AIG and Bailouts: Welcome to the Real World

“If there is a single episode in this entire 18 months that has made me more angry, I can’t think of one other than AIG. AIG exploited a huge gap in the regulatory system.”

These words were spoken by Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System in testimony on Tuesday, March 3, 2009 before the Senate Banking Committee. Bernanke expressed further anguish at the behavior of AIG on 60 Minutes Sunday evening.

Professor, welcome to the real world!

Treasury Secretary Timothy Geithner echoed some of the same feelings in testimony on the same day before the House Ways and Means Committee when he stated that some areas of AIG were not under “adult supervision.”

Come on, Timmy, I try and stop people from making the same claim about the bank bailout plans of the Treasury Department.

Is the Obama team becoming so defensive about their program that they are beginning to resort to name calling to deflect criticism?

Did AIG exploit a huge gap in the regulatory system? Yes, they did. And that is what people do over and over again in the real world. It is called “responding to incentives.” The world is full of incentives…some positive incentives…some negative incentives…and so on. That is what the study of economics is all about! Give the people in the Obama administration a copy of “Freakonomics”!

I have been in the Federal Reserve System. I have worked for a cabinet Secretary in Washington, DC. And I have run publicly traded financial institutions. One thing is especially clear to me: people respond to incentives.

Some of those incentives are to innovate in products and markets. And, what do economists tell potential innovators to look for? Missing markets. Incomplete Markets. Places that are not being served or regulated.

Why do you look in these areas? Well, because that is where a person - or a business - can find a place to achieve a competitive advantage. Being a “first-mover” or a “second-mover” into a market is a way to achieve exceptional returns…at least for a short time period. And, this is plenty of incentive to draw people into the effort.

It is a highly risky effort and a lot of people and businesses fail because it is so risky. But, the incentives are substantial enough that people are continually drawn into the exercise.

A competitive advantage may not last for a very long time. People that find opportunities to arbitrage markets (traders) may find segments in a market place to exploit for a period of time. But, over time, competitive advantage does not seem to last for specific trading schemes (see Enron and Long Term Capital Management). In such cases, you need to keep coming up with something new. That is what businesses producing Information Goods do.

One of the games played in the financial services area (and I have experienced this in my professional life beginning in the 1960s) is to find the hole in the regulatory structure. It is a game that the regulators are always behind in. The private sector does something, the regulators close the gap with new regulations, the private sector finds a way around this, and the regulators have to close the gap again. And the game goes on and on because the incentives are such that it is still worthwhile to the private sector to continue to innovate.

Furthermore, anything the government does sets up incentives. And that is why the Obama “recovery plan” is so important - it changes a lot of the incentives that exist within the economy - for better or for worse. Notice the long, long lines of governors, mayors, and other officials that have gathered with their hands out for funds from the “recovery plan”. I am not going to comment any further on the “recovery plan” at this time other than to just highlight the fact that this plan changes incentives, regardless of how much stimulus it provides.

But, to be an equal-opportunity critic, I must mention that the previous administration created incentives that resulted in the present financial crisis. Maintaining negative real rates of interest for at least 18 months created plenty of incentive to leverage and innovate in financial structures and instruments. This period of innovation has created a massive crisis with respect to asset values. (For more on this see my blog post “AIG and Our Core Economic Issue: Unknown Asset Values”.) In my mind, there is going to have to be a resolution to the asset value problem before any stimulus package is going to have much of an effect on the economy.

Anytime the government attempts to impose its hand on the private sector “things happen.” The government is just not attuned to enter the very complex tangled web of the real world with simplistic plans to “set things straight.” Even within the government public officials have started pointing fingers at each other when events don’t go as desired. Last night I saw Barney Frank interviewed by Rachael Maddow. Frank made it very clear that we got into the AIG mess because “the Fed”, without coming to Congress, gave AIG $85 billion last September and this started off all the mess. And, the reason why this bonus thing and other events have occurred is that “the Fed” without the advice or consultation of Congress gave AIG the $85 billion with “no strings attached”!

Wow! Go figur’ that, will ya!

Now, the Wall Street Journal has the headline this morning ”Obama to Avoid Auto Bankruptcies.” The “experts” in the government, we are told, are going to restructure General Motors Corp. and Chrysler LLC outside of the bankruptcy courts. This, we are expected to believe, will give the taxpayers a better and more protected solution than will a court solution. We await the conclusion…

The real world is tough. People don’t always do what you want them to do. Incentives matter. We must be careful about the incentives we are creating for the future, for one other fact from the field of economics is very clear: sometimes it takes a long time for the full effect of incentives to work their way through an economy. As a consequence, we can often lose sight of the cause of a problem because the incentives that created the problem are embedded somewhere in the distant past.

Comments

[Thadeus Thornton III]

In other words, incentives usually cultivate some form of greed, which results in manipulations, which is how we got into this mess. I would think the "manipulations" would be less devastating if some of the regulations in the banking and investment sector had been in place and policed. But then again, agencies have been known to look the other way whilst opportunities were being exploited anyway.

2009 Mar 17 09:38 AM

[User 68127]

Rarely will you find the smartest people working for government. Those who want to be creative and, for better or worse, reap the result of their efforts will be in the private sector. Those who value conformity and the security of a paycheck regardless of performance will tend to be in govt.

The govt will constantly be chasing those more gifted and motivated entrepreneurs and trying to bring them down to their level and control them. Unable to catch them, and lacking the intellectual and moral basis to change their behavior, the govt will resort to manipulation and brute force.

2009 Mar 17 02:48 PM

[Kman58]

I think you only got it partly right. And then generalized and twisted it just enough to be noticeable.

Incentives are necessary after all, if you want to get people to work to better thier condition, then history shows that you have to actually offer them an improved condition as a result. If you prefer to term this kind of thing greed, then I think you are in that case being excessive.


On Mar 17 09:38 AM Thadeus Thornton III wrote:

> In other words, incentives usually cultivate some form of greed,
> which results in manipulations, which is how we got into this mess.
> I would think the "manipulations" would be less devastating if some
> of the regulations in the banking and investment sector had been
> in place and policed. But then again, agencies have been known to
> look the other way whilst opportunities were being exploited anyway.

2009 Mar 18 09:13 PM