Jeremy Grantham: "Immoral Hazard" and the Loss of Standards

I believe in synchronicity, so I found it noteworthy that I came across two articles that gave great prominence to the issue of values, one Jeremy Grantham’s April newsletter, “Immoral Hazard,” the other a post by Willem Buiter on, of all things, the Olympics.

Grantham’s excellent piece is unfortunately too long to present in full; so we’ll give some key sections. He starts by focusing on incompetence (object lessons being Volcker versus Greenspan) but as you will see, the real issue is the question of having standards, both individually and as a society. The issue of competence is a subset of this broader concern.

Grantham does a particularly good job of savaging the idea that we can’t afford failure, um, economic dislocation. He argues that tolerating imprudence has costs that are dismissed too casually.

From Grantham (courtesy reader Scott):

It’s not that the former Fed boss Greenspan was incompetent that is remarkable. Incompetence is common enough after all, even in important jobs. What’s remarkable is that so many people don’t seem, even now, to get it. Do people just believe high-quality self-justifying blarney? Or is it just that they apparently want to believe that critical jobs in a great country attract great talent by divine right. Sometimes, of course, they do, but sometimes the most important jobs – even that of a presidency or a Fed boss – end up with mediocrities….

Paul Volcker inherited about as big a mess as we have today. He worked out what he had to do and did it with unusual lack of concern about what Congress thought of the necessary pain involved and the number of enemies he might make. He paid the price for forthright behavior by being replaced, despite a record for correct and tough behavior that makes for the most invidious comparison today. When Volcker was replaced, by the way, he did not moan and groan but like an old soldier quietly disappeared. There were no high-profi le announcements about the economy or any $300,000-an-evening appearances paid for by financial firms.

Greenspan came onto my radar screen in the late sixties as a seller of economic and fi nancial advice to the investment industry. To be brutally honest, he was considered run of the mill by anyone I knew then or have met later who knew his service then. His high point in most memories, certainly mine, was a famous call in January 1973 that, “it can,” a few days before a market decline of over 60% in real terms, second only to the Great Crash in a century, accompanied also by a bitter recession. This was one of the first of a long line of terrible prognostications for which he has remarkably not been remembered, except by a handful of us amateur historians. Then in the midseventies he disappeared into some government job, of which I was barely aware, until he re-emerged with a bang in 1987, without as far as I can find having done anything documentably very well. And we can agree that at least occasionally people can indeed prove their effectiveness beyond doubt…..We can all wonder at the incredible vision, drive, organizational skill, and willingness to sacrifice resources that were required by the Manhattan Project and compare it to the rudderless or even deliberate avoidance of leadership of the greatest issues today: climate change and energy security. We can only wonder what a Manhattan Project aimed at alternative energy might have accomplished by now, had it been started 15 years ago.

What we have had in lieu of vision, leadership, and backbone is a series of easy paths taken. At the time that Paul Volcker broke the back of infl ation in the early 1980s, the recognition that risk and leverage had consequences was baked into the pie: if you were to take excessive risk you had better win the bet. If you missed the target, the expected result would be more or less total failure, and that seemed then and for decades earlier a reasonable law of nature. Now in contrast we get ready to celebrate the 20th anniversary of the era of the Great Moral Hazard. Slowly at fi rst, but with steadily growing traction, the idea was planted that asset bubbles would be tolerated, but consequences of their bursting would be moderated or avoided entirely by increasingly vigorous actions sometimes, like now, bordering on the hysterical. This is to say that if all went well, enormous profi ts could be made by speculators – largely the great fi nancial fi rms, including some formerly conservative blue chip banks – by riding and leveraging the bubbles. If all went badly, then the costs would be passed on to others.

The idea that occasional economic setbacks might benefit the system in the long run was one of the early ideas to
disappear. Yet if you prop up weak sisters who would otherwise fail and in failing present their more efficient competitors with extra growth, you must surely weaken the system. Desperation pricing from weak fi rms who simply should not exist can weaken the profi tability of a whole industry, as it has for the airlines. The average efficiency of most industries is reduced with at least some effects on our global competitiveness. With a slightly lower average return on equity, the ability to reinvest drops so that, in this world of moral hazard where recessions are few and mild, GDP growth is a little less than it might have been….

