The Sovereign Mind

Free thought on politics and real life

Why the Credit Crisis: Greed or Fear?

leave a comment »


FreeDigitalPhotos.net

If you ask anyone why the credit crisis happened, you are likely to get a one word answer: Greed.

In some cases, that one word answer is followed by a rant about how the free market failed because of the greed of bank executives who tried to make money off of risky loans. But this argument doesn’t make sense to me. The free market is based on a balance of greed and fear. Greed provides the incentive for businesses to try to make money, while fear of losing money provides the necessary incentive to mitigate risk. In an ideal free market, these two forces balance out each other, promoting business decisions that appropriately balance risk and reward.

So how can greed be part of what makes the free market work, and at the same time be the cause of it’s current trouble? Greed caused executives to make decisions they thought had the potential to make a lot of money. There’s nothing wrong with that. The problem is that they apparently greatly misjudged the risk of the decisions they were making. In other words, they did not have enough fear to ensure wise financial decisions.

So, I don’t believe the cause of the crisis was too much greed. Instead, I believe the cause was not enough fear.

But the more important question is: how did so many people make such a bad choice? It would be understandable if just a few businesses suffered from this lack of fear, causing them to make overly-risky decisions. The free market accounts for those who make bad decisions. Specifically, the free market is designed to destroy them so that those who make better decisions take their place. So the fact that bad decisions were made is not surprising. What is surprising, and what the free market could not mitigate, is the fact that a large portion of our financial system was caught up in this. When one person makes a bad decision, we blame that person. But when many people make bad decisions, that indicates a systemic problem.

So, what systemic flaw caused so many people to be not as fearful as they should have been? I don’t have the definitive answer, but it seems to me that there are only two possibilities:

1) The Echo Chamber. Since everyone was saying the market was secure and growing, people got overconfident. That confidence spilled over to others, until you have an echo chamber where everyone is saying how great the market is, but no one has really done the research to find out for sure. So executives and shareholders didn’t have enough fear, which would have caused them to look into it sooner instead of assuming their investments were solid.

2) The Safety Blanket. Perhaps people didn’t have enough fear because there really wasn’t anything to fear. After all, if the government is going to step in when things get bad, then that minimizes the fear of risky investment that I would otherwise have. If I can get all the benefit when times are good, and a minimal amount of the pain when times are bad, bring on the sub-prime loans.

So which is it? Or is it some of both? Before we jump in head first to try to fix things, I think it’s important we fully understand what caused this. If the first reason is true, then we need to re-think the prevailing wisdom that the market is the ultimate regulator. In that case, we need more regulation (or, more accurately, we need the right regulation) to make sure that the market is not getting overconfident. If the second reason is true, we actually need less government involvement so that companies are responsible for there own bad decisions, which would promote less risky investment. If it is both, then we are in a tricky situation where we need both more regulation and less government intervention at the same time. That’s not exactly the kind of solution that lend itself well to sound bites and bumper stickers, which unfortunately is the primary political language that our country speaks.

If the credit crisis was caused by a lack of fear, I’ve got plenty of fear to go around: fear that–if we allow politics to rule this issue–we might not get this right.

Greed, meet fear. You two should talk.

Advertisements

Written by Mike

October 26, 2008 at 9:19 pm

Posted in politics

Tagged with , ,

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: