Political Ignorance and Blaming "the Jews" for the Economic Crisis:

Political scientists Neil Malhotra and Yotam Margalit have an article describing survey data showing that some 25% of [non-Jewish] Americans believe that "the Jews" deserve at least "a moderate amount" or "a great deal" of blame for the current economic crisis. Some 32% of self-identified Democrats and 18% of Republicans take that view. Similar results were obtained in a recent survey of opinion in several European nations.

I. Blaming the Jews as a Consequence of Rational Political Ignorance.

These figures are shocking, but not as surprising as they might seem. Previous surveys show that large percentages of the public endorse a variety of ridiculous conspiracy theories about political and economic events. As I explained in the post linked in the previous sentence, such beliefs are in large part the result of widespread "rational ignorance" about politics. Because any one vote has only an infinitesmal chance of affecting electoral outcomes, there is little incentive to spend time acquiring political information in order to become a better-informed voter; consequently, most citizens know very little about politics and public policy.

People who are ignorant about politics are more likely to endorse crude or simplistic explanations for political events. "The Jews did it" is a much simpler explanation for the financial crisis than a variety of complex policy errors that most voters don't know about and might not understand it if they did. Unfortunately, Malhotra and Margalit don't provide data correlating general political ignorance with belief in an anti-Semitic explanation for the crisis. However, they do note that blaming the Jews is inversely correlated with education; only 18% of respondents with bachelor's degrees blame the Jews at least a "moderate amount." By contrast, that view is held by 27% of respondents with lesser educational attainment. Obviously, education is highly correlated with political knowledge.

II. Blaming the Jews as a Form of "Rational Irrationality."

Simple ignorance is not, of course, the sole explanation for widespread belief in anti-Semitic explanations of the financial crisis. Also relevant is the fact that most people are highly biased in their evaluation of whatever political information they do know"rational irrationality." Thus, a person with preexisting anti-Semitic prejudices (perhaps a belief tha Jews have excessive influence over banking and finance) is likely to interpret whatever she hears about the financial crisis in light of those biases. A 2007 ADL survey conducted before the current crisis found that 18% of American gentiles believe that Jews have "too much control/influence on Wall Street" and 20% think that they have "too much power in the business world." These figures are comparable to the 25% who today blame the crisis in large part on the Jews, and suggest that many of those who blame the Jews do so in part because of preexisting anti-Semitic biases. Obviously, such biases are reinforced by simple ignorance. The less you know about economics and public policy, the less likely you are to be aware of more sophisticated explanations of the crisis, and the more likely you are to fall back on crude prejudices in trying to understand it.

III. Does it Matter?

Many readers probably assume that the answer to this question is obvious. If large numbers of people blame the Jews for the financial crisis, there might be an anti-Semitic backlash or even violence against Jews. In the US, however, there has been very little such backlash so far and anti-Semitism is largely absent from mainstream political discourse.

The more subtle and perhaps more important effect of these attitudes is in their impact on public opinion about how to respond to the crisis. If you believe that the crisis was in large part caused by the misdeeds of "the Jews," that is likely to affect your evaluation of how to respond to it. Malhotra and Margalit present some preliminary data suggesting such effects, finding that survey respondents reminded of Bernie Madoff's Jewishness are more likely to oppose corporate tax cuts to "create jobs" as a potential remedy for the recession. That finding, however, is likely to be just the tip of the iceberg of possible interactions between belief in anti-Semitic explanations for the crisis and beliefs about appropriate remedies.

Obviously, public opinion is not the only determinant of government policy. But it often does have a substantial impact. To the extent that opinion is significantly influenced by ridiculous conspiracy theories (anti-Semitic or otherwise), that impact is unlikely to be positive.

UPDATE: I should note that the survey results cited by Malhotra and Margalit count only gentiles, and did not include Jewish respondents. This has little effect on the data, since Jews are less than 2% of the American population. But it is perhaps worth pointing out.


Thomas Sowell on Public Ignorance and the Financial Crisis:

The Reason website has an interview with economist Thomas Sowell about his forthcoming book on the financial crisis. Sowell makes several good points, including one about public ignorance of economics:

Reason: What do crisis like this, and public reaction, say about general public understanding of economics?

Sowell: I think in the U.S. and in most of the world the public understanding of economics is abysmal. But it's one thing not to understand something. I don't understand brain surgery. It's another to want to form policies on things on which you are ignorant. I hear the wonderful phrase "I want to make a difference" when it comes to policy. I would be horrified if I wanted to make a difference in brain surgery. The only difference is more people would die on the operating table.

