Roberts on the Financial Crisis

Russell Roberts will not win the Nobel Prize in economics.  That honor is reserved to number crunching theorists who extend the frontier of economic understanding of economists.  Roberts' contribution is to extend the frontier of economic understanding of non-economists and students, and he may have no peers.  He has written textbooks and novels.  He posts for the popular blog, Cafe Hayek, and is the host of EconTalk.  He has even produced a rap video contrasting the economics of Keynes and Hayek and students love it.  His latest project, "Gambling with Other People's Money," is an explanation of the inflating of the housing bubble, the ensuing financial crisis and steps that the government can take to avoid future crises.

The problem that draws Roberts' focus is that the government, time and time again, "socialized losses" while allowing private agents to retain profits.  At several points in the paper, Roberts paraphrases Milton Friedman who wisely described capitalism as a profit a loss system.  The profits encourage risk taking and the losses, prudence.  The financial system that developed from the interplay of large financial institutions, elected and appointed public officials, and other special interest groups was decidedly not capitalist.  It encouraged risk without prudence.  Roberts calls it crony capitalism. 

Roberts skillfully uses an allegory of a poker game to describe the incentives of all the players when losses are present and then how behavior changes when the fear of losses is reduced or eliminated.  The people at the allegorical poker table represent different types of economic agents: equity holders, debt holders, Fannie and Freddie, commercial and investment bankers, and consumers.  The behavior of each changed as the government shifted risk from these economic agents to taxpayers with dire consequences for the economy as a whole. 

Although the government receives a large share of criticism, it would be unfair to characterize the paper as an apologia for capitalism.  Market participants also draw criticism.  For example, besides their role in the symbiotic dance with regulators, commercial and investment bankers draw Roberts' criticism for following the perverse incentives, establishing faulty incentive based compensation, etc.

At the end of the paper, Roberts lists reforms that the government could make that would restore risk and reduce the likelihood of a future catastrophic economic event.  He believes that these changes would lower government outlays, reduce wealth transfers to the rich and reduce the probability or severity of future financial crises.  I think that he is on to something.