Global Financial crises due to ignorance, not greed, says Jeffrey Friedman

Listening to ABC radio national, counterpoint, this afternoon, I heard an interview with Jeffrey Friedman, who was introduced by the interviewer with the notion that the Great Finance Crisis was caused by too much information, rather than anything else.

Interestingly, Friedmans waved aside the claim that greed was the root-cause of the GCF. Greed=evil=GCF is a common (albeit glib) argument that has been floating around for some time. Examples are: greed & ignorance responsible for housing crisis (back in 2007, before it was global) and National Public Radio gave an equally greed=bad argument in 2008.

I would suggest that in capitalist societies, greed is a good thing - that to claim that somehow everyone should act in their self-interest, but that at some point the super-self-interested are doing it wrong is to miss the point of the system. If greed is the reason why the global system fell apart, then it ought to have collapsed in the industrial revolution, when finances were being greedily absorbed by factory bosses. Or when oil barons were behaving greedily. It didn't.

If we agree that individuals in the capitalist society ought to act in their own self-interest whatever that may be, and that they do this within whatever legal constraints apply, then greed, being the act of effecting this self-interest is always good. Moreover, if too much greed is the problem, then we are doomed to forever have global financial crises, because I seriously doubt there is anyway to reign in the self-interested.

So I liked the premise - there was something other than self-interest at the heart of the financial crisis. Friendman argued

The financial crisis was caused by the complex, constantly growing web of regulations designed to constrain and redirect modern capitalism.

The details of the article on which the interview was based is found here

These regulations interacted with each other to foster the issuance and securitization of subprime mortgages; their rating as AA or AAA; and their concentration on the balance sheets (and off the balance sheets) of many commercial and investment banks. As a practical matter, it was impossible to predict the disastrous outcome of these interacting regulations.

I know I am cheating, by only quoting the abstract of Friedman's introduction, but I feel this largely summarises his argument on radio. The ignorance which birthed the crisis was created (at least in this argument) by too much and too complex regulation. The "ignorance" approach was addressed by Kaufmann somewhat pre-emptively in March, in capture and the financial crisis:

There has been a reticence in rigorously studying the extent to which money in politics, 'legal corruption', and capture may have played a significant role in causing the mammoth crisis we are in now.... it is naive to claim that the problem was mere 'ignorance'

however, `ignorance' is not really the problem cited by Friedman - rather it is that the economic system is impossibly complex to forecast and control. The conclusion Friedman draws in his article (June 1) is both more complex, and more compelling.

The problem of the regulator and the scholar—and of the citizen of a social democracy—is essentially the same: There is too much information. This is why modern societies seem “complex.” And it creates the special kind of ignorance with which modern political actors are plagued: Not the costliness of information but its overabundance... While from an optimistic perspective, therefore, the financial crisis might be seen as a “perfect storm” of unanticipated regulatory interactions, and thus as unlikely to be repeated, a more realistic view would treat the crisis, and the current intellectual response to it, as warning signs of more, and possibly worse, to come.

Further, Friedman claims that it is policy (rather than economics) at fault. A core example in the argument is that prudential regulators put credit ratings agencies in an impossibly strong position - non-competitive by law and then legislated that consumers especially government buyers and super-annuation funds, use the AAA bonds as rated by these agencies. Friedman argues that if there were substantial competition between agencies then the faux-AAA rated subprime bonds might not have arisen.

So here's a question - should the ratings agencies be regulated? And what would competition between ratings agencies look like - particularly when "you may only use AAA rated bonds" regulations remain in effect.

Finally, Friedman's argument (and others elsewhere) seem to imply the market had a self-inflicted blind spot. In this case the ratings agencies did not provide true transparency. Friedman doen't really dewll on this, suffice to imply that it's probably not wise, in the absence of information, to promote one-eyed guides.

However, some have claimed that the GFC implies the efficient market hypothesis (EMH) is dead. I would argue that it really shows that some information (credit ratings are for dopes) was not widely available. And hence, while this information remained private to a select few, some people probably made (or at least did not lose) a substantial amount of cash. Once the information did permeate the market, the price of the sub-primes nose-dived in accordance with the EMH.

So I wonder, as I flail about with nil economic training, is there a theory of transitions for economic principles? From an engineering approach, rules a such as EMH appear as steady-state descriptions -- but the interesting activities we see are all dynamic responses, that is, it is the transitions to new steady states where the profit and loss are made. What I need now is an introduction to economic dynamics. That, and some sleep.