Editor’s Note: This column has been adapted from Alexei Bayer’s remarks at the Yale Club in New York City on May 5, 2009, upon acceptance of the Excellence in Financial Journalism award presented by the New York State Society of Certified Public Accountants.
The current economic downturn is atypical in at least one respect. There have been so many scapegoats — including bankers, mortgage brokers, regulators and rating agencies — that the usual suspects have been temporarily forgotten. Only rarely do we hear the traditional complaint that economists screwed up, failing to warn us that there was a bubble in the housing market and that so much credit was extended that the financial system was at risk.
But economists did warn about the problem. Some of the most respected economists have been talking about risks in the financial services sector for years. Few got the timing exactly right, but some came remarkably close. (See for instance our interview with Yale economist Robert Shiller in the June issue of Research.) Plenty of mainstream economists saw the U.S. economy as dangerously unbalanced and overextended. As the late Herbert Stein, the chairman of the Council of Economic Advisors under Richard Nixon, postulated in his Stein’s Law: “Things that can’t go on forever never do.”
Actually, you didn’t need sophisticated economic models to know that things were going astray, just common sense. Debt growth, and the leveraging of assets with the help of increasingly sophisticated forms of financial engineering, certainly couldn’t go on forever. Since debt growth was outstripping consumer incomes, there was going to come a time when entire segments of the population would not be able to service their debts. House prices were outpacing income growth as well, which also meant that eventually the bottom was going to fall out of the real estate market. When asset prices increase faster than incomes, they eventually need to come down to become affordable once more, or else inflation will accelerate to raise nominal incomes.
The financial system was supposedly protected by sophisticated risk management models developed by mathematical geniuses working on Wall Street. But the spotty performance of risk management systems in crises — i.e., when they are needed most — was demonstrated in 1998 by the collapse of Long-Term Capital Management (LTCM), a prestigious hedge fund run by some Nobel Prize-winning economists. Its investment strategy seemed solid from the point of view of mathematics, but its algorithms became useless when confronted with reality.
Ordinary consumers and homeowners might not have been aware of the risks involved. They trusted too much in professionals. But professionals themselves — traders, speculators and market participants — could not have been ignorant of the fact that they were playing with fire.
The Madoff Syndrome
When the Bernie Madoff case came to light, people wondered how so many seemingly sophisticated investors — and highly educated people with very high IQs even if they weren’t professional investors — got caught in a Ponzi scheme, one of the oldest and least sophisticated scams in the book. Why didn’t they see through the deception?
My view is that Madoff’s investors suspected that a scam was underway. They were getting a steady rate of return which not only beat the market and outperformed all benchmarks and bested other fund managers’ results, but never varied either in lean or fat years. Everybody knows that this is impossible and that markets are volatile, unpredictable and impossible to outsmart consistently.
But that was Bernie, his investors reasoned. He was the quintessential insider. He had made a pile of money working on Wall Street. He must know something the general public doesn’t. Probably he gets some inside tips and he is smart enough to get away with it. In other words, most of Madoff’s clients knew that such returns as they were getting were impossible in the real world, but preferred to think that Madoff was working some kind of magic.