When something bad happens it is often helpful to think about why it has happened in two ways: did someone have a reason to make it happen, or did it happen by accident? This can also be expressed in a slightly different way: were incentives to blame, or ignorance?  Jeffrey Friedman and  Wladimir Kraus have made a compelling argument that ignorance explains more about the world than we often realize, using the 2008 financial crisis as an example. This post is an attempt to summarise their argument.

Economists often remind us that incentives matter. Indeed this is sometimes said to be the cornerstone of ‘the economic way of thinking’. Russ Roberts gives the example of death rates on British ships bringing convicts to Australia in the 18th Century – rather than attempting to raise ship captains’ awareness of the badness of letting their passengers die, the government gave captains a bonus for every convict that walked off their ship. This was very effective.

Clearly this way of thinking can be very powerful. It is the foundation of the price system, which is the mechanism that markets use to allocate resources effectively in a world where information is dispersed: if demand for pizza rises, the price of pizza rises, giving cooks and restaurant owners an incentive to sell more pizza. It helps to explain why some people stay on welfare payments for long periods of time: the welfare money they lose when they go into work represents a significant disincentive to work. Or, if you offer something like a bailout to businesses that go bust, you reduce the incentive for them to act prudently to avoid going bust.

This last example is what is known as moral hazard. And it is a popular and compelling explanation for the 2008 financial crisis. Banks expected to be bailed out if they went bust, so they acted more recklessly than they would if they thought they would be on the line for their mistakes.

However, Friedman and Kraus argue that this popular and compelling explanation may in fact be wrong. A good way of testing it would be to compare how the bankers involved in making bad decisions acted where perverse incentives applied, and how they acted where perverse incentives did not apply.

One strong piece of evidence against the incentives narrative is that bankers seem to have acted the same way with their personal investments as they did with their business investments.

Many bankers lost a lot of money personally in the crisis because their personal portfolios were not ‘bailed out’ in the same way that their banks were. If we are to treat the ‘incentives story’ as a falsifiable proposition (as all claims about the world should be treated), this might be a fairly strong reason to disregard it.

This may be where ignorance comes in. If bankers acted the way they did because they were unaware of the risks they were taking, then we would expect their private and business investments to be pretty similar.

However, it is strange that so many bankers seemed to make the same mistake. We know that they were not acting in a neutral environment: as Friedman and Kraus have shown, regulations like the Basel accords and the US’s recourse rule directed banks to prefer mortgage debt to business debt. Other regulations directed banks to rely on the risk judgments of three specific ratings agencies, giving those agencies protection from competition.

(On the ratings agencies point, astonishingly, it seems that nobody realized that these agencies were basically protected from competition. Both bankers and regulators assumed they were being subjected to market forces, leading to everyone trusting them a lot more than they would if they knew they were dealing with protected monopolies.)

These regulations were designed to make banks act prudently: the regulators had no incentive to make banks act badly. It seems possible that they did not realize the error of their ways until it was too late. Perhaps regulatory ignorance was to blame.

It is important to stress that the regulators should not be blamed personally. They probably made the best choice they could have made given the information available to them. Rather it is the position they found themselves in that seems to have been to blame. If a single bank (or even a handful) makes a mistake, that bank will suffer but the whole sector probably won’t. It is only when a whole sector of a market (or almost all that market) makes an error that we should worry. (Incidentally, as shaky as the housing and financial sectors were, the real trouble did not begin until monetary policy tightened unexpectedly, as Scott Sumner outlined at our recent Adam Smith Lecture.)

Given ignorance, we should expect errors to take place. Because regulation necessarily applies to everyone in a market, a regulatory error affects everyone.  That may be the fundamental problem with regulation, and a reason to have a strong ‘prima facie’ objection to regulation. It is better to have one hundred firms making one hundred different mistakes that happen at different times and in different ways to one hundred firms making one single mistake that happens at the same time for everyone.

None of this implies any special knowledge on the part of firms. Indeed regulators may be much more expert than the firms they are regulating, but the danger of a collective error would still give us a reason to generally object to regulation in principle, no matter how sensible it may seem.