A recent post by Ezra Klein, “What ‘Inside Job’ got wrong,” manages the impressive feat of being spectacularly off base, rhetorically dishonest, and embarrassingly revealing of the lack of a moral compass all at once.
Since being off base is a major part of Klein’s brand, I suppose one should not be surprised; those who’ve had the good fortune to have limited contact with his output can read Jon Walker’s “Ezra Klein: Insurance Exchanges Don’t Work and Must be Expanded Dramatically,” or Physicians for a National Health Care Program’s “Does Ezra Klein really think ‘managed care didn’t kill anyone’?” for two of many examples.
I’m going to shred this piece in some detail, first, because it will be entertaining, and second, I hope that it will encourage readers to take a cold, bloodyminded look at the excuses made for malfeasance in our elites.
Let’s start at the top:
I finally watched “Inside Job” this weekend. It was an excellent documentary for people who don’t want to understand the financial crisis but want to believe they would’ve seen it coming. Watching it, you’d think that the only people who missed the meltdown were corrupt fools, and the way to spot the next one is to have fewer corrupt fools. But that’s not true. Worse, it’s dangerously untrue. In telling the wrong story about how the financial crisis happened, it misinforms about how to keep it from happening again.
The only objection Klein raises to Inside Job is that it punctures the favorite defense of economists, regulators, and their mouthpieces in the media “whocoulddanode?” Klein rejects the notion that corruption played a role; there no effort to rebut the evidence proffered in Inside Job and numerous other accounts (including on this blog and in ECONNED). He simply sidesteps the issue of corruption via straw-manning: “corrupt fools”.
The most corrupt were decidedly not fools, they knew better and still took the destructive, profitable course. One can say a lot of bad things about Larry Summers, but no one would call him a fool, and given his track record (Inside Job sidesteps Summers giving his pal Andrei Shleifer a free pass over allegations of self-dealing in Russia that Harvard had to pay at least $31 million to settle), the “corrupt” label fits all too well. Similarly, it is no accident that the hedge fund Magnetar, which successfully bet against lethal CDOs that it created, was named a type of star that emits copious amounts of toxic radiation. Bear Stearns, hardly known for having an elevated sense of morality, still refused to create CDOs for John Paulson in 2005 because it was obvious to them that the deals would be designed to fail. But pretty much everyone else on the Street was happy to peddle the finance equivalent of sewage to their clients. And that’s hardly a new tradition; the Frank Partnoy book FIASCO describes how he and his colleagues took great pride in the early 1990s ripping off the faces of customers and blowing them up (their lingo, not mine)
And courtesy Richard Smith, let’s look at some of Klein’s rhetorical sleights of hand:
Watching it, you’d think that the only people who missed the meltdown were corrupt fools (straw man), and the way to spot (no, avert, not “spot”; you are getting ahead of yourself, the next few paras are about spotting) the next one is to have fewer corrupt fools. But that’s not true (isn’t it? would a lower corrupt fool quota help, or not?). Worse, it’s dangerously untrue (how: what’s untrue? what’s dangerous?). In telling the wrong story about how the financial crisis happened (unsubstantiated assertion), it misinforms about how to keep it from happening again (unsubstantiated assertion).
From this unpromising start, the post goes completely off the rails. Yes, Klein makes weak attempts to fulfill some of the charges made, but as we will see, they range from not-terribly-convincing to outright absurd.
But first, we need to perform an osculectomy, which former investment banker and New York Observer columnist Michael Thomas has outed as a surgical procedure only done on a very hush-hush basis in New York, Los Angeles, and Washington, DC. It becomes necessary when Party A has kissed the ass of Party B with such intensity that a vacuum bond is formed that is so strong that it can only be broken by surgical intervention. In this case, Klein needs to be forceably detached from the posterior of Michael Lewis.
Klein holds up Michael Lewis’ book The Big Short as the ne plus ultra on the financial crisis. That’s mighty peculiar, since Lewis wrote about the subprime shorts, a subset of players involved in the US mortgage mess (which itself was the detonator rather than the totality of the financial crisis), and even then only some carefully selected players (his most notable omission is John Paulson). And it isn’t even the best account of this investment strategy; the more comprehensive and instructive book there is Greg Zuckerman’s The Greatest Trade Ever, which was published five months before The Big Short . As we wrote in March 2010:
Lewis’ tale is neat, plausible to a mass market audience fed a steady diet of subprime markets stupidity and greed, and incomplete in critical ways that render his account fundamentally misleading. It’s almost too bad the book’s so readable, because a lot of people will mistake readability for accuracy, and it’s a pity that Lewis, being a brand name author, has been given a free pass by big-name media like 60 Minutes (old people) and The Daily Show (young people) to sell to an audience of tens of millions a version of the financial crisis that just won’t stand up – not if we’re really trying to get to the heart of the matter, rather than simply wishing to be entertained by breezy well-told stories that provide a bit of easy-to-digest instruction without challenging conventional wisdom.