The only encouraging thing about public reaction to the crisis is that going by polls citizens seem to have more misgivings about some of these policies than politicians or the media. Still, though there have been studies that indicate the New Deal prolonged the Great Depression by years, what is also clear is it was enormously popular. FDR was elected four straight times, and more than once without ever having brought unemployment down to single digits. An economic disaster does not necessarily mean a political disaster. If we could raise the average level of understanding of economics to what [prominent 19th century economist] Alfred Marshall had in 1890, the vast majority of politicians would be voted out of office.

I would add that public policy would be greatly improved if the average voter understood what Adam Smith knew about economics when he published The Wealth of Nations back in 1776. Reinforcing one of Sowell's points, I discussed how some politically popular New Deal programs helped prolong the Depression here and here. As Sowell suggests, the interesting thing about these programs is not just that they had extremely harmful effects, but that their authors didn't suffer any political punishment as a result - in part because most voters lacked the economic knowledge to understand what was happening.


Soros on Principles of Financial Regulation and Efficient Market Hypothesis:

George Soros has a very interesting opinion piece in the Financial Times, June 17, 2009 (might be behind subscriber wall at the FT, but I received it by email from his office, so I'll quote some bits from there). The essay outlines in short form his principles for reform of financial regulation. I am still absorbing this, so I won't comment here, but I put them out for your thoughts. I will try to post up some other stuff on the financial regulation reform proposals coming from the Obama administration over the next couple of days. (As ever, however, I am always eager to learn from what co-blogger Zywicki has to say about this stuff, and particularly the bankruptcy questions of Chrysler, GM, and Delphi - I am no expert by any stretch on sale v reorganization, or anything else, re bankruptcy. See Todd's earlier post comparing Chrysler, GM and the secured creditor treatment in each.)

So, Soros starts out with a general comment on the comparative disadvantages of un-regulation and government regulators:

I am not an advocate of too much regulation. Having gone too far in deregulating - which contributed to the current crisis - we must resist the temptation to go too far in the opposite direction. While markets are imperfect, regulators are even more so. Not only are they human, they are also bureaucratic and subject to political influences, therefore regulations should be kept to a minimum.

He then goes on to propose three guiding principles for regulatory reform. The first is that regulators must accept responsibility for not allowing bubbles to get out of control. This is framed within the inherent contradiction, Soros suggests, that regulators are no better than markets at identifying what's a bubble and what's not.

[S]ince markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big. Alan Greenspan, the former chairman of the Federal Reserve, and others have expressly refused that responsibility. If markets cannot recognise bubbles, they argued, neither can regulators. They were right and yet the authorities must accept the assignment, even knowing that they are bound to be wrong. They will, however, have the benefit of feedback from the markets so they can and must continually re-calibrate to correct their mistakes.

The implicit assumption here - correct, in my view - is that we have a problem of too-big-to-fail in these bubbles, systemic risk, and the loss of the threat of moral hazard: the Greenspan and next the Bernanke put. It is therefore not a sufficient answer for regulators to refuse to take on the burden of bubble-popping. This seems to me quite persuasive.

Second, Soros goes on, the problem is not merely the money supply, though that is a factor, it is also the availability of credit and then leverage off of it:

Second, to control asset bubbles it is not enough to control the money supply; we must also control the availability of credit. This cannot be done with monetary tools alone - we must also use credit controls such as margin requirements and minimum capital requirements. Currently these tend to be fixed irrespective of the market's mood. Part of the authorities' job is to counteract these moods. Margin and minimum capital requirements should be adjusted to suit market conditions. Regulators should vary the loan-to-value ratio on commercial and residential mortgages for risk-weighting purposes to forestall real estate bubbles.

Again, I think this is broadly persuasive. I say this despite being a big fan of John Taylor's new, short book from the Hoover Institution Press, Getting Off Track. The strong version of Taylor's argument, Steve Krasner noted to me in conversation last week at Stanford, is that if the Fed had simply followed the Taylor rule regarding the money supply, then the bubble would not have developed. On the strong version of Taylor's argument in the book, whatever the failures of regulation or, responding to Greenspan's reply to Taylor, the global savings glut, it doesn't matter - the money supply was the problem. Soros is implicitly saying that money supply alone is not the issue; credit and leverage matter on their own, and so does regulation directly going to credit, e.g., margin and capital requirements. Again, I am a big fan of Taylor's book - but I am content to read the argument more weakly, so to understand that the crisis is overdetermined, and that money supply, credit and leverage, political temptations in regulation, etc., all play a role. I think most financial commentators would go with the weaker position of overdetermination of causes. And on the credit question - more precisely, the leverage question - Soros is right, I think.

