Inside Job and Predator Nation by Charles Ferguson

Inside Job is a 2010 documentary about the Great Financial Crisis. Predator Nation is a 2012 book that provides more details related to the documentary.

Frederic Mishkin is an economist interviewed in the documentary. Before 2008, I used Frederic Mishkin’s textbook in my banking class. There are a lot of things in the textbook I don’t agree with. But it is much easier to use a textbook in teaching. After 2008, I felt compelled to drop the textbook.

The following is a statement by Mishkin, quote from Predator Nation.

This was the environment in mid-2006, when Professor Mishkin wrote, “Iceland is not an emerging economy …  [and] comparisons of Iceland with emerging market countries, like Thailand and Turkey, are not only facile, but completely misguided.” He went on:

Iceland, however, has excellent institutions: indeed, as we have seen, the quality of its bureaucracy and low levels of corruption, rank it among the best-run countries in the world as we saw in the overview chapter. In contrast to the inadequate prudential supervision in countries that have experienced financial instability, Iceland’s prudential supervisors are seen as honest and competent. Their statements that the banking system in Iceland is safe and sound should be taken at face value. (P 262)

In general, Charles Ferguson had the following to say about the financial institutions and the academia.

How can an entire industry come to be structured, and incented, such that employees are systematically encourage loot and destroy their own firms? Why did the market forces permit this to occur? Why did market forces not give rise to any firm that systematically collected and analyzed information about total size of risk exposures in the industry? Why did deregulation and economic theory fail so spectacularly and completely? There has been astonishingly little examination and public discussion of these questions by economists, and what little they have said has not, for the most part, been impressive. Conflicts of interest certainly play a major role here. (P 280)

In 2022, Nobel Prize in Economics was awarded to Ben Bernanke, Douglas Diamond And Philip Dybvig. Bernanke was the FED chair from 2006 to 2014. The Nobel committee made the following statement about Douglas Diamond’s 1984 paper,

However, one difficulty remains. If the bank is monitoring the borrowers – who is monitoring the banks? In practice, we cannot rely on each depositor knowing whether the bank is doing its job properly. One of the conclusions in Diamond’s article is that the way in which banks are organised means they do not need to be monitored by the depositors.

If the bank cuts corners on monitoring borrowers, it risks large losses on its loans. The bank would thus be unable to repay what it promised its depositors and collapse. Therefore, it is in the bank’s own interest to monitor its borrowers without the depositors needing to monitor the bank. (P. 6)

It is exactly this kind of attitude that caused the 2008 financial crisis. In 2005, William Black wrote a book, The Best Way to Rob a Bank is to Own One. That book provided a lot of stories how bank insiders rob the banks.

The statement from the Nobel committee continued,

Even if the bank performs its monitoring duties well, it will incur losses on some of its loans. However, the risk that a major bank will collapse due to this is small, as long as the bank manages its lending activities in a responsible manner. This is because a bank grants loans to a large number of borrowers. Even if a few borrowers default on their loans, the losses across all loans will be small and predict able. Not putting all their eggs in the same basket reduces the average risk in the bank’s loans portfolio. Thanks to the bank acting as an intermediary, the costs are reduced for bankruptcy and monitoring borrowers. This benefits society as a whole.

Diamond’s model explains how the existence of banks leads to a reduction in the cost of transferring savings to productive investments, known as the cost of credit intermediation. This cost reduction allows a larger number of societally valuable investment projects to be financed. If many banks fail at the same time, such as during the depression of the 1930s, the cost of credit intermediation increases so dramatically that much of the economy stops functioning. Monitoring requires knowledge that dissipates when a bank fails, and this knowledge takes time to recreate; the consequences of bank failures are therefore not only extremely negative, but also long term. (p 6)

The benefits generally are generally absorbed by the banking institutions in the form of high wages and bonuses. The costs are downloaded to the whole society.  The following are some more statements and comments.

A bank will always incur losses on a few of its loans. But as long as the bank lends responsibly, the losses across all loans will be small and predictable. (P 6)

When an institution is very powerful, it doesn’t need to be responsible. The 2008 financial crisis and subsequent bail out proved this.  

New financial intermediaries which, like banks, earned money on maturity transformation emerged outside the regulated banking sector in the early 2000s. Runs on these shadow banks were central to the serious financial crisis of 2008–2009. Diamond and Dybvig’s theories work equally well for analysing such events even though, in practice, regulation cannot always keep up with the rapidly changing nature of the financial system. (p7)

“regulation cannot always keep up with the rapidly changing nature of the financial system” This shows the ad hoc nature of the current theory and regulation. Regulations are designed to adapt to the changing financial institutions. If the main street is more powerful than the Wall Street,  regulations will be set in a way to make destabilizing activities unprofitable and illegal. Removing insurance on financial activities, instead of strengthening the insurance, should be the way.

Research cannot provide final answers for how the financial system should be regulated. Deposit insurance does not always work as intended; it may encourage banks to engage in risky speculation where the taxpayers will foot the bill when it goes badly. The need to save the banking system during crises can also lead to unacceptable profits for the banks’ owners and employees. Other types of rules about bank capital and ones that limit the amount of borrowing in the economy may thus be necessary. The advantages and disadvantages of such rules must be analysed, and how well they work may change over time. (p 7)

“Deposit insurance does not always work as intended; it may encourage banks to engage in risky speculation where the taxpayers will foot the bill when it goes badly. The need to save the banking system during crises can also lead to unacceptable profits for the banks’ owners and employees.” All social institutions, including financial institutions, are evolving. The real problem, from the perspective of ordinary people, is that the financial systems and the governments are controlled by a small number of the financial elites, not by the vast majority of the common people.

How the financial markets should be regulated to fulfil their function – channeling savings to productive investments without causing recurring crises – is a question that researchers and politicians continue to wrestle with. The research being rewarded this year, and the work that builds upon it, makes society much better equipped to take on this challenge. This reduces the risk of financial crises developing into long-term depressions with severe consequences for society, which is of the greatest benefit to us all. (P 7)

These works, by justifying greater protections to the banks, lead the whole societies to greater instability. Conservation law is the first law of thermodynamics. It should also be the first law of economics. By granting the financial elites so many privileges and protections, the powerful governments inevitably harm the majority of the people.

It is interesting to compare the opinions of Charles Ferguson and the mainstream academia, as represented by the verdict of the Nobel committee.

References

Inside Job, Predator Nation by Charles Ferguson

Nobel committee statement

https://www.nobelprize.org/uploads/2022/10/popular-economicsciencesprize2022.pdf