The defense of bailouts is that the alternative is ugly.But surely the penalties for excessive risk taking, issuing flaky paper, passing it on – often in its entirety – to others, and not even understanding the consequences of the low grade paper that you yourself issue should be ugly. “Yes, of course, we would like to punish the excessive risk takers” goes the line, but we can’t do it without hurting the innocent economy. But we will never know what can be absorbed if the penalties are always removed by a bailout. In more traditional times, say, from 1945 to 1985, the economy could absorb substantial punishment from recessions and still grow faster than it has done in the last 10 years.

The real incompetence here goes back over 20 years: the refusal to deal with investment bubbles as they form, combined with willingness, even eagerness, to rush to the rescue as they break. It’s almost as if neither Greenspan nor Bernanke allows himself to see the bubbles. Greenspan was always confl icted and contradictory about whether bubbles could even exist or not. Bernanke, in contrast, has more of the typical academic’s certainty that the established belief in market effi ciency is correct and therefore investment bubbles must be merely the product of investors’ overheated imaginations. It would be convenient to have such an important role as Fed Chairman fi lled by someone who actually deals with the real world, messy or not, that is given to inconvenient bursts of euphoria and riddled by considerations of career and business risk, which modify behavior far away from economic efficiency….

As discussed many times in the investment business, pessimism or realism in the face of probable trouble is just plain bad for business and bad for careers. What I am only slowly realizing, though, is how similar the career risk appears to be for the Fed. It doesn’t want to move against bubbles because Congress and business do not like it and show their dislike in unmistakable terms. Even Fed chairmen get bullied and have their faces slapped if they stick to their guns, which will, not surprisingly, be rare since everyone values his career or does not want to be replaced à la Volcker. So, be as optimistic as possible, be nice to everyone, bail everyone out, and hope for the best. If all goes well after all, you will have a lot of grateful bailees who will happily hire you for $300,000 a pop. By the way, that such payments to prior Fed offi cials are in themselves a moral hazard and an obvious confl ict of interest that could moderate their prior behavior, is apparently too crude an accusation even to have surfaced yet. Well it should surface. Selling services to financial interests whose fates have been in your hands should simply not be tolerated as acceptable or ethical behavior by a former Fed Chairman.

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  1. Anonymous

    Lovely article. It’s the first mention I’ve seen of the revolving-door moral hazard for Fed chairmen themselves. A more systemic hazard than the usual politicians-turned-lobbyists
    or generals-turned-military contractors.

    Why academics as Fed chairmen instead of real businessmen? I think it was Mish who pointed out that US Fed chairmen tend to be political nonentities, unlike Europe. Someone like Trichet at the ECB was a political heavyweight in France and can push back when pressured to change his course. It seems that Bernanke was chosen for his lack of clout and for his helicopter speech.

  2. Independent Accountant

    Repeal the Federal Reserve Act. Why not worry about the revolving door between Goldman Sachs and the US Treasury too?

  3. Pep

    Any chance Volcker could/would come back? When’s Bernanke’s term up? Methinks this might be the fastest way to fix the mess that is the financial industry right now. Can you imagine how many financial executives would be crapping in their pants if they knew they had to deal once again with a Volcker Fed?

    Seriously though, any thoughts on if he would be willing to come back?

  4. Richard Kline

    The issue with imprudent behavior is that the costs are typically on the backend while the profits are on the front end. In this situation of a cost/timeframe disjunction, many people simply cannot restrain their behavior, especially where the profits are highly likely and the costs are vague or low-probability regardless of their severity. The issue in many respects isn’t a ‘moral’ one; it is a psychological gradient which few can resist (and everybody else says, perhaps accurately, that there’s something wrong with those of us that do). Consider: Do you think that someone like Chuck Prince would havd changed the tune he called even if he knew, unlike as has happened, that he would lose every penny of his personal fortune if things went bad? If so, you think better of him than I do.