Soros finally - third - says that financial regulation must take up the question of efficient market theory. On this, he is most controversial. He has addressed much criticism toward the EMH over the years - and the arguments are not always the same, nor of the same level of breadth or generality. On the one hand, the latest edition of Bratton's Corporate Finance textbook, which I am about to use in the Fall semester for the first time in a couple of years and which begins with a discussion of efficient markets, expresses much greater caution, consistent with most academic commentators. Certainly that is my feeling, particularly with regard to credit markets and instruments. On the other hand, I was dismayed by how thoroughly my law students last year dismissed market efficiency as having any value at all and the very idea of quantitative valuation (of course, this would save them the trouble of doing the present value arithmetic ...). So what is Soros's formulation of the critique of EMH and how conceptually global is it in this iteration?

Third, we must reconceptualise the meaning of market risk. The efficient market hypothesis postulates that markets tend towards equilibrium and deviations occur in a random fashion; moreover, markets are supposed to function without any discontinuity in the sequence of prices. Under these conditions market risks can be equated with the risks affecting individual market participants. As long as they manage their risks properly, regulators ought to be happy.

But the efficient market hypothesis is unrealistic. Markets are subject to imbalances that individual participants may ignore if they think they can liquidate their positions. Regulators cannot ignore these imbalances. If too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or, worse, a collapse. In that case the authorities may have to come to the rescue. That means that there is systemic risk in the market in addition to the risks most market participants perceived prior to the crisis.

The securitisation of mortgages added a new dimension of systemic risk. Financial engineers claimed they were reducing risks through geographic diversification: in fact they were increasing them by creating an agency problem. The agents were more interested in maximising fee income than in protecting the interests of bondholders. That is the verity that was ignored by regulators and market participants alike.

The critique of efficient market theory here is agent-failure. No argument there - the agency problems go deep into the heart of the financial services institutions themselves, to include the fundamental problem of what Steve Schwarcz has described as secondary agent failures - misalignments of both duty of care and duty of loyalty. AT bottom, Soros is pointing to information uncertainties in two directions: one, as between managers and financial agents and, two, between compensation in the present on uncertain future payoffs, without an effective mechanism of clawback to correct results after the fact or an effective discounting mechanism to address potential future failure. But at bottom the critique in this piece of EMH is an agent-principal critique. One can add other critiques; some stronger and some weaker, but Soros has identified the one most amenable to regulatory reform, I reckon.

Given the agent-centered critique, it is no surprise that Soros favors a "skin in the game" approach - and he says that the 5% retention by originators in securitizations is too small:

To avert a repetition, the agents must have "skin in the game" but the five per cent proposed by the administration is more symbolic than substantive. I would consider ten per cent as the minimum requirement. To allow for possible discontinuities in markets securities held by banks should carry a higher risk rating than they do under the Basel Accords. Banks should pay for the implicit guarantee they enjoy by using less leverage and accepting restrictions on how they invest depositors' money; they should not be allowed to speculate for their own account with other people's money.

It is probably impractical to separate investment banking from commercial banking as the US did with the Glass Steagull Act of 1933. But there has to be an internal firewall that separates proprietary trading from commercial banking. Proprietary trading ought to be financed out of a bank's own capital. If a bank is too big to fail, regulators must go even further to protect its capital from undue risk. They must regulate the compensation packages of proprietary traders so that risks and rewards are properly aligned. This may push proprietary trading out of banks into hedge funds. That is where it properly belongs.

Again, little argument from me that proprietary trading conceptually at least belongs in the hedge funds and private equity funds, whether that is practical today or not. Proprietary trading is not the only problem. I ordinarily teach a private equity course each year; it covers the industry as a whole, including venture capital, buy out funds of various kinds, etc., and I throw in little bit on hedge funds as they aren't really covered elsewhere in our curriculum. But I was troubled when last I taught the class in spring 2008 at a quote in a Henry Kaufmann article in the WSJ - I always talked as an academic about private equity serving to bring managerial efficiencies to public companies via buyouts and all sorts of jolly stuff. Whereas Kaufmann quoted a LBO fund manager as shrugging and saying, in paraphrase, we're just part of the big mechanism that takes money from the Fed and pours it into the housing markets and take a cut along the way. Ouch, ouch, double ouch.