The balance of the post provides ample support for those charges.
Klein’s touting of Lewis is in keeping with his posture towards the crisis: he wants to stay on the well trodden path of accepted narratives. And that serves the perps just fine. Complexity, opacity and leverage were the generators of this disaster; the more the financial services industry can do to deter investigation into them, the better.
The piece gets even more bizarre:
In 2007, Lewis wrote a piece mocking the worrywarts trying to sound the alarm at Davos. “Davos,” he wrote, “is where people with no talent for risk-taking gather to imagine what actual risk-takers might do.”
It’s ironic that Lewis, who later wrote a book lionizing outsiders who bet against the herd mentality when they were later proven right, took the low risk course in early 2007 and ridiculed nay sayers. If you read the short Bloomberg piece, Lewis was the loud and proud mouthpiece of conventional superficial nonsense circa January 2007: he had bought the Great Moderation and the idea that the world had actually reduced risk significantly by slicing, dicing, and trading it. Before you say it’s easy for me to say that, in post four days before the Lewis piece, “The Beginning of the End?“, we wrote:
We’ve commented from time to time on loose credit conditions (see our “Rising Tide of Liquidity“, plus Part 2 and Part 3 on the same topic) and indifference to risk (“Where Has the (Perception of) Risk Gone?“).
The tide may be turning. Today, the New York Times had a lengthy, well researched article, “Tremors at the Door,” on the reversal of fortune in the subprime mortgage market. Defaults by borrowers have risen to a level where the lenders themselves are increasingly in jeopardy:
Yet Klein tries to invert the interpretation of this embarrassingly bad Lewis piece:
He knows financial markets, knows the people in financial markets, and knows the products in financial markets. But he missed it. Completely. And no explanation of the financial crisis that doesn’t have room for Lewis to miss it is sufficient.
What kind of meshugas is this? Because Klein’s favorite financial writer missed the onset of the crisis, we are to give all the analysts, economists, regulators, and bankers a free pass? And he can say this with a straight face after the Financial Crisis Inquiry Commission documented in far more detail than Inside Job that there were plenty of warning signs?
Let’s get down to real basics: can Klein simply not tell the difference between Lewis, a bond salesman 25 years ago, and author/journalist since then, and a genuine in-touch expert on some aspect or other of modern finance?
Or do we assume Klein does know the difference, which makes Klein’s remark a decidedly, not to say, insanely journalist-centric view of the crisis. I shall not speculate about why a journalist who doesn’t know anything about finance might be tempted to conclude that the crisis was actually all about journalism. Still, it’s impressive (though not necessarily in a good way) to see someone actually publish that conclusion, quite unselfconsciously; if that’s what he meant to say.
And this is where Klein’s choice (whether deliberate or out of learned blindness) is particularly convenient ; it’s the device he uses to dodge the central issue of corruption. As Tom Adams noted via e-mail:
I am fairly amazed that someone purporting to be writing about how “inside Job” is dangerously wrong can spend the entire rest of the article discussing Michael Lewis.
In so doing, Klein ignores the most obvious reason that he is effectively confirming his own summary about “Inside Job” – that it suggests anyone who didn’t see it coming was corrupt.
Obviously – the answer is that Lewis has been corrupted as well. It’s not the hard corruption of CDO salesmen saying the CDO manager was independent when he was fig leaf that allowed the bank to dump its toxic exposures, or of mortgage brokers telling their customers they were getting a 30 year fixed rate mortgage and instead giving them documents for an options ARM at closing, but it is a form of corruption nevertheless. He is a member of the NYC media elite, a group enraptured by its own wonderfulness. For Lewis and his peers, the crisis aws an excellent marketing device and they exploited it for their own purposes. Lewis was not interested in explaining (or anticipating) the financial crisis. He was interested in selling books. With his books, he is also deeply in love with his own narrative devices – outsider takes on the establishment, acts unconventionally, wins.
