Sunday, March 23, 2014

Why does Congress spend so much money?

Its the incentives, stupid. HT: Karla

1 comment:

  1. Response to What good are economists?

    Comparing economists’ missed forecast of the financial crisis of 2007 – 2009 to a doctors forecast to predict disease seems a bit ludicrous. Medical science is still discovering the causes and transmission of disease. Financial markets are created by business transactions and should be more clearly understood.

    Robert Shiller noted the beginnings of the housing bubble in his book Irrational Exhuberence. Dean Baker, an economist with the Center for Economic and Policy Research, and Paul Krugman, the Nobel prize winning economists also spoke of the housing bubble. Signs existed for the average consumer to begin questioning the rise in home prices, as evidenced by the increase in google searches of the term “housing bubble.” (Silver, 2012)

    Auditors learn that fraud is difficult to detect when there is collusion. It appears that the financial market acted in collusion by improperly disclosing the risk of loans. The rating agencies, primarily S&P and Moody’s, did not understand the risk of a new type of security, collateral debt obligation (CDO). Also, even if the rating agency understood the risk to make the correct risk assessment, they did not have incentive to do so. The rating agencies earn a profit by providing a rating and not for the accuracy of the rating. The problem solving principles as discussed in Froeb’s textbook ask three simple questions which can be applied to the recent financial crisis:

    1. Who is making the bad decision?

    Financial lenders and rating agencies

    2. Did the decision maker have enough information to make a good decision?
    Yes for financial lenders, and perhaps no for the rating agencies. The rating agencies may not have understood the complexity of CDO and the correlated risk. (Silver, 2012)

    3. Does the decision maker have the incentive to make a good decision?

    No, both the financial lenders and rating agencies were amassing large profits through these transactions.

    What is most disturbing is that now that we have a better understanding of the cause of the crisis we have not corrected the problems. The individuals who were culpable were not prosecuted, except in rare instances and companies were fined without admitting guilt. The political power of Wall Street continues to reign in our nation’s capital. (Connaughton, 2012) Greed continues in financial institutions and the incentive to make good decisions is still missing.

    Connaughton, Jeff, 10/3/2012. Prospecta Press. The Payoff: Why Wall Street Always Wins

    Silver, Nate, 9/27/2012. Penguin Press. The Signal and the Noise: Why So Many Predictions Fail – But Some Don’t

    Froeb, L., McCann, B., Shor, M., & Ward, M. (2014). Managerial Economics: A Problem Solving Approach (Third Edit.). Mason, OH: South-Western Cengage Learning.