Tuesday, September 16, 2008


I was pretty certain that I would not be the only one invoking the noun Schadenfreude while reflecting on the fall of Lehman Brothers, particularly since, as the Associated Press reported yesterday, it was so evident at the man-in-the-street level. However, now that the media has made a spectacle of former Lehman employees engaged in the moral equivalent of the "perp walk," it may be time to ask "Should we feel sorry for bankers?," which happens to be the title of a BBC News Magazine article by Finlo Rohrer released today on the BBC NEWS Web site. To represent the opposition to Schadenfreude, Rohrer selected Allister Heath, editor of the London business newspaper City AM. Here is Heath's position:

A lot of people will think "who cares"? Some people will be privately satisfied but it is short-sighted. Yes, they have made terrible mistakes, but it is just wrong to take pleasure in other people's misfortunes.

Their misfortune will make everyone else worse off. They have powered the UK economy in the last few years.

Clearly, Heath's "they" refers to a body of readers without whom his newspaper would be out of business; but, as a journalist, he should be as sensitive to fine points of semantics as he is to both the needs and opinions of his readers. Had he read Paul Krugman's Sunday op-ed column for The New York Times, he might have been more aware of the extent to which the collective noun "banker" has become too ambiguous to be particularly meaningful:

To understand the problem, you need to know that the old world of banking, in which institutions housed in big marble buildings accepted deposits and lent the money out to long-term clients, has largely vanished, replaced by what is widely called the “shadow banking system.” Depository banks, the guys in the marble buildings, now play only a minor role in channeling funds from savers to borrowers; most of the business of finance is carried out through complex deals arranged by “nondepository” institutions, institutions like the late lamented Bear Stearns — and Lehman.

The new system was supposed to do a better job of spreading and reducing risk. But in the aftermath of the housing bust and the resulting mortgage crisis, it seems apparent that risk wasn’t so much reduced as hidden: all too many investors had no idea how exposed they were.

And as the unknown unknowns have turned into known unknowns, the system has been experiencing postmodern bank runs. These don’t look like the old-fashioned version: with few exceptions, we’re not talking about mobs of distraught depositors pounding on closed bank doors. Instead, we’re talking about frantic phone calls and mouse clicks, as financial players pull credit lines and try to unwind counterparty risk. But the economic effects — a freezing up of credit, a downward spiral in asset values — are the same as those of the great bank runs of the 1930s.

And here’s the thing: The defenses set up to prevent a return of those bank runs, mainly deposit insurance and access to credit lines with the Federal Reserve, only protect the guys in the marble buildings, who aren’t at the heart of the current crisis. That creates the real possibility that 2008 could be 1931 revisited.

In taking as a fundamental premise that need to channel funds from savers to borrowers, Krugman echoes the same perspective on the financial sector that Robert Solow laid out so nicely in his recent review of Kevin Phillips Bad Money for The New Republic:

Every elementary economics textbook explains to the beginning student that a financial system is intended to perform two important functions in a modern economy. Somehow a nation's savings has to finance its investments in housing, industrial and commercial buildings and machinery, computers, inventories, and so on. The saving is done by a very large number of households and institutions, ranging from very small to very big. The investment is done by a smaller--but still huge--number of mostly medium-to-large business firms. The first function of the financial system is to "intermediate" in this process: to collect the savings in many forms--bank accounts, mutual funds, insurance-company reserves, direct purchases of stocks--and to allocate it to the firms and other entities that seem to have the most profitable ways to use it to build real capital. The financial sector, needless to say, collects a fee for this service: it pays savers less than it charges investors. (I omit international flows of saving and investment, as well as the financing of local, state, and national governments. The financial sector intermediates here, too.)

The investment decisions of businesses have uncertain outcomes. The businesses themselves cannot know how their long-lived investments will eventually turn out; and the ultimate savers know even less. And investment decisions generate real risks, as we are all now painfully aware. So do most other transactions intermediated by the financial system, though the risks may be tied only tenuously to the production and the distribution of goods and services. And so the second function of the financial sector is to arrange transactions that shift the bearing of commercial risks from those who are prepared to pay a fee to get rid of them to those who are less averse to risk and are willing to take them on in exchange for a fee. This is a complicated business, more or less by definition. It is full of surprises. Even the basic underlying risks are complicated, and reasonable people--let alone the unreasonable ones--may evaluate them very differently. The risks generated within the financial sector are even more complicated, more psychological, more open to manipulation, and harder to understand and value than those that arise from "real" events.

Solow's first function basically involves the operations that take place in Krugman's "big marble buildings;" and those operations are regulated to provide the defenses cited at the end of the above Krugman quote. By now we all know that those "nondepository" institutions, which are concerned more with Solow's second function, are not subject to the same regulations; and both Solow and Krugman have written about the failure of both the financial sector to regulate itself and the failure of our government to compensate for the financial sector's negligence. We also know the underlying cause of that failure on both fronts: However hard to understand that second function may be, those "nondepository" institutions were just too profitable; so why should members of the financial structure invest major commitments of their precious time to understanding the working of that second function well enough to address how it may best be regulated, particularly when that time could be better spent engaging that second function in the interest of more profits? Within the financial sector it seemed perfectly legitimate to simply accept that high risk should be the price of high profits, and a portion of those profits could be then invested in lobbyists who could easily persuade our representatives in Washington that this precept was more important than defense against financial catastrophe. After all, didn't a rising tide lift all boats?

So, should we feel sorry for bankers, rather than reveling in Schadenfreude? At the very least one might think that we should withhold wrath and/or ridicule from the guys in those "big marble buildings," who continue to try to play by a sound set of rules. Nevertheless, those guys could have had influential voices in talk of the financial sector regulating its second function; but we see no evidence that they did any such thing. Since we are invoking a German noun, one might compare them to those "ordinary German citizens," who could see the smoke coming from the concentration camps and chose not to think about what was causing that smoke. That comparison might be even stronger those first-function bankers were complicit, if not active, in the lobbying activities to keep further Federal regulations out of the whole system. Thus, in this country, there do not appear to be a lot of reasons for us to feel sorry for the bankers as a category, however vague the semantics of that category may now be. Whether or not British citizens should feel the same way is their own affair; and hopefully they will make their decision on the basis of more than the opinion of an "insider" journalist like Heath. Presumably, at the very least, they will be following the new proposals for regulation being introduced by Chancellor Alistair Darling.

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