He was not looking to explain why everyone got it wrong nor did he bother to take on two of the biggest forces in the market – Paulson and Magnetar – because they didn’t fit his narrative. And the narrative was what mattered because Lewis has honed his storytelling approaches and has a large audience eager for more stories that present the same arc. That is what the was selling, not the “truth”.
Then Klein tries the dodge because no one saw the particular way the crisis played out, no one can be held responsible for not seeing it:
A lot of observers understood we had a housing bubble — Dean Baker, for instance, had been sounding the alarm for years — but few of the housing skeptics saw everything going on behind the bubble: That the subprime mortgages had been packaged into bonds, that the bonds had been sliced into tranches, that the formulas being used to price and rate the tranches got the variable expressing correlation wrong, that an extraordinary number of banks had purchased an extraordinary amount of insurance against getting that correlation wrong from AIG, that AIG had also priced the correlation wrong and would be unable to pay its debts in the event of a meltdown, that a meltdown would freeze the mostly unregulated shadow market that major financial institutions and players used to fund themselves, that the modern financial system was so fragile that an uptick in delinquent subprime mortgages could effectively crash the global economy.
Klein needs to get out more. See the fallacy in his reasoning? Note he demand that someone have foretold the specific path the crisis went down for them to get credit for having called it. And as an aside, par for his knowledge of the crisis, Klein’s discussion of AIG is badly confused. He mistakes the damage that the collapse of AIG would have caused via its status as being the world’s biggest insurer (which would have been horrific) with the losses that resulted from AIG having written credit default swaps on subprime-related CDOs that it could not honor (you can debate how much that ultimately cost, but the New York Fed forked over roughly $30 billion, which is a large but not financial-system-wrecking number).
Why is Klein’s requirement that someone have been able to project the course of the crisis unreasonable? Even if you can specify PERFECTLY the rules that govern how a system works, in a system subject to not all that many forces, it quickly becomes impossible to make an accurate forecast. This issue was identified in 1899 by mathematician Henri Poincaré, who won a prize for demonstrating that a long-unsolved puzzle from physics, that of determining the movements of three or more celestial objects (meaning their gravitational forces could affect each other), was for all practical purposes unsolvable. You needed to specify their initial conditions (mass, location, velocity) to such an extraordinary degree of precision that even a miniscule error leads the
actual path of the object to diverge from the predicted path. Those deviations increase as time passes, so that the actual path may lose all resemblance to the predicted path.
Think of how much more complicated our financial system is than the movements of three celestial bodies. We can’t specify how actors operate with highly accurate mathematical formulas. We have a lot more than three actors. Therefore any attempts to predict what will happen are likely to be subject to the same problem that Poincaré stumbled upon: even if you can describe the forces at work accurately, you cannot make useful predictions, at least not over anything other than very short time frames.
But you could nevertheless very clearly see in late 2006 and 2007 that Things Were Going to End Badly merely by reading the Financial Times. You could tell we were in the midst of a global credit mania. There was regular discussion of the “wall of liquidity”. Credit spreads for every type of lending were at unprecedented, astonishingly low levels by any historical standards. It was not hard to anticipate with so much profligate lending going on in every sector of the market that there would be tremendous losses down the road.
If you want to see what a financial services expert who was not a credit markets insider could infer before the crisis, I suggest you read the paper released in April 2007 by an equity analyst, Henry Maxey of the UK investment management boutique Ruffer. It’s a remarkable piece of work.
We then get to more dictation from the Ministry of Truth via Klein:
What’s remarkable about the financial crisis isn’t just how many people got it wrong, but how many people who got it wrong had an incentive to get it right. Journalists. Hedge funds. Independent investors. Academics. Regulators. Even traders, many of whom had most of their money tied up in their soon-to-be-worthless firms. “Inside Job” is perhaps strongest in detailing the conflicts of interest that various people had when it came to the financial sector, but the reason those ties were “conflicts” was that they also had substantial reasons — fame, fortune, acclaim, job security, etc. — to get it right.
Huh? He can write this with a straight face? He has the incentives 100% wrong.
