djwonk

On the way into the office this morning, I was reading two different things. These two quotes seemed to pull at me:

a. “But my wise old aunt Selma, now 91, often reminds me that the sins of omission are greater than the sins of commission, and that the greatest evils in the world, like mass poverty, are more the result of inaction than that of direct brutality.” -David Bornstein, So You Want to Change the World

b. “French President Nicolas Sarkozy said Thursday world came within “a whisker of catastrophe” during the recent financial crisis and that those responsible for the crisis must be identified and held accountable.” -Express, 9/25/08, by The Washington Post

Certainly there is plenty of blame to go around. But identifying the “culprits” (or their whiskers) is not quite so easy. Who is responsible for the crisis due to their actions? Due to their inactions?

The culprits?

1. What about homeowners who got mortgages that they could not afford? Are they completely innocent? Perhaps many were tricked or did not understand variable rates. But if we are assigning blame, we should be willing to perceive shades of gray.

I will note that assigning blame is sort of like bringing donuts to the office — if you bring them, you better bring enough for everybody. So while we are blaming, we might as well not discriminate against the “less noticeable.”

2. Moving “up the chain” so to speak, we next arrive at the lenders. Financial institutions that offer loans without the proper diligence put their firms at risk. This is true. So do we blame the institutions themselves? Perhaps we should also blame the people who work there?

3. The individuals that work at these institutions are supposedly intelligent and properly incentivized, right? If so, on the whole, they would not promote their individual short-term gains over the institutions.

4. But what if the organization has the wrong incentive structure in place? Perhaps the organization “had it coming” to them. Call it karma or call it statistics. But management has to realize the impact of its choices.

5. Let’s move “across the food chain” now. Since these financial institutions are highly connected in the financial markets, they put other institutions at risk as well. In economic terms, this might be considered an “externality”, a cost that one “organization” can impose on another. The problem with externalities is that the organization affected was not responsible. A typical example is air pollution. If Mexico pollutes and the wind blows it into Texas, Texas is harmed but Mexico is not. Is the creator of the externality to blame? Yes, in some sense.

6. But in another sense, the recipient of the externality sometimes can pursue strategies to minimize the effect. Doing so is part of the cost of doing business. Let’s think about this in a bilateral transaction sense — a connected institution can reduce its potential for damage by being skeptical — asking tough questions about institutions that it depends on, hedging its bets, and having alternative plans ready.

7. If the ecosystem as a whole is built on strong bilateral understandings, conventional thinking would say that the ecosystem should not be damaged by the loss of a few “bad apples.”

8. This raises another question — maybe we are too quick to assign blame to individual firms! Perhaps the whole financial ecosystem wasn’t as strong as we gave it credit for. Perhaps we are merely scapegoating when we complain about Bear Stearns, Lehman Brothers, or AIG. Chaos theory probably could offer scenarios in which such an ecosystem, even if strong at the bilateral level, could still have failure modes.

9. What about regulators? Don’t they have a responsibility to oversee the financial markets? Don’t they have the intelligence and foresight, and thus, the responsibility to act?

Conclusion

In practice, the person that throws the second punch is most likely to get caught and blamed. But what about the first punch? What if it wasn’t a punch, but a stinging insult? What about all the actions that led up to the conflict? Assigning blame to the most visible offense is overly simplistic.

Let’s use our brains instead of just finding scapegoats. Let us understand the nature of the problem across the whole system — and then correct the problem using as-specific-as-possible, targeted interventions.