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March 24, 2010

Latest Posts from Economist's View

Latest Posts from Economist's View

What market Discipline?

Posted: 24 Mar 2010 01:20 AM PDT

How much did executives at Bear Stearns and Lehman Brothers lose as a result of the financial crisis?:

Paid to Fail, by Lucian Bebchuk, Alma Cohen, and Holger Spamann, Commentary, Project Syndicate: ...Lehman's executives made deliberate decisions to pursue an aggressive investment strategy, take on greater risks, and substantially increase leverage. Were these decisions the result of hubris and errors in judgment or the product of flawed incentives?
After Bear Stearns and Lehman Brothers melted down, ushering in a worldwide crisis, media reports largely assumed that the wealth of these firms' executives was wiped out, together with that of the firms they navigated into disaster. This "standard narrative" led commentators to downplay the role of flawed compensation arrangements and the importance of reforming the structures of executive pay.
In our study, "The Wages of Failure: Executive Compensation at Bear Stearns and Lehman Brothers 2000-2008," we examine this standard narrative and find it to be incorrect. We ... find that,... during 2000-2008, the top five executives at Bear Stearns and Lehman pocketed about $1.4 billion and $1 billion, respectively, or roughly $250 million per executive. These cash proceeds are substantially higher than the value of the holdings that the executives held at the beginning of the period. Thus, while the long-term shareholders in their firms were largely decimated, the executives' performance-based compensation kept them in positive territory.
The divergence between how top executives and their companies' shareholders fared raises a serious concern that the aggressive risk-taking at Bear Stearns and Lehman – and other financial firms with similar pay arrangements – could have been the product of flawed incentives. ...
It is important for financial firms – and firms in general – to reform compensation structures to ensure tighter alignment between executive payoffs and long-term results. ...
Had such compensation structures been in place at Bear Stearns and Lehman, their top executives would not have been able to derive such large amounts of performance-based compensation for managing the firms in the years leading up to their collapse. This would have significantly reduced the executives' incentives to engage in risk-taking.
Indeed,... comprehensive and robust reform of pay structures ... could do a great deal to improve incentives and prevent the type of excessive risk-taking that firms encouraged in the years preceding the financial crisis... Reforms that redress these destructive incentives should stand as an important lesson and legacy of Bear Stearns, Lehman Brothers, and the crisis they helped to fuel.

links for 2010-03-23

Posted: 23 Mar 2010 11:04 PM PDT

"Stop Panicking: Capitalism Repeatedly Recovers from Financial Crises"

Posted: 23 Mar 2010 10:53 AM PDT

Bill Easterly emails to ask what I think of this:

Stop panicking: Capitalism repeatedly recovers from financial crises, by William Easterly: I am just beginning to dive into the awesome book by Carmen Reinhart and Ken Rogoff, This Time is Different: Eight Centuries of Financial Folly. Along with great analysis, they have some wonderful pictures, evidence, and data. What I say here is my own take on it.
First, financial crises are remarkably common. Their Figure 5.1 shows the number of countries that have defaulted on their external debt (one possible dimension of a financial crisis) over the last two centuries. The numbers come in episodic waves of defaults and involve a remarkably high number of countries in each wave:

Second, the global capitalist system does well in the long run anyway. Average per capita income in the world (a shaky estimate, but probably right order of magnitude) increased by a multiple of 12 over 1800-2008, despite repeated epidemics of financial crises.
The US is arguably the country with democratic capitalism the longest, and it also shows a steady upward trend from 1870 to the present, despite repeated banking crises (using those identified by Reinhart and Rogoff), with usually little effect of each crisis on output relative to trend (except for the Great Depression).

Reinhart and Rogoff calculate directly the growth pattern before and after crises in advanced capitalist economies, and growth does indeed recover quickly to the trend growth rate of around 2 percent per capita per annum. 2 percent per capita is roughly the same growth rate that increased US per capita income so much from 1870 to the present.

y-axis reads "Real GDP Growth (Percent)"

I don't mean to minimize the short run pain that the current financial crisis has caused. It's horrible. But there is no reason to panic about the long run growth potential looking forward.
The obvious rejoinder is Keynes' "in the long run, we are all dead." But we can't ignore that Capitalism already survived repeated financial crises and has made us all vastly better off despite them. So here's a counter-quote: "In the long run, we are all better off because our dead ancestors stuck with capitalism."

My take is a bit different. The graph of per capita income from 1870 - 2008 seems to say we shouldn't worry that aggressive intervention to stimulate the economy will cause long-run problems. It may help substantially in the short-run, but the graph above indicates it's unlikely to have long-run consequences. So, I agree, let's not panic. Let's not panic and start reducing stimulus measures too soon, or be too timid with stimulative policies, out of fear it might harm long-run growth. As the Great Depression shows us -- a time when there were legitimate fears about capitalism ending -- the more attention we pay to the short-run problems that undermine support for capitalism, the better chance there is that it will survive in the long-run.

I should acknowledge the Reinhart and Rogoff finding that debt levels higher than 90% of GDP are associated with lower economic growth:

...[D]ebt burdens are racing to thresholds of (roughly) 90 per cent of gross domestic product and above. That level has historically been associated with notably lower growth.
While the exact mechanism is not certain, we presume that at some point, interest rate premia react to unchecked deficits, forcing governments to tighten fiscal policy. Higher taxes have an especially deleterious effect on growth. ...
Given these risks of higher government debt, how quickly should governments exit from fiscal stimulus? This is not an easy task, especially given weak employment, which is again quite characteristic of the post-second world war financial crises... Given the likelihood of continued weak consumption growth in the US..., rapid withdrawal of stimulus could easily tilt the economy back into recession. Yet, the sooner politicians reconcile themselves to accepting adjustment, the lower the risks of truly paralysing debt problems down the road. ...

But as Rogoff notes elsewhere,

Monetary policy has done what it can to limit damage. Fiscal policy I would also give high marks to. We moved in the right direction in as timely a manner as possible.

I am not as willing to give fiscal policy high marks. We could have, and should have, done more to help the economy, and it certainly could have been more timely. As for fears more aggressive intervention will lower long-run growth, so long as we have the discipline to exit from these policies gracefully -- to pay the bill for the stimulus package in the good times -- long-run growth should not be affected by aggressive intervention in the short-run.

I believe that when the time comes to pay for the stimulus package, we'll do the right thing, just as we've always done in the past (yes, I know I'm being Pollyannish). And, in any case, the long-run debt problem has little to do with the stabilization measures used to counter the effects of the recession. The growth in health care costs is the problem in the long-run, nothing else matters much in comparison. If we fix the health cost escalation problem, a much more aggressive intervention to help the economy could have easily been absorbed into the budget without creating problems. And if we don't fix the health cost problem, the size of the stimulus package is of little consequence by comparison.

Finally, on the general "stop panicking" message, when people are hurting -- and they are -- we ought to panic. Legislators have given little indication that the understand the urgency of the employment problem we face. We need more panic, not less, about the employment situation.

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