Getting out of this crisis involves identifying who was right and who was wrong.  We have had little accountability so far.  The Rubinites are back in charge and we can only hope (and pray) that they have changed, because they were destructively wrong before.  Phil Gramm is wounded by his silly statements during the presidential campaign ("Nation of whiners").  And it is hard to identify anything that Paulson and the Bushies did right.  Accountability really should go further.  Where are the people that got it right?  Doesn’t someone want to give them a job in government?

I wondered a few months ago "What Economic School of Thought Will Prevail?" noting that Keynesian economics dominated until the 1970′s when Friedman’s monetarism gradually took over.  Monetarism focused upon controlling the money supply and "letting the market work" and avoiding "excessive regulation", which translated into "anything goes."  Greenspan, with his Ayn Rand objectivism, has been the poster child for avoiding excessive regulation.  Robert Rubin and Lawrence Summers drank this KoolAid, with only slightly different flavoring.  Rubin continues relatively un-reformed, saying that he would have done nothing different at CitiBank as of last April.

I hoped Behavioral Economics would enter the fray, to take over from the fictional and destructive Rational Economic Man.  But the winner seems to be Keynes, whose thoughts do take into account the irrationality of the people whose collective activities make up the market.

Greenspan-ism can no longer vie for the title because Greenspan himself admitted his fundamental beliefs were wrong. 

“In other words, you found that your view of the world, your ideology, was not right, it was not working,” Mr. Waxman said.

“Absolutely, precisely,” Mr. Greenspan replied. “You know, that’s precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.” …

Those that continue arguing that markets and economies will work all by themselves are simply uninformed… they haven’t received the memo from the boss.  Without rules, we have predatory capitalism, unstable capitalism, irrational capitalism.

Robert Sidelsky discusses Keynes more in an article today.

People are irrational, the Rational Economic Man does not exist, and the question becomes "what rule-based systems work?"

The basic question Keynes asked was: How do rational people behave under conditions of uncertainty? The answer he gave was profound and extends far beyond economics. People fall back on “conventions,” which give them the assurance that they are doing the right thing. 

Conventions are habits or social norms.  We are creatures of habit of course, with very little ability to be truly objective.

Above all, we run with the crowd. A master of aphorism, Keynes wrote that a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.”

There has been a lot of ruin recently.  I don’t know how conventional it has been.

Conventions are really a nice way of saying "herd behavior."

Investors do not process new information efficiently because they don’t know which information is relevant. Conventional behavior easily turns into herd behavior. Financial markets are punctuated by alternating currents of euphoria and panic.

The "free trade" types follow the herd.  They are resistant to contrary information.  Even though Keynes said that net exports are a fundamental part of aggregate demand needed for an economy to run at capacity.  The free traders tried to upend that maxim by saying trade deficits make us more efficient.  But merely saying things a lot does not make it true.

A first principle of the new economics is that it must be reality based, not fiction based.  The Rational Economic Man should be banished.  The free trade theory has been implemented to make the U.S. the unilateral free traders in a world where others did not do so. 

A national economic and trade strategy is needed, identifying fundamental components of an economy that we need, and enacting policies designed to build that economy.

You can’t even demagogue a "national economic and trade strategy" as socialism anymore, because of the bailout of the "Masters of the Universe."

Joseph Stiglitz provides a scathing critique, in Vanity Fair, of handling financial system matters under Reagan, Clinton and Bush II.  He wants to have influence getting the diagnosis right so we don’t slip back into ruin when the crisis subsides.   He also can continue writing with a sharp pen since it appears no administration job is waiting for him.

Stiglitz identifies five problems at the heart of his diagnosis.  First:

In 1987 the Reagan administration decided to remove Paul Volcker as chairman of the Federal Reserve Board and appoint Alan Greenspan in his place. Volcker had done what central bankers are supposed to do. On his watch, inflation had been brought down from more than 11 percent to under 4 percent. In the world of central banking, that should have earned him a grade of A+++ and assured his re-appointment. But Volcker also understood that financial markets need to be regulated. Reagan wanted someone who did not believe any such thing, and he found him in a devotee of the objectivist philosopher and free-market zealot Ayn Rand.

Second, repealing Glass-Steagal:

The deregulation philosophy would pay unwelcome dividends for years to come. In November 1999, Congress repealed the Glass-Steagall Act—the culmination of a $300 million lobbying effort by the banking and financial-services industries, and spearheaded in Congress by Senator Phil Gramm. Glass-Steagall had long separated commercial banks (which lend money) and investment banks (which organize the sale of bonds and equities); it had been enacted in the aftermath of the Great Depression and was meant to curb the excesses of that era, including grave conflicts of interest. For instance, without separation, if a company whose shares had been issued by an investment bank, with its strong endorsement, got into trouble, wouldn’t its commercial arm, if it had one, feel pressure to lend it money, perhaps unwisely? An ensuing spiral of bad judgment is not hard to foresee. I had opposed repeal of Glass-Steagall. The proponents said, in effect, Trust us: we will create Chinese walls to make sure that the problems of the past do not recur. As an economist, I certainly possessed a healthy degree of trust, trust in the power of economic incentives to bend human behavior toward self-interest—toward short-term self-interest, at any rate, rather than Tocqueville’s “self interest rightly understood.”

