Prof. Krugman battles a strawman argument in his latest column on the perils of insufficient regulation of the financial markets. He follows his description of the the sub-prime meltdown with this:
But the innovations of recent years — the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn’t have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized.
Why was this allowed to happen? At a deep level, I believe that the problem was ideological: policy makers, committed to the view that the market is always right, simply ignored the warning signs.
The market is always right? My goodness, what maroon could believe that, and isn't it wonderful that Prof. Krugman is here to deride their lunacy?
Back in reality, the efficient market hypothesis does not claim that "the market is always right" - in essence, it claims that the market is always wrong but in ways that cannot be systematically and reliably predicted. Here is an explanation to which Krugmanites may rally:
Economists have a rather Zen-like view of stocks. They believe that investors are rational, and that stock prices are therefore unpredictable. It sounds peculiar, but the logic is ironclad. Rational investors would take into account everything they know -- all the information available about where profits, interest rates, technology and so on are going -- when buying or selling stock. So stock prices would already reflect all available knowledge, and would change only when new information came in. And new information is, by definition, unpredictable -- otherwise it wouldn't be new -- which means that changes in stock prices would be unpredictable too. Q.E.D.
Except, of course, that real investors aren't entirely rational. Being human, they are driven by fear, greed and the madness of crowds. In principle this should create patterns in stock prices, and in principle you can use those patterns to outperform the market. Good luck. But while it may be very hard to tell whether the market is overvalued or undervalued (remember that Alan Greenspan warned of "irrational exuberance" when the Dow was at about 6,500), one thing is for sure: It fluctuates more than it should.
That comes from Krugman himself of course, who understood perfectly well the concept of efficient markets when Clinton was President. But since the Krug 2007 has such confidence in the ability of regulators to foresee that which is opaque to the rest of us, let's continue this benchmarking exercise by re-reading his stock market forecast as of January 2000, written on the eve of the great tech market collapse:
Why was the market so easily spooked? Presumably because everyone -- me included -- is even more confused than usual about what stocks are really worth these days...
...In fact, current stock prices already have built in the expectation of economic performance that not long ago we would have considered incredible; performance that is merely terrific would be seen as a big letdown.
So which will it be -- terrific or incredible? We all have our opinions -- being a pessimist by nature, I think that things will be merely terrific -- but nobody, and I mean nobody, really knows. And a rational market would accept this ignorance, and wait for some actual evidence in favor of one side or the other.
Of course, it doesn't work that way. Yesterday, something -- if I knew what, I would be a lot richer -- caused investors to become slightly less convinced than they had been the day before that we are living in the best of all possible worlds. And the result was a huge destruction of paper -- um, I mean virtual -- wealth.
But hey, it's still a terrific economy. Or do I mean incredible?
Helpful. The bubble was obvious later, of course. And Krugman subtly acknowledges that even if the market is not rational, it is irrational in ways that cannot be predicted.
Well, back to the current morass. Krugman is correct that individual dealmakers are not returning their once-handsome bonuses, which is one area of skewed incentives - people who arrange complicated deals can reduce the hazards of asymetric information by keeping their own money in the deal (and this is a point a savvy investor will explore prior to writing a check). That said, some major banks have lost billions in their own deals, so we presume they were as surprised as their investors by the dismal performance of the underlying assets.
Among the credit rating agencies Moody's and Standard and Poor's have spent a century building a reputation for providing credible analysis of complicated deals so they had a huge incentive to get these deals right - oops.
As to the omniscient and benevolent regulators Krugman envisions (NO, not the ones that made the Asian crisis worse!), I suspect that if, in their wisdom, they had prevented the sub-prime meltdown, it would have simply by saying "no" to all sorts of loans, some of which would, with the benefit of hindsight, have merited that "no". But not all - per the WSJ, roughly half of sub-prime borrowers should have qualified for a conventional mortgage.
As a practical matter, I can scarcely see Democrats standing by while a Federal regulator exhorted banks to reduce their lending to women, minorities and those with low or uncertain incomes, but obviously that is how it would have played out in Krug-world.
BONUS IRONY: Surely I am not alone in being struck by the fact that the Nutroots (of which I am deeming Krugman to be an honorary member) spend a small fraction of their time deriding the Republicans as seeking a strong father figure to protect them from terrorists and brown people, and a large fraction of their time clamoring for a strong government leader to protect them from everything else?
And surely I am not alone in thinking that the previous sentence is staggeringly clumsy?
All agreed, then, so I'll quit calling you Shirley.