    The fundamental principle of regulation is to require prudence in situations where a cost/timeframe disjunction is such that cost potential alone will not restrain behavior. The function of regulation is to save people and processes from themselves; otherwise, the practices in question would simply be banned. This is what all the selfish “useless government regulation” schmucks of a generation conveniently ignore, to our cost even more than theirs.

    The airline industry used to be the poster child for anti-regulatory stupidity. You have to be AARP fodder to remember back when US airlines were, in effect, regulated utilities with near fixed market shares and modest but highly certain profits—but that wasn’t enough for their executives and major stockholder who wished to be ‘captians of industry’ and personally much better compensated. So they screamed for and were rewarded with deregulation. And promptly destroyed themselves. They were the poster child for the folly of anti-regulation until Enron and ‘energy deregulation,’ that is, where mass and obvious fraud exponentiated the same trajectory. About these fool bankers who got Glass-Stegal repealed and the SEC neutered . . . the book on them isn’t yet written but the galley reviews are a howler.

    Paul Volcker: many of us do _not_ remember his decisions of ’78-’82 over-fondly. He saved capital but explicitly at the expense of workers for whom he did and cared damned little. His probity is welcome; his charity is not to be found. But that’s another story, and he did believe in central banking unlike St. Alan. I don’t believe that Greenspin was ‘conflicted’ about bubbles; I feel sure that he knew, in principle, that they existed. It would have been highly inconvenient to his philosophy, purposes, and peers for him to acknowledge them (them, multiple) in their initial and highly profitable phases under his watch, though; he never did, and still wants you to believe that no one could. Calling him incompetent is too kind. *hmmphh*

  5. Anonymous

    Anon at 1:25 —

    Without in any way commenting/defending Bernanke, what makes you suppose that ‘real businessmen (or women)’ would provide a superior pool for leadership at the Fed? (And, likewise, leave aside whether academics are such a pool as well). Real businessmen have led/managed real businesses in this nation over the last few decades and, based on the track record, seem quite satisfied with asset bubbles, excessive CEO compensation approaches, credit-fueled fake expansions, market and shareholder value fundamentalism, beggaring of workers through stagnant wages and disappearing benefits, anti-unionism, brand promises without brand delivery, ‘free’ market ideology, short term profiteering, and, of course, financing candidates instead of paying taxes to finance real government.

    “Real” business people have done just fine personally under the hoax whose name is Greenspan.

    Are there any people of integrity out there?

    Of course.

    But, suggesting any reasonable probability in the odds of finding them by ‘categories’ — whether ‘academics’ or ‘real businessmen’ — is to miss a core element of our current catastrophe: the extensive deterioration of integrity and enlightened concern for others as an honorable part of our shared character.

    Neither is how real businessmen get ahead.

  6. Anonymous

    Bravo to Grantham! A rare bird who actually tells it like it is.

    I agree with Anon (8:08 AM) that this is really all about the widespread decline in integrity (if such a thing can possibly be measured).

    As part of that theme, I think it is very much a function of the tremendous rise in “corporate bullshit” talk. An extensive vocabulary has evolved over time that is used for the purpose of obfuscation (covering your ass), sounding like an “expert” (to the layman), or making things sound better than they really are (euphemisms).

    All of our management in the government, corporate, and finance domain are infected through and through with this. For example, words like “synergies, business model, franchise, streamline, player, etc, etc”.

    If people can’t even talk straight anymore, tell me how can they THINK straight or ACT straight?

    This behaviour pattern is now extremely pervasive and has become a “must” for anyone looking to get promoted in the corporate world. If you examine the WORDS that people employ, you can learn a great deal about their character and intellect. Read any of the public pronouncements by Greenspan, Bernanke, the presidential candidates, and most CEOs and it all becomes very clear. I find it all very Orwellian, and yet few people seem to recognize this brainwashing for what it is.

  7. Anonymous

    Let us not forget that Volcker too blinked when his anti-inflation policies threated in 1982 to bring down Mexico and with it the New York banks which held Mexican loans. This reversal led to the stock market boom in the 80s which ended too in tragedy which Greenspan was forced to bail out.

