The World Financial Crisis

In his recent talk, Gary Parr, Deputy Chairman of Lazard and a much sought after financial adviser in the current credit crunch, addressed the world financial crisis. It is a rare but welcome opportunity to meet someone who has first hand experience with multinational corporations and governments and who is involved in high profile decision-making processes that affect so many people worldwide. And it is even rarer to meet such a person and realize that he is not only a calculating businessman, but actually quite human and ethically concerned. Mr. Parr’s talk was stimulating and, apart from facts and numbers, he touched on many complex ethical issues that have no simple answers. I will discuss some of them, in particular corporate social responsibility, government intervention, and institutional design.

How did it happen?
In his talk, Mr. Parr identified human nature as one of the key causes of the current financial crisis. The problem is not, however, egoistic behavior, as one might have thought. Instead, inductive reasoning is the main culprit. Inductive reasoning, based on the assumption that the future will be like the past, is essential for human beings to survive in this world, but it may also drive them into an existential or financial crisis. If everyone believes that prices will go up, as in our case housing prices, because housing prices always went up in the past, and the issued credit volume by lenders is not fully backed by real assets, then we may face a vicious problem of collective action when prices actually fall.

The problem of collective action that arises in this case is, quite refreshingly, not that no action takes place, as in the Prisoner’s Dilemma game where everybody defects. Instead, the problem is that too much action takes place because everyone tries to sell, and the run on the banks effectively shuts them down. To illustrate this point, Mr. Parr used the metaphor of a ship in danger to capsize because too many people lean on one side of the boat. Coordinated action, then, if everyone runs from the one side of the boat to the other, will surely do the trick and sink the ship. How can we avoid such unwelcome collective disaster?

Possible solutions
Back to human nature. I think that a good starting point to solve this problem is David Hume’s insight that human beings cannot change their nature, but they can change their environment. Human beings can, by intelligent institutional design, artificially create institutions that guard themselves against collective failure such as we currently experience.

One such institutional coordination device is free markets. If everything goes fine, the invisible hand optimally allocates our scarce resources. That is a start. But markets alone do not always produce socially optimal outcomes. Indeed, as the last couple of months have shown, markets may not even produce stable suboptimal outcomes, but instead falter altogether. But what should we do if the invisible hand gets out of hand? The most obvious answer to this question is government intervention. There are two options. We can either follow a piecemeal strategy or call for systematic government regulations.

The general strategy in the US has been, in particular over the last eight years during which the Bush administration reduced regulations for banks, insurers, lenders, and credit raters, to interfere with the market only in emergency cases and otherwise to let the market work as freely as possible. But this strategy is extremely short-sighted because it does not allow us to prevent unfavorable situations such as that which we currently face. It allows only for rescue plans and ad hoc modifications to the current system, as Mr. Parr discussed.

It seems that in order to prevent collective failure, more systematic institutional design is necessary. The government must tame the market by legislating more rigorous rules for the ‘banking game’ that actually produce socially desirable outcomes, or at least avoid collective disaster. But is this sufficient? Does changing the rules of the game prevent corporations from following extremely risky strategies that, if they should go wrong, must be absorbed by taxpayers because a collapse of these enterprises would be even worse for the public?

It seems that there is still a missing link that forces corporations and their managements to be more responsible for their actions. One possible solution to this problem is partial state ownership. The idea is straightforward. If the government bails out ailing companies, then it should receive a share in the company’s ownership in return, and when stock market prices recover, the government should sell the shares to private investors to the benefit of the taxpayers. This ties private interests to the public interest, at least partially, and thus forces all actors to pull in the same direction. No collective action problem here. Paul Krugman’s recent article on this topic is insightful.