Bad Rules Produce Bad Outcomes: Underlying Public-Policy Causes of the U.S. Financial Crisis

Article excerpt

The current global financial crisis is the worst economic crisis since the Great Depression, with no end in sight. Already, much political finger pointing has occurred, with most of those fingers pointed at supposedly greedy bankers, investors, and hedge-fund managers as well as the financial deregulation of recent decades. Governments everywhere are rushing to enact new regulatory protections to prevent another crisis of this magnitude. Yet if history is any guide, these new regulations will set up the global economy for yet another financial crisis, perhaps worse than the present one, or create regulatory straitjackets that will greatly impede economic growth.

This article will first explore the interactions between finance and human nature, for public policymaking--enacting laws and adopting regulations--that ignores or misinterprets those interactions, is doomed to fail. Indeed, policymaking that responds to symptoms and consequences of perceived problems, rather than forthrightly addressing the underlying causes of real problems, will introduce greater fragility into the financial system.

After drawing observations from an analysis of interactions between finance and human behavior, I will then examine 11 underlying public-policy causes of the financial crisis and offer recommendations for addressing those causes, or at least ameliorating their deleterious effects.

Interactions between Finance and Human Nature

The current financial crisis represents a collision between finance and human nature. The consequences of this collision are as a predictable as the consequences of a collision between human nature and the physics of the real world. Unfortunately, politicians either seem oblivious to or deliberately ignore the interactions between finance and human nature when enacting laws and regulations affecting financial activities.

Behavioral economics seeks to explain the role of human behavior in economic decisionmaking. That is, certain aspects of human nature, of how human beings approach financial decisionmaking, are extremely critical in understanding the underlying causes of the current financial crisis. Misunderstanding how humans approach financial decisionmaking leads to policymaking that creates a frequently refreshed hothouse environment in which financial crises flower every decade or so.

To put this point another way, most people make financial decisions that seem rational to them at the time even though the aggregate effect over time of thousands or millions of similar decisions may have disastrous macroeconomic or social consequences. In particular, if people, as individuals or as managers of organizations, make decisions that appear to them to be in their self-interest under the laws and regulations in effect at that time ("the rules of the game"), but the product of those decisions, when viewed after the fact, is not desirable, then clearly the rules of the game had a negative impact on that decisionmaking. Hence, bad rules produce bad outcomes.

The following is a discussion of five aspects of human behavior that relate to finance and therefore must be taken into account when establishing the rules of the game as they apply to financial transactions and outcomes. Alter the rules of any game--baseball, football, basketball, or finance--and the players will alter the way they play the game. Key to improving the game is to give players an incentive to act in their own self-interest while also maximizing the outcome of the game for all concerned.

Arbitraging the Rules of the Game in an Attempt to Gain an Advantage

Trying to arbitrage the rules of the game--interpreting the rules in a manner that seems to favor the decisionmaker--is a very understandable human trait. After all, successful, lawful arbitrages reduce costs, which in turn increases the profits, or capital, created by the transaction. Lawfully arbitraging the Internal Revenue Code and other tax laws is so widespread, and readily accepted, that insufficient thought is given to the distorting effect on economic decisionmaking of those arbitraging activities. …