  8. S

    Much as I agree that Greenspan and his ilk were/are a disaster (to include Kohn), they deserve context. Not that it justifies their actions (lack) but rather frames their inaction in the political context they deserve. During the late seventies/eighties you had the cold war and the associated political economy (China opening, free trade at any cost, especially if they were/might become an ally). The 90s saw an acceleration of that trend (NAFTA, WTO), with the injection of new paradigms and their asset light service model – the investment bank being the master alchemist. The internationalist agenda embraced economic dogma favoring intangibles over the more difficult to contrive tangibles. To wit, note for example that banks in early 90s had tangible books basically equivalent to book whereas today intangibles count ~50% of book. Oh the wonders of purchase. The economic hands off dogma spread like wildfire in the 80s (Volker was there for that too – though I don’t know his offical position on it?) and offered a little for each party to chew on: the left for its socializing and poverty retarding promise and the right for its market opening opportunities. Therein lies the question for Greenspan and Bernanke: what is/was the next best alternative? Put in this light, it becomes painfully obvious that their decisions are inherently political (foreordained actually) yet it is the economic lens through which the litmus test is repeatedly conducted. The results are purposefully inconclusive. The leveraged bet on the US financial sector with some help from the hubris that we simply are specially anointed is just the other side of 300M vs 3 billion plus. Only the bet hasn’t turned out as planned. Suddenly, the US finds itself adopting a very eastern point for view: patience, eventually we will turn the corner. How to convert a world fixated on long term capital gain to short termism, without the opium? US companies are finding financial reward in the form of stock gains on their minority position, but in the process are handing over time in the form of process, technology and design. Have to be there right?

    The bubble palliative was/is aimed square at obfuscating the centrifugal forces sucking the air out of the middle class. The great technology liberation sought only to accelerate the global wage arbitrage. Sure we create jobs, but they are low paying service jobs as anyone who looks at the numbers can see. And it is a trend. Creative destruction it turns out includes an utterly mis-used modifier.

    So is really so surprising that the Fed and Treasury have pursued such paths? Did they really have an alternative? Perhaps the leverage junkies were the smart ones after all: it would be too much to assume they saw the future (but let’s pretend) and decided dice throwing was the better probability. Greenspan would surely argue market efficiency. Indeed if the market is efficient, then it is rather ominous, no?

  9. Anonymous

    “We can only wonder what a Manhattan Project aimed at alternative energy might have accomplished by now, had it been started 15 years ago.”

    More of this Manhattan transfer tripe. The object of the Manhattan project was F**KING BOMB. You know? Something that goes BANG! It’s damn easy to determine if it works or not and the taxpayers aren’t about to stage a palace revolt in wartime.

    Alternative energy is a completely different plate of spaghetti. Politics all over the place and, most importantly, NO CLEAR DEFINITION of success.

    If we don’t clear the fecal smudge of weak minded historical thinking off our glasses it’s unlikely we will do more than a Richard Weaver “Ideas have Consequences” diatribe about lost liberal values.

    So let’s palaver on about morality, why not? And serve up a nice green salad of Paul Volker – who lately seems close to senile if his latest speaking engagements are any indication. Of course, he’s an economist so expectations mustn’t be set very high.

  10. S

    on Q larry summers has a good synopysis of the trade issue and aligning interests which goes to the heart of why US policy (and bublbles) are functionally necessary to keep the US engaged in the internationalist mode. The lobby and inertia is strong. The treasury market is yet another malformed dimension of the policies. can’t wait to read the sequel may 5th.

  11. Richard Kline

    And more on Alan Greenspin, ‘What did he know, and when did he know it’ re the Subcrime Housing Bubble, over at Barry Ritholtz”s Big Picture [always a quality aggregator, Big Buy], BR has posted up portions of an article by Jim McTague of Barron’s concerning Greenspin’s doctoral thesis of 1977: This was done _on the subject of housing price changes_. And in it’s content, it is quite clear that Greenspan understoo THIRTY YEAR’S AGO that housing prices could and would bubble, and that folks would refi and cashout valuation gains. Greenspan knew _exactly what was going on_ in the housing market after 2002. Incompetent, that isn’t the word for him.

  12. Flow5

    Paul Volcker – accolades? they reflect a total myopia of the events during 1979-1983.

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