Asset bubbles are very popular. They look like increased wealth to the community. That’s why regulators are reluctant to intervene. If they do, they make people look less prosperous immediately, and they can’t prove the counterfactual, if they had left things alone, the damage would have been worse. Recall the orthodoxy then was you couldn’t recognize a bubble in progress, better to clean up afterwords. And that’s before you get to the corruption that Klein is so keen not to discuss: regulatory revolving doors, annual bonus cycles which promote the institutionalized “devil take the hindmost” attitude, known in finance as “IBG-YBG” for “I’ll be gone, you’ll be gone”.
Did Klein miss the rise of access journalism? Clearly so. Even then, the Economist, the oracle of leading edge conventional wisdom, pointed out the existence of a global housing bubble in June 2005, in a can’t-miss-it cover story with lots of supporting analysis. The subtitle: “The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops.”
The salient characteristic of this bubble was the so-called wall of liquidity. There were plenty of nervous longs as of early 2007, but they figured they could get out when things got bad. That turned out to be incorrect, and predictably so, because liquidity collapses in bear markets.
But with hedge funds and other money managers subject to monthly reporting, and punished if they show lower performance than their peer group, their incentives are to follow the herd. Contra Lewis and popular wisdom, every mortgage industry conference had worried panels about subprime from 2005 onward. I’ve spoken to industry participants who said they knew they were rationalizing continuing to participate in the market because the institutional pressures were to do so. Other people looked to be making money, so exiting the market would lead to pushback from shareholders. And this behavior isn’t new either. As Keynes said, “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him”
And then we get to Klein giving everyone (most importantly the elites!) a free pass:
And ultimately, that’s what makes the financial crisis so scary. The complexity of the system far exceeded the capacity of the participants, experts and watchdogs. Even after the crisis happened, it was devilishly hard to understand what was going on. Some people managed to connect the right dots, in the right ways and at the right times, but not so many, and not through such reproducible methods, that it’s clear how we can make their success the norm.
This is worse than useless, since Klein incorrectly throws up his hands and effectively says no one can understand what happened and therefore there’s no answer. One of the reasons the crisis has been so “difficult to understand” is that the government and banking elites have been taking extraordinary efforts to obscure the truth. The AIG bailout, the GSE bailouts, the alphabet soup of Fed facilities, the con game of the “stress tests”, the refusal to release information, the ridiculous government programs to “restart” the market, the efforts to deny the mortgage crisis, HAMP, the ongoing efforts to prop up the banks even though the are insolvent, they are all massive efforts at obscuring what really happened and what is still going on. This is not a coincidence; it is a deliberate effort orchestrated by the banks, the Fed, and the Treasury.
And plenty of people have sound proposals for what ought to be done. The best formal work in this area, if Klein would bother doing even the most basic digging, comes from the Bank of England. The answer, in short form, is prohibition: banning certain activities and products, breaking up the banks and implementing other measures to reduce the interconnectedness of the system and contain risk taking.
Before you say we can’t do that, the banks will decamp to the Caymans or innovate around it, let me tell you the dirty secret the finance industry does not want you to know: the ECB or the Fed and possibly even the Bank of England could impose what amounted to a global regulatory regime on the biggest banks any time they wanted to (and that could include hard restriction on lending to parties outside the regulatory cordon sanitarie).
First, any big bank needs to be backstopped by a pretty solid central bank. They all know that even if they harrumph otherwise, no big bank is going to take much counterparty risk with a not-credibly-backstopped big player; they’d see their funding costs rise and the positions they could take reduced, which would quickly reduce profits and those sacrosanct bonuses). Second, all bank payment systems in a particular currency ultimately need to be settled via central bank payment system for that currency (for instance, the US’s Fedwire is the critical dollar payment system) and there is no way for the banks to innovate around that. And the big dealer banks need direct access to Fedwire; going through a correspondent is not viable from a cost and operational standpoint. If you are a serious capital markets player, your need to trade dollar and euro instruments. The need to use to central bank controlled facilities in the dollar and euro means the Fed and ECB could dictate terms if they chose to.
So this gets us back to the issue that Klein wants us to ignore: corruption and capture. The problem is not that there are no solutions. There are steps that we could take now to make modern finance much less risky, but that involves imposing pain on bankers. And that has not happened because, as Simon Johnson pointed out in May 2009, is that the US has suffered a “quiet coup” and is now in the thrall of financial oligarchs. The obstacle isn’t scariness or complexity, it’s the lack of political will.
It’s easy to understand why Klein writes this sort of piece. What is hard to fathom is why anyone, other than his patrons, continues to give what he has to say much credence.