Third, "applying the leeches":

Then along came the Bush tax cuts, enacted first on June 7, 2001, with a follow-on installment two years later. The president and his advisers seemed to believe that tax cuts, especially for upper-income Americans and corporations, were a cure-all for any economic disease—the modern-day equivalent of leeches. The tax cuts played a pivotal role in shaping the background conditions of the current crisis.

Fourth, "faking the numbers":

Unfortunately, in the negotiations over what became Sarbanes-Oxley a decision was made not to deal with what many, including the respected former head of the S.E.C. Arthur Levitt, believed to be a fundamental underlying problem: stock options. … But a collateral problem with stock options is that they provide incentives for bad accounting: top management has every incentive to provide distorted information in order to pump up share prices. The incentive structure of the rating agencies also proved perverse.

Fifth, "letting it bleed":

The bailout package was like a massive transfusion to a patient suffering from internal bleeding—and nothing was being done about the source of the problem, namely all those foreclosures. Valuable time was wasted as Paulson pushed his own plan, “cash for trash,” buying up the bad assets and putting the risk onto American taxpayers. When he finally abandoned it, providing banks with money they needed, he did it in a way that not only cheated America’s taxpayers but failed to ensure that the banks would use the money to re-start lending. He even allowed the banks to pour out money to their shareholders as taxpayers were pouring money into the banks. …

If the administration had really wanted to restore confidence in the financial system, it would have begun by addressing the underlying problems—the flawed incentive structures and the inadequate regulatory system.

And Stiglitz just does not like Greenspan’s world view:

The truth is most of the individual mistakes boil down to just one: a belief that markets are self-adjusting and that the role of government should be minimal. Looking back at that belief during hearings this fall on Capitol Hill, Alan Greenspan said out loud, “I have found a flaw.” Congressman Henry Waxman pushed him, responding, “In other words, you found that your view of the world, your ideology, was not right; it was not working.” “Absolutely, precisely,” Greenspan said. The embrace by America—and much of the rest of the world—of this flawed economic philosophy made it inevitable that we would eventually arrive at the place we are today.

Krugman has been a downer for a while.  A editorial pessimist.  While he still is AWOL in the debate about a truly sane trade policy, he did warn about major financial problems that the business press cheerleaders ignored.  Krugman writes a "told ya so" piece today.  And why did those dedicated to emulating the Rational Economic Man ignore the warnings?

One answer to these questions is that nobody likes a party pooper. While the housing bubble was still inflating, lenders were making lots of money issuing mortgages to anyone who walked in the door; investment banks were making even more money repackaging those mortgages into shiny new securities; and money managers who booked big paper profits by buying those securities with borrowed funds looked like geniuses, and were paid accordingly. Who wanted to hear from dismal economists warning that the whole thing was, in effect, a giant Ponzi scheme?

It is more fun to be optimistic.  People like you better.  You make them feel good and positive.  "It’ll all be okay."  Even Very. Serious. People. like to feel good.  But sometimes there are clouds building on the horizon that you really have to take a look at.

A few months ago I found myself at a meeting of economists and
finance officials, discussing — what else? — the crisis. There was a
lot of soul-searching going on. One senior policy maker asked, “Why
didn’t we see this coming?”

There was, of course, only one thing to say in reply, so I said it: “What do you mean ‘we,’ white man?”

There it is.  "Told ya so."  It must feel good in a sad way, though not so good as receiving the 2008 Nobel Price in Economics, I suppose.

Who got us into this mess?  I’ve laid much at the feet of Phil Gramm in this blog.  But the credit needs to be spread around.

Time magazine famously named Mr. Greenspan, Robert Rubin and Lawrence Summers “The Committee to Save the World” — the “Three Marketeers” who “prevented a global meltdown.” In effect, everyone declared a victory party over our pullback from the brink, while forgetting to ask how we got so close to the brink in the first place.

You’ve heard of these guys before, I think. Will Summers and the Rubinites use their knowledge now to truly correct things?  We all better hope so.

Krugman’s ultimate point is to do the financial reform now.  Control the out-of-control derivatives and subprime mortgages and the other smoke-and-mirrors "financial products".  Lest we forget later. 

And because we’re all so worried about the current crisis, it’s hard to focus on the longer-term issues — on reining in our out-of-control financial system, so as to prevent or at least limit the next crisis. Yet the experience of the last decade suggests that we should be worrying about financial reform, above all regulating the “shadow banking system” at the heart of the current mess, sooner rather than later.

