FAILED LEADERSHIP AND ITS CONSEQUENCES: disorganized and organized crimes

It has been an amazing past few weeks. In less than a month, we have witnessed massive failures in political and economic governance world-wide and a moving spiritual appeal for individual responsibility by the Pope on his visit to America. The Papal message of individual responsibility (self-governance) was combined with an extraordinary focus on those left behind. It was was a badly needed rejoinder to the leadership failures we see every day, here in America and elsewhere as well.

The political and economic malaise that is evident globally stems from an appalling lack of leadership in both government and industry. The Pope stressed the importance of spirituality in motivating personal responsibility. His visit was a stunning display of respect for individual lives and a call for individuals, institutions and countries all over the world to address global problems with compassion and charity. Our politicians and business leaders have undermined our trust in government and business. Sadly, they seem not to have heard the Pope’s message. They neither lead nor do they listen.

Among our current economic and political failures, we can include:

Massive migration into an ill prepared Europe stemming from four years of warfare in Syria and Iraq. The failure of Western leaders to marshal sufficient resources to cope with the breakdown in Syria and Iraq and the growing strength of ISIS, who now controls the largest amount of territory in the two states combined, means emigration into Europe will dominate political life in Europe far into the future. The flood is only beginning.

Russian military intervention in Syria that underlines the failed leadership in the US and in Europe to deal seriously with the Syrian disaster. Leading from behind has been demonstrated to be a much-faulted strategic conception combined with feckless political leadership. Put simply, leading from behind is not leading at all.

Iranian Nuclear deal that now goes into effect is not a treaty (that would require two/thirds approval by the Senate), but as an executive agreement. Leadership that skirts American constitutional process in order to ram home an agreement whose full terms have not been disclosed is a travesty to our traditions of governance. Those who lead in this manner show a total disregard for allowing the judgment of the people’s representatives. Whatever the outcome in Iran, here in the US, it is a bad example to follow.

Unexpected resignation of the Speaker of the House shocked the politicos within the beltway. It leaves the Republican opposition disorganized and the Administration praying that the Boehner walk away will at least provide passage of continuing resolution so that the Government will not be shut down. The shambles into which the Republican Party has fallen is not a good omen for political governance. We are reminded of Ring Lardners great baseball quote. “Although he cant field, he cant hit either.”1This leaves non-elected officials (such as the Supreme Court or the Federal Reserve) in charge of policy. Leadership failure has very long term consequences.

Growth slowdowns in emerging markets have thrown prices for basic resources into the toilet. The effects on employment in the resource industry have just begun, but the effects on the prices of resource stocks have been devastating. In case you havent noticed, equity markets worldwide are in a state of panic. Partly, the collapse of basic resource prices is responsible, but not entirely. The loss of direction in economic policy displays the same failure of leadership noted in the political arena.

Federal Reserve vacillation in choosing a definitive policy stance and communicating its direction going forward has added to the bearish movement of equities. The best characterization of the FOMC may have has been the recent translation of its acronym: the Federal Open Mouth Committee. The Fed has pulled a Lucy, as one economist has pointed out.2If the Fed knows where it’s going, it hasn’t let the market in on its big secret.

Exposure of Volkswagens fraudulent auto emissions gimmick is just the beginning of a continuing set of disclosures that reek of massive failures in VWs corporate governance. The damage to the worlds second largest auto manufacturer is incalculable at this stage. The damage will not be limited to VW. The German auto industry employs one of of seven in the labor force. The consequences will be manifold. Government has failed as well. VWs contravention of environmental regulations in both Europe as well as the United States indicates the regulators on both sides of the Atlantic were asleep at the switch or perhaps suborned from their real duties of protecting the public. Public confidence in government regulation should and will fall sharply. Our trust in our governments falls when leadership fails.

Disorganized Crimes has mainly focused its attention on continued examples of corporate misgovernance in the US. However, we have always thought that corporate governance is a subset of a larger governance structure that takes account of government, the courts, and our institutional arrangements. Those institutions include what we term as the regulatory state. And, no state today, is without that panoply of regulatory bodies that effect day-to-day governance. We have all become dependent on this massive regulatory state to guard the public interest, the more so when individual shareholders cannot control the operations of the companies they own. The parallel to 2007-2008 is striking. Firms failed and the regulatory bodies failed with them. It was not a case of deregulation. It was repeated failures to apply the existing regulations. Don’t let the government deceive you by blaming the “other guy.”

