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Incentives in Financial Markets

As the majority of economists were (and most of them still are) working on a model in which markets ensure superior outcomes if left to themselves, they could not foresee the financial crisis. All the deregulation that happened since the early 80s, the supposed rational behavior of market participants, the technological capacity for calculating risks and the financial derivatives that allowed risks to be spread across a large number of market participants, were supposed to ensure that the financial market was close to perfect, so major disruptions would be a thing of the past. Top economists like Lucas (2003) went even further: “[Macroeconomics’] central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.” Undisturbed by the fact that banking crises were virtually nonexistent between the end of WWII and the mid 1970s while the number of countries experiencing banking crises shot up to 20% of all countries (weighted by their share of world GDP) in the fiercely deregulated financial markets of the mid 1990s (Reinhart & Rogoff 2008; cf. Chang 2012), economists propagated (and many still do) constructs like the efficient market and rational expectations hypotheses (EMH and REH respectively), that tell us that sufficiently deregulated markets will always get it right on average and will neutralize the effects of any attempts to interfere. When things do go south despite this, Real Business Cycle Theory (RBCT) tells us that the cause must be exogenous as EMH and REH ensure that the market itself cannot be at fault. In short, EMH and REH sing the praises of the market, while RBCT helps to reassign blame if events seem to prove that praise misguided (Varoufakis 2013).

Both EMH and REH however, require market participants’ time-horizons to be long and their incentives to be symmetrical in the sense that they stand to gain as much from a good deal as they are to lose from a bad one. Anthropological research by best-selling author Luyendijk (2015), however, has shown that the real incentives facing people working in the London City (and arguably Wall Street and other financial centers as well), do not even remotely come close to this ideal. He describes a world of zero job security in which people that make smaller than average profits on their trades are periodically ‘culled’, that is, fired by the hundreds. As this can happen on a moment’s notice, long-run consequences of decisions play no part in any decision making and as trades are assessed only on the profit – and not the risk – they entail, traders have very strong incentives to secure their jobs and their bonuses by taking excessive risks. If the gamble turns out right, you get a big bonus and get to gamble another day. If it does not, it is only ‘other people’s money’ that the trader is not personally liable for (but as such trades may cost you your job, there is an incentive to administratively hide the bad deal and/or to try and compensate for the loss by taking an even bigger gamble hoping to be luckier this time). So, far from harboring a randomized distribution of risk-loving and risk-averse as well as short and long term oriented traders, this institutional set-up means that only short-sighted, consequences-be-damned risk-lovers have any chance to survive in the business. Together they created the massive bubble that burst in 2008. As governments and ultimately tax-payers are squeezed to cover bank losses their thinking turned out to be right all along: even if everything goes wrong on a world scale, they’ll be bailed out with other people’s money.

Not only does this seem incredibly unfair, it also cripples the last vestiges of any market forces keeping financial markets sane for it shows that neither traders, nor the banks they work for, will be held accountable for the losses that result from their unscrupulous risk taking. This implies that today’s financial system is not a free market at all, let alone an efficient one. In a functioning market, after all, competition should ensure that companies that manage their costs and risks most prudentially can stay in the market longest. But if you are a too-big-to-fail bank you will be bailed out first and the worthless assets you created due to excessive risk-taking will be bought by central banks (CBs) under the guise of quantitative easing (QE) later. CBs thus artificially breathe life into markets that would collapse if they were left to themselves (as economists usually argue they should).

The idea is that the money that QE creates, will prop up banks’ reserves and entice them to step up their lending for productive investments. But this can only happen if such investment opportunities exist and as effective demand slacks under the weight of the recession, and deteriorates further due to austerity measures and low wage policies, such opportunities are few and far between. So the surest way for banks to invest the proceeds of quantitative easing profitably, is by buying the very assets that CBs’ quantitative easing programs are targeting. Thus, a new bubble is forming through the unholy alliance of financiers, governments and CBs. So, whereas the bubble bursting in 2008 was at least in part caused by overoptimistic households taking on excessive debt, households have no part in creating it this time (but I do fear they will be forced to pick up the tab again when it implodes). In Varoufakis’ (2013) terms democracy is temporarily or indefinitely suspended in favor of what he calls a bankruptocracy: the reign of banks that should have gone bankrupt. I, for one, am not surprised by the voter revolts (e.g. Trump’s electoral success in the US; the extreme right rising to unprecedented prominence on mainland Europe; the Brexit vote in the UK and the pirate party tripling its seats in Iceland’s parliament) following this state of affairs. Voters may not know or understand exactly what is going on, but they do feel they are being played, squeezed and used by ‘the establishment’ and when a screw-you vote is available I can hardly blame them for casting it.

But, but, but… surely governments cannot allow too-big-to-fail banks to actually fail, for if they did, all their clients would go down with them, right? You cannot actually be suggesting that would be the preferred outcome? Well, I am not, or not completely. I like the suggestion Steve Keen made in Room for Discussion (2016), where he says that the failing banks should have gone bankrupt as commercial banks, but instead of going off the market and taking their clients down with them, governments should have nationalized them and continued their services. Moreover, instead of creating an artificial market for worthless financial assets through QE, the state would have done better to expand CBs tool kit so they can improve banks’ financial health by scrapping private debt through a program that Keen dubs the people’s QE, which does not target bank assets, but relieves the underlying debt causing the assets to lose value in the first place. Thus, e.g. the much maligned subprime mortgages would be cancelled as would the assets repackaging their risks into collateral debt obligations (CDO’s) and what not. Such a program would thus shorten the banks’ balance sheets and deflate the original bubble, rather than replace it with a new one. Through the shortening of the banks’ balance sheets, a modicum of market discipline would be restored, while the associated debt relief would boost consumer confidence and demand (thus upping profit opportunities and productive investment to boot) (see also Blyth & Lonergan 2014). The latter effect would surely result in rising inflation, but, as Keen points out, this is exactly what CB’s are trying to achieve through QE anyway, but as long as QE money sloshes around within the financial system, they will keep on failing dismally at it. All in all then, the people’s QE deflates bubbles that need deflating, relieves the debt burden for those that are least responsible for the crisis but suffer its consequences most and restores some market discipline instead of suspending it.

So why doesn’t this happen? It doesn’t happen because regulatory capture (see e.g. Buiter 2009) keeps many career politicians hostage: after their term is up, politicians hope to cash in on the favors they extended to banks by pursuing careers there (and these careers pay a LOT better than political ones, so again, who can blame them?). Meanwhile, the many (financial) ties between many influential economists and financial and insurance companies, suggest they are not immune to regulatory capture either (my source is focused on Dutch media-economists, but the Inside Job documentary suggests economists elsewhere are hardly more independent). So criticizing the status quo impedes politicians’ careers and the most influential economists are in no position to offer objective advice. No wonder then that proposals like the People’s QE are hardly ever seriously discussed.


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