And finally ... derivatives. Do not fail to note Soros's blunt comment on credit default swaps (italics added below). I am not sure I would have focused on CDSs, once having put them onto public exchanges and regularized and made public the counterparty relationships. Nor do I think that the underlying securitizations are themselves the problem. I grant the agency issues that Soros raises and of course there is a huge, huge problem with insurance that turns out to be a license to kill. The problem is more than just license to kill. It is also what we might call a "license to be indifferent" - arising from what has been talked about as the "phantom" creditor problem - formally holding debt the risks of which have already, but non-publicly or transparently, been counter-partied away, leaving one with an incentive to indifference or something more toxic. Moreover, the mere existence of an insurance market in CDSs does not, by itself alone, solve the valuation problem of the underlying assets or the insurance. Still, I think I probably would have instead focused on the derivatives built to leverage the securitizations themselves as being the most dangerous and toxic assets in all of this:

Finally, I have strong views on the regulation of derivatives. The prevailing opinion is that they ought to be traded on regulated exchanges. That is not enough. The issuance and trading of derivatives ought to be as strictly regulated as stocks. Regulators ought to insist that derivatives be homogenous, standardised and transparent.

Custom made derivatives only serve to improve the profit margin of the financial engineers designing them. In fact, some derivatives ought not to be traded at all. I have in mind credit default swaps. Consider the recent bankruptcy of AbitibiBowater and thatof General Motors. In both cases, some bondholders owned CDS and stood to gain more by bankruptcy than by reorganisation. It is like buying life insurance on someone else's life and owning a licence to kill him. CDS are instruments of destruction that ought to be outlawed.

Whether one agrees with Soros on each item, or the strength he assigns each item, this is an outstanding short essay on reform agendas. As I remarked in my note on the passing of Peter Bernstein, Soros on these issues of finance and political finance is in a category of senior, seasoned observer who is both at home with the analysis of risk but also very clear as to its limits, and rooted in the practical world of markets first and theory second. You can, as I do, think that Soros's funding for things like Moveon.org and other bitterly partisan political ventures a very bad thing - and I mean a very bad thing, and a very bad thing including for the Democratic Party, but that's a whole different discussion - while seeing the value in this kind of informed intervention. The financial crisis is a matter, unlike a range of others, that fits Soros's very considerable public talents hand to glove.


A Flaw in George Soros' Case for Increased Government Regulation of the Financial System:

I am no expert on finance. Therefore, I cannot tell whether George Soros' proposals for increased regulation of the financial system have merit or not. Soros has probably forgotten more about finance than I ever knew to begin with. However, Soros' position has at least one serious weakness that is common to many arguments for increased government intervention in society: it fails to give adequate consideration to the shortcomings of the political process. Strangely, Soros admits that government is likely to do an even worse job in this area than he believes the private sector has; yet he still ends up supporting increased regulation.

Soros argues that speculative bubbles are a form of market failure that can cause great harm to the economy when the bubbles pop. He therefore concludes that we need government intervention to prevent bubbles from forming. However, he concedes that government regulators are unlikely to do any better at predicting dangerous bubbles than the market does:

[S]ince markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big. Alan Greenspan, the former chairman of the Federal Reserve, and others have expressly refused that responsibility. If markets cannot recognise bubbles, they argued, neither can regulators. They were right and yet the authorities must accept the assignment, even knowing that they are bound to be wrong. They will, however, have the benefit of feedback from the markets so they can and must continually re-calibrate to correct their mistakes. [Emphasis added]

If, as Soros believes, government regulators will be just as bad or worse at predicting bubbles than market participants, it's not clear why he expects government intervention in this area to improve things. "Feedback from markets" certainly doesn't create any comparative advantage for government regulators; after all, the private sector can use feedback from markets as well.

Soros' argument could still work if government financial regulation were costless. If that were so, the regulators might occasionally prevent a dangerous bubble from forming, while not causing any harm in the many cases where they are "bound to be wrong." However, as Soros himself points out, government financial regulation isn't costless because "While markets are imperfect, regulators are even more so. Not only are they human, they are also bureaucratic and subject to political influences." Unfortunately, he doesn't do enough to consider the likely impact of these "political influences." The rest of his argument for increased regulation proceeds as if government were a "benevolent despot," willing and able to implement the right kind of regulation so long as he gets the right advice from experts like Soros.

Common systematic shortcomings of government suggest that Soros' "political influences" might cause even more harm in the field of financial regulation than elsewhere. As I discussed in this post, government intervention typically suffers from three major shortcomings: inadequate knowledge on the part of government officials, widespread political ignorance among the electorate, and the power of interest groups who can "capture" the political process and use it to benefit themselves at the expense of the general public.

