During the Depression, Smith's invisible hand functioned
in the following way: The mortgage business began in
1932, in response to a liquidity crisis. Back then, a 20 percent down payment
was considered the minimum a bank would approve. And for this, the largest
investment of their lives, borrowers would travel to their local bank and sit
down with a loan officer who probably knew them, whose kids played baseball
with theirs.
In those days,
the banks owned the loans. If the loan went bad, the banks lost the money. If
you knew the man and he fell on hard times, it
was difficult to put his wife and kids out on the street on Friday, only to see
him in the next pew that Sunday. Faced with that potential embarrassment,
bankers were careful to make only those loans borrowers could afford. When
customers had problems, the bank was much more likely to work with them to find
a solution.
In today's
overconnected world, banks externalize the costs of bad loans by creating
Collateralized Debt Obligations and passing the losses off to endowments and
pension funds. Some shadow entity takes the losses, the banks make a profit on
the transactions, and bankers get the added benefit of never having to look the
bankrupt person in the eye.
John Maynard Keynes's ideas worked splendidly when the world
was less connected. Economic and fiscal policies that stimulated demand created
local factory jobs. When those workers spent their paychecks, other jobs were
created -- the multiplier effect. Today, stimulus creates more spending but the
jobs and the trickle-down are in China.
The mathematically elegant formulas that win Nobel Prizes
for modern economists are based on assumptions that no longer apply, and on historical
data that is no longer meaningful in our overconnected environment. Unfortunately,
those formulas are shaping much of the advice being dispensed. They were right
for a less connected world but are wrong now.
Consider Robert Merton, who won the Nobel Prize in economics
for his work on the Black-Scholes Model. Merton's model enabled people to assign
the appropriate value to exotic financial instruments such as futures contracts
and plain vanilla stock options. Merton became a victim of his own invention. He
was one of the founders of Long Term Capital Management, which based its
derivative trading strategies on the Black-Scholes Model. In 1998, "fat tails" that
the model failed to take into account caused the bankruptcy of the firm and nearly
triggered an international financial contagion. The slavish devotion to the
model persists; it raised its ugly head again during the 2008 financial crisis.
The improper application of the theory is one of the things
that fueled the spectacular growth in over-the-counter derivatives, from $60
trillion in 2000 to more than $600 trillion in 2008. This growth took place
while the economists and regulators using bricks and mortar logic were arguing
that derivatives distributed risk, when in fact massive amounts of derivatives concentrated risk.