The barriers to reform will be great once the economy starts humming as we hope it will

For once the economy is on the road to recovery, the wheeler-dealers will be making easy money again — and will lobby hard against anyone who tries to limit their bottom lines. Moreover, the success of recovery efforts will come to seem preordained, even though it wasn’t, and the urgency of action will be lost.

I can agree with that.

I have argued the ridiculousness of modeling economics on the Rational Economic Man (REM).  Why?  He does not exist.  We are human.  REM is not human.  He is a construct.

Because we are human, emotions rule.  And we cannot perceive and compute all relevant information.  But we do "fight or flight" pretty well when the saber tooth tiger threatens our cave.  Irrational behavior, inaccurate perceptions and inaccurate decision making rules markets.  

David Brooks says Ayn Rand’s and Alan Greenspan’s objectivism does not work to explain economics and markets, and that behavioral economics may come out on top.  In recognizing that people reject facts that do not fit with their world view, and construct facts that do fit their world view… he totally misses his own screw ups.  For example, he is an irrational free trader that cannot understand why people worry about the trade deficit.

Today he writes.  

Roughly speaking, there are four steps to every decision. First,
you perceive a situation. Then you think of possible courses of action.
Then you calculate which course is in your best interest. Then you take
the action.

Over the past few centuries, public policy analysts have assumed
that step three is the most important. Economic models and entire
social science disciplines are premised on the assumption that people
are mostly engaged in rationally calculating and maximizing their
self-interest. …

Perhaps this will be the moment when we shift our focus from step three, rational calculation, to step one, perception.

I wrote about folks trying to inject rationalism into markets through artificial intelligence robots.  But behavioral economics has interesting ideas that are probably more accurate than the proverbial "Econ 101."   Danial Kahneman won the 2002 Nobel Price in Economics for his work injecting psychology into economics.

Wikipedia summarizes this way:

Behavioral economics and behavioral finance are closely related fields which apply scientific research on human and social, cognitive and emotional factors to better understand economic decisions and how they affect market prices, returns and the allocation of resources. The fields are primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory.

Brooks again:

My sense is that this financial crisis is going to amount to a coming-out party for behavioral economists and others who are bringing sophisticated psychology to the realm of public policy. At least these folks have plausible explanations for why so many people could have been so gigantically wrong about the risks they were taking.

Nassim Nicholas Taleb has been deeply influenced by this stream of research. Taleb not only has an explanation for what’s happening, he saw it coming. His popular books “Fooled by Randomness” and “The Back Swan” were broadsides at the risk-management models used in the financial world and beyond.

In “The Black Swan,” Taleb wrote, “The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup.” Globalization, he noted, “creates interlocking fragility.” He warned that while the growth of giant banks gives the appearance of stability, in reality, it raises the risk of a systemic collapse — “when one fails, they all fail.”

And we are not suited to process all the information. 

Taleb believes that our brains evolved to suit a world much simpler than the one we now face. 

David Brooks is first among us for an unsuitable brain.  His conclusions in most of his writings vary wildly from his facts.  And his facts are selected to fit his conclusions in a nasty editorial feedback loop.

Explaining markets through behavioral economics is one thing.  Applying it is another.  How does this translate into public policy.  We need an out from the unhelpful "regulation/socialism" and "deregulation/free market" binary logic.

Now excuse me while I go about rationally pondering that question.

Alan Greespan testified before the House Committee of Government Oversight and Reform today.  He has been criticized by some for not cracking down on market excesses.

Mr. Greenspan conceded a more serious flaw in his own philosophy that unfettered free markets sit at the root of a superior economy.

“I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms,” Mr. Greenspan said.

Referring to his free-market ideology, Mr. Greenspan added: “I have found a flaw. I don’t know how significant or permanent it is. But I have been very distressed by that fact.”

Mr. Waxman pressed the former Fed chair to clarify his words. “In other words, you found that your view of the world, your ideology, was not right, it was not working,” Mr. Waxman said.

“Absolutely, precisely,” Mr. Greenspan replied. “You know, that’s precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.” …

In his prepared remarks, Mr. Greenspan said he was in “a state of shocked disbelief” about the breakdown in the ability of banks to regulate themselves. He also warned about the economic consequences of the crisis, saying that he “cannot see how we will avoid a significant rise in layoffs and unemployment.

I don’t know.  We would have some real ballast and resistance to financial debacles if trade policy did not hollow out our economy.  But some smart people predicted disaster. from derivatives.

Warren E. Buffett presciently observed five years ago that derivatives were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Felix G. Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential “hydrogen bombs.” 

And even if you think Soros is a politically toxic, the guy is brilliant in finance.

George Soros, the prominent financier, avoids using the financial contracts known as derivatives “because we don’t really understand how they work.”

What about Alan Greenspan? 

Well.

For more than a decade, the former Federal Reserve Chairman Alan Greenspan has fiercely objected whenever derivatives have come under scrutiny in Congress or on Wall Street. “What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so,” Mr. Greenspan told the Senate Banking Committee in 2003. “We think it would be a mistake” to more deeply regulate the contracts, he added.