Moral Hazard and Conventional Wisdom

Was moral hazard, in the form of expectations of a bailout, responsible for the reckless behavior that led to the banking crisis? James Surowiecki argues, quite convincingly I think, that the moral hazard argument is overrated:

In order to believe that the banks engaged in reckless behavior because they assumed that if they got into trouble, the government would bail them out, you have to believe not only that financial institutions thought it would be fine if their share prices were driven down to near-zero as long as they were rescued in the end. You also have to believe that the banks knew that what they were doing was reckless, and that there was a meaningful chance that it would wreck their companies, but decided that it was still worth doing because if everything went south, the government would step in. And that, even before Dimon’s comment yesterday, always seemed improbable, because all of the accounts of the banks’ behavior in the years leading up to the crisis suggest that most of them were swept up in housing-market hysteria like everyone else.

In a way, the moral-hazard argument ascribes far too much foresight, intelligence, and rationality to the banks. It assumes they were coldly calculating the chances and consequences of failure and forging ahead nonetheless, when the reality seems to be that for the most part they were blissfully ignorant and arrogant about the flaws in their lending and investment strategies.

I think Surowiecki is correct as far as he goes, but he doesn’t go far enough. To me the interesting question is, just why were bankers so ‘blissfully ignorant and arrogant’? The Epicurean Dealmaker provides an eloquent answer:

I also explained that the fast pace and high pressure of the business tend to attract individuals who do not attach great importance to deep, theoretical, or introspective thought. Rather, quickness of intellect, nice interpersonal judgment, and a certain calculating capacity akin to the ability of practiced chess players to think several moves ahead are the most valuable and prized attributes in my industry. What I did not explain was the natural corollary to these observations; namely, that due to their vocational preoccupations and intellectual predispositions, investment bankers tend to be extremely adept and quick at sussing out and acting on what is commonly known as the conventional wisdom.

This should not be surprising, either. After all, investment bankers spend all their waking hours figuring out and relaying to clients what "the market thinks" about deals, securities, and prices. Investment banks are gatekeepers to the markets, whether underwriting securities, trading financial instruments, or structuring and executing mergers and acquisitions. And what is the market itself but a gigantic, multi-tentacled, complexly interlinked engine for the real-time calculation of conventional wisdom? Figuring out, anticipating, and shaping conventional wisdom is what investment bankers do. It is the ocean in which we swim.

(More words of wisdom from TED can be found here).