One of my favorite commentators and the coauthor of one of the most important books on the recent financial crisis, James Kwak, has just posted a profound and timely addition to his blog. He notes the developing interest in behavioral economics and the importance of understanding irrationality in decisionmaking, most prominently by my pathbreaking colleague, Dan Ariely. But Kwak then goes on to caution that such new understandings and even our more sophisticated awareness of risk carry with them the danger of excusing action by large corporations and corporate executives–a danger that has led to catastrophe, whether in the financial system or in the Gulf. As he puts it:
It’s not individual irrationality; it’s power, pure and simple. Free market economics has already whitewashed enough egregious corporate behavior. Let’s not repeat that mistake with behavioral economics.
The fact is that risks are known and they have often been deliberately ignored because those who have ignored them simply can. I want to laugh when I hear bankers and brokers whining about Black Swans–so-called small tail events that are so unlikely that either no one saw them coming or, if they did, could really do anything about avoiding those risks. One only has to read a few pages of Michael Lewis’ The Big Short to see through that load of codswallop. This was a disaster knowingly entered into by people who thought (often correctly) that they could nevertheless profit wildly in the process. I vividly remember reading, long before Wachovia acquired Golden West in 2006, the growing number of reports in the media about the overheated California housing market. I was not the only person reading the Wall Street Journal at the time. We are now seeing and hearing one report after another about how the oil drilling industry misled regulators about precautions they would take, or deliberately structured their activities to avoid or reduce oversight, when drilling at great depths, actively maneuvered to rig the regulations in their favor, or simply ignored the disasters already surrounding their activities. And so the story goes.
So how does this happen? We have many theories, some of which are sometimes correct. But there is one simple and constant reality about the way in which American economic regulation works: power really, really matters. We are witnessing this play out vividly in the final stages of the financial reform process, where the financial industry as a whole is spending $1.4 million every day to try to fend off the impact of the financial reform legislation. Today the Wall Street Journal reports that the largest banks and investment companies alone spent over $40 million in lobbying Congress in the first quarter of 2010. And we saw the same thing with health care reform and in every other area of economic activity that matters. This scale of influence leads not merely to regulatory capture, a concept that is only now being fully appreciated. It is full-blooded economic, political and cultural capture and its evolution is striking at the heart of American democracy.
Are we powerless to stop this development? There are things that can be done. Hopeful signs emanate from the financial reform conference committee where Barney Frank is reported today to be holding the line, making it hard for lobbyists to get in the door. But a truly effective reform would have been to break down the ultra large banks, for example. There are many reasons to take this action; one of the most important is the sheer, disproportionate political power they wield by virtue of their size. Do we have the courage to attempt such breakups? So far not: the Brown-Kauffman bill in the Senate would have placed a rather gentle limit on the absolute size of banks, yet it was easily defeated by a large majority of Senators backed by the very large banks and their supporters within the Treasury.
We might well be watching democratic abdication before our eyes. In five years many of us will claim we never saw this coming!
