Wednesday, December 8, 2010

Too smart for our own good?

Larry Summers has resigned as head of the President's Council of Economic Advisers to return to Harvard as a Professor of Economics. This ends another phase in a very distinguished career that includes being Chief Economist at the World Bank, Secretary of the Treasury under President Clinton, and President of Harvard University. This career confirms what people, who know him personally say of him, that he is unquestionably brilliant. He knows more than many professional colleagues, he has more facts at his disposal, is more articulate, more persuasive in arguing for his view and a more devastating critic of the views he disagrees with.

But this brilliant man had a significant hand in producing the current economic crisis. He argued for deregulation in the financial sector, for changing the laws that limited mergers between banks and investment houses, he successfully fought efforts to regulate derivative trading. Summers vastly expanded the scope of financial speculation that is a major source of the current crisis. Summers paved the way for investment firms like Goldman, Sachs to make enormous profits. He himself became a millionaire many times over.

How was this possible? How could brilliant people like Summers, like many of the high-flying financiers produce the economic collapse of 2007/2008 from which we are still suffering? How is it possible that Summers and those like him still hold positions of power, of enormous influence and prestige?

It is tempting to think that Summers, and people like him, are brilliant but somehow morally defective. Here, after all, are Goldman Sachs and other investment houses, Bank of America and many other big banks once again making obscene amounts of money while ordinary Americans are out of work and threatened by hunger. It is difficult to resist the idea that these smart investors just don’t care about the damage they do to other Americans as long as they themselves are making plenty of money.

But if we think back a few years, we realize that all these large institutions took unreasonable risks which came extremely close to bankrupting their own businesses had the government not made huge sums of cash--several trillions of dollars--available to investment banks and other institutions to tide them over a critical period.

So we must ask our question again: how could people that are so smart take these completely unreasonable risks. Today it looks as if those risks just affected the working people of this country but a few years ago those risks came very close to destroying the investment houses and big banks themselves. These bright people now, all of the sudden, don’t look quite so smart because they almost ruined their own businesses.

One must look at the business culture represented by Summers and people like him to understand this. They all believe that there is no better economic system than ours, whether we call it “capitalism,” or “the free market,” or whatever else. Everyone also believes that it is competition that makes the system so fabulously productive. Entrepreneurs are spurred on to greater effort and greater ingenuity by competition with other entrepreneurs.

Few people, however, are willing to admit that competition often is profoundly damaging. The current economic failures are a case in point. In the early years of this century investment houses and banks discovered new ways of making money, for instance by selling mortgages to people who could not really afford to keep up with the payments. Then came another idea of bundling these mortgages and selling them to other investors. Everyone made lots of money with risky investments. But the competition for greater profits inevitably pushes investors into more marginal and more high-risk undertakings. In order to compete successfully you need to take greater risks. If you refuse to do so your profits will decline as compared to your competitors and your stockholders will ask you why your profits are lower than those of some of the other banks or investment houses. They will start grumbling about maybe replacing you. So you take greater risks

Competition spurs entrepreneurs to greater efforts and often into greater risks. Sooner or later somebody goes simply too far and we have another bubble bursting, businesses going bankrupt, borrowers being unable to pay their debts, lenders being short of cash. Before you know it the economy is in a recession or maybe worse. Capitalism is a permanent game of chicken that repeatedly pushes some players over the edge and those players pull up others along with them. Some government restrictions on private risk-taking would be good for everyone. But the Summerses of this world are too arrogant; they think that they will never be the ones who go over the edge. Given past history that confidence is not justified.

Even brilliant people can blind themselves to realities if they are sufficiently greedy. They may be too smart for our own good.