All three of these problems are likely to be especially severe in the field of financial regulation. Even those who worry less about political ignorance than I do would be hard-pressed to argue that the voters have a good understanding of complex finance policy issues. It's telling that some 25% of the public is so ignorant that they blame "the Jews" for the financial crisis. Such widespread ignorance suggests that voters will do a poor job of monitoring the performance of regulators, and also creates the danger that public ignorance will push the government to adopt severely flawed policies that seem attractive to voters with little understanding of the financial system.

It is also clear that there are interest groups in the finance industry who will lobby regulators to try to "capture" them and use government power to benefit themselves at the expense of the general public. Banks and large institutional investors are obvious examples. There are few other sectors of the economy with so many powerful, concentrated interest groups. The danger of special interest lobbying is, of course, exacerbated by widespread political ignorance. Ignorant voters can easily be fooled into believing that policies pushed by special interests will actually benefit the general public. This is especially likely in a crisis atmosphere like the present.

Finally, as Soros himself points out, government financial regulators suffer from inadequate knowledge and are likely to make mistakes as a result. The same complex nature of the financial system that ensures widespread public ignorance also makes it difficult for regulators to gather sufficient information to know when they should act. If regulators act on poor information, they might engage in interventions that create serious harm - as the Federal Reserve discovered on several occasions in its history, including the Great Depression.

Does all this necessarily prove that increased regulation of the financial system is undesirable? No, it doesn't. But it does suggest that justifying increased regulation requires a much stronger argument than that given by Soros. It isn't enough to prove that a market failure exists, even a very serious one. We also need proof that government regulators have the knowledge and incentives needed to improve on market outcomes without causing harm that outweighs any benefits they might create. Even if Soros is right about the alleged failures of the market, he hasn't shown that government intervention will be better. Indeed, for reasons he himself hints at, it might be much worse.

UPDATE: It's possible that Soros wants the new regulation to be conducted by experts insulated from the pressures of the democratic process. If so, that would partly (though by no means entirely) protect against the dangers of public ignorance and interest group lobbying. Unfortunately, the "rule of experts" solution to political ignorance has serious flaws of its own, which I discussed in detail here.


Global Governance or Governmental Network Coordination for Global Financial Regulation?

Peter Mandelson, currently Business Secretary in the UK government of Gordon Brown and formerly EU trade commissioner, has an op-ed in today's WSJ (June 19, 2009), "We Need More Global Governance: The Crisis Reveals the Weakness of Nation-Based Regulation," (might be behind subscriber wall). (Reader warning: this goes on for a while.)

This piece offers a striking example of the intersection of substantive views of monetary policy affecting one's policy views of what regulatory reform (in this case global regulatory reform) should mean. The explanatory gap I point out below in the piece goes beyond criticism about both the weakness of ideas of global governance, or the careful exploitation of strategic ambiguities in what the term is supposed to mean (one thing to me to get me on board, another thing to you to get you on board). It points in the direction that Ilya raised in his last post on this, to say that if you have one substantive economic view of the crisis, then you can propose that public governance bureaucracies can improve the situation; but if you have another, you have reasons to reach exactly the opposite conclusion.

Mandelson starts by offering a carefully phrased account of how the global financial crisis, next global recession, came about. He liberally spreads around the blame, without putting any of it on identifiable actors, all very diplomatically. However, his assessment of What Went Wrong finally lands on a very specific contention:

[W]hat enabled the banking crisis to happen was a structural imbalance in the growth model of the global economy over the last two decades.

That model has produced unprecedented global growth, but it also developed a serious weakness at its center. Unless we address that weakness, any other counter-recessionary strategy is palliative at best. The risk is that as the global economy slowly returns to growth, the urgency to address this fundamental problem will recede.

Reduced to its crudest form the problem was this: Credit was too cheap in the developed world. It was kept cheap by a number of factors. The commitment of China to an export-led growth model, matched by a willingness from rich-world consumers to keep spending, created persistent surpluses in China in particular.

Those surpluses were invested in developed-world debt, particularly the U.S., pushing down interest rates. That encouraged investors to look for riskier and riskier investments to increase their yield. It also encouraged people to buy houses they couldn't afford with the help of people who probably shouldn't have lent them the money in the first place. That debt was sold around the world. The end of the housing bubble revealed the risk in the system.

Note that the article signally fails to mention the policy of central bank policy, and in particular Fed policy, under Greenspan and later Bernanke, having allowed the money supply to rise too high and allowing interest rates to remain too low. When I first read the piece, I assumed that this was mere diplomacy on Mandelson's part. But, as it happens, the final substantive interpretation that Mandelson gives for ultimate causes takes an unequivocal position in the sharp debate over the role that monetary policy and central bank policy played in allowing the bubble to develop, and that in turn impacts his policy views. And in ways that draw in Ilya's central contention from his last post directly.