Steve Randy Waldman has a good critique of Tyler Cowen’s view that the financial crisis is due to a downward revision of overly optimistic estimations of our wealth.
I agree. If the boom had been due to people in general believing they were richer than they were, we’d have seen soaring share prices and a boom in capital spending in the mid-00s, as we did during the tech bubble. But we didn’t. Instead, as Steve says, the problem was not generalized over-optimism but rather a specific one, confined to banks.
Steve blames this on bad incentives. I’m not sure this is the whole story. For one thing, in the UK at least, it seems that the pay of banks’ bosses was not out of line (pdf) with that of bosses generally, suggesting that, in one respect, there was nothing unusual about bankers’ incentives. And for another, insofar as incentives were wrong, they had been wrong for years. So why did banks collapse in the late 00s, rather than earlier?
Here’s a theory. It’s to do with organizational brittleness. Here are some background principles:
- The death rate for firms generally is high. Of the UK’s biggest employers in 1907, only three are still independent, stock market-listed companies today.
- Companies embody specific vintages of organizational capital. Their expertise depends upon the state of technology when they were formed. It’s rare for a firm to transform itself from one activity to a completely different one; Nokia, which used to be a cable firm, is a rare exception - and a less healthy one than it seemed a few years ago.
- Because organizational capital is fixed, firms have “very limited capacities to acquire knowledge (pdf).” Rather than adapting to new conditions, firms die.
And here’s the thing. Banking changed in the 00s, in such a way as to render the vintage organizational capital of many banks obsolete, and thus to kill them.
Traditionally, banking consisted of getting deposits from savers and lending them to home buyers and companies. But in the 00s, this changed. Savings came not from UK and US households, but from Asians who wanted AAA bonds. This meant that many banks’ traditional business models were useless. They had to use wholesale funding, collateralized against manufactured securities, rather than merely domestic deposits. And this required that, rather than judge credit risk, in which they had some experience, they had to judge liquidity risk - in which, we know now, they were (even) less expert. It is no accident that the two “UK” banks to have done best during the crisis - HSBC and Standard Chartered - happened to be banks whose vintage capital gave them the ability to attract Asian deposits.
The banking crisis, then, was an example of a general corporate problem - the same sort of thing that killed Tower Records, Borders, Polaroid and countless others - an inability to adapt their business model to market and technical change.
I say all this because this story doesn’t fit comfortably into a Keynes vs. Hayek-style debate. It’s awkward for Keynesians because the story here isn’t an orthodox one of market failure, but rather of organizational failure - and a failure of organizations run from the top-down, which is what many statist Keynesians admire.
On the other hand, though, it’s awkward for Hayekians, because the message of the crisis and subsequent recession is that markets - actually existing ones rather than the textbook fairy tales - cannot smoothly absorb the failure of big organizations.