribly important to determine whether the looming threat of default is simply one of several possible equilibrium paths. As Felix acknowledged in his response to my post, it is true in principle that "a company or country can find it easy to repay debt when spreads are low, thereby justifying the low spreads, while finding it hard to repay debt when spreads are high, justifying the high spreads." Default under these conditions would be terribly wasteful, and I can see no reason why attempts to avoid it should not be pursued vigorously.

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Update (3/11). Paul Krugman also seems to think that it's worth considering the possibility of multiple self-fulfilling default probabilities in the context of sovereign defaults (h/t Mark Thoma):

Markets are getting slightly more bullish on Greek debt — and Peter Boone and Simon Johnson are crying bubble. I’m not so sure, but I think their argument highlights something else: the possibility of multiple equilibria in sovereign solvency...

Suppose that Greece had as much credibility as Germany, and could borrow at a real interest rate of 2 percent. Then stabilizing the real value of its debt, even with a debt ratio of 150 percent, would require a primary surplus of only 3 percent of GDP. That’s certainly possible for some countries, although maybe not for Greece.

Boone and Johnson assume, however, that Greece would have to pay 10 percent nominal, say 8 percent real. Servicing that would require a primary surplus of 12 percent of GDP, probably impossible for almost anyone.

So this suggests that optimism or pessimism about future default can, to at least some degree, be a self-fulfilling prophecy. Not a new insight, I know, but it looks increasingly important for thinking about where we are now.

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Update (3/19). And here's Richard Portes arguing for the importance and empirical relevance of multiple self-fulfilling default probabilities, based on his work with Daniel Cohen (h/t Mark Thoma):

Naked CDS, as a speculative instrument, may be a key link in a vicious chain. Buy CDS low, push down the underlying (e.g., short it), and take a profit from both. Meanwhile, the rise in CDS prices will raise the cost of funding of the reference entity – it normally cannot issue at a rate that won’t cover the cost of insuring the exposure. That will harm its fiscal or cash flow position. Then there will be more bets on default, or at least on a further rise in the CDS price. If market participants believe that others will bet similarly, then we have the equivalent of a ‘run’. And the downward spiral is amplified by the credit rating agencies, which follow rather than lead. There is clearly an incentive for coordinated manipulation, and anyone familiar with the markets can cite examples which look very much like this. The probability of default is not independent of the cost of borrowing – hence there may be multiple equilibria, with self-fulfilling expectations, as Daniel Cohen and I have argued.