What we are witnessing in the VW disaster is a twin failure: the failure of corporate governance at VW and the regulatory failures in Europe and America. The regulations are suppose to stand guard for the public. The agencies charged with overseeing compliance to environmental law have behaved as dupes over a long period. They remind us of the investors in the Bernie Madoff scandal, each relying on their friends continued investment with Madoff to assure themselves that nothing was wrong. When business leaders in public companies fail, shareholders can and now often arise to throw out failed executives. When government regulators fail even to execute their own mandates, the public interest is not only trampled but citizens lose their belief that their government will be there to act in their interest. What then

What should we make of this extraordinary regulatory failure Clearly, the leaders of these agencies have failed to lead. They are not even able to carry out the regulations they demanded to be placed on the books. It is scarcely satisfying to see these failures in virtually every country irrespective of its political ideology. No matter what the ideological underpinnings, regulatory failure is also leadership failure. It undermines our belief that somewhere, someone is paying attention to the needs of the citizens, and doing it competently, honestly and regularly.

Where does the public go from here In 1961 John F Kennedy aroused the passions of many Americans with his clarion calI: Ask not what your country can do for you! Ask what you can do for your country.3 The exact quote is And so, my fellow Americans: ask not what your country can do for you, ask what you can do for your country. The public needs to turn this phrase around and ask ‘What is Government, which dictates so much of my life, doing for me’ Can Government keep me safe from terror, from economic decline When I retire, will there be sufficient resources for me in my old age Will the national health plan be there when I fall ill Can government provide the moral compass to judge who are the organized criminals in our society Maybe not Maybe I ought not to trust my future to a government that seems to function in a directionless fashion headed by leaders who are leading from behind

By his speeches, and the locations of his visits, the Pope seemed to be saying, Do what you can to alleviate the suffering in the world. It is your responsibility. It struck a spiritual chord in America that our deficient political leadership would do well not to ignore. Politicians and administrators who fail to lead, lose the respect of their countries citizens. In the next emergency, if government is not respected, government can no longer lead. Who then will follow

This past week provoked me to remember the actor Peter Finch crying into the night in the movie Network, Im mad as hell and I am not going to take this anymore.4 People in America are mad as hell. Who can blame them

They are mad in Europe. They are mad in China. They are mad in Russia. The flood of immigrants into Europe are not only mad, they are escaping a geography that is no longer a state.

When we speak of the United States, we think of an organized polity with recognized borders, recognizable leaders who direct our attention and to whom, ordinarily, we accord our respect. That is not our present State of the Union. Today, in America we are ‘mad as hell.” Are we going to “take it anymore”

  1. This is how I remembered it from my youth. Looking it up on the web, the best I could find was Although he is a very poor fielder, he is a very poor hitter. I may have read the remark in an old Grantland Rice book and to me it reads better as it is in the text. []
  2. David Malpass, “The Fed Pulls a Lucy,” WSJ 9/17/2015 []
  3. John F. Kennedy, Inaugural, Washington January 20, 1961 []
  4. Network, United Artists (1976). The speech and its repercussions can be found at https://www.youtube.com/watchv=q_qgVn-Op7Q []

Judging the Risk of Future Black Swans: some policy implications

Economists and policy wonks are still intrigued by the events of 2007-8. The basic question is how to account for the fact that financial specialists extensively trained for judging risk got run-over by the collapse in the collateralized mortgage market. It has been well documented that the housing price run-up and its sudden stabilization was followed by a sudden and sharp collapse. This sequence displayed the same generic pattern of prior boom-bust price scenarios. One key to understanding such scenarios is that the process of leveling out in prices followed by a flattening is the precursor signal to a subsequent sharp fall in prices. It seems that the flattening period creates somewhat of a panic situation and, after a brief period of flat prices at the elevated level of the prior boom, huge doubts creep in. A rational investor will rush to sell these assets. When the music stops, it is time to quickly find an empty seat.

What kind of an expectation model underlies that kind of seemingly quixotic behavior A number of writers have produced models that seem to explain this behavior as a rational process produced by significant change in available information. A recent attempt is by a well known Professor of Finance who had an intimate connection as a consultant to one of the archetypal failure companies, (AIGFP).1 The critical element in the financial crisis is the collapse of the overnight repo market, whose collateral was often mortgage backed securities. Gorton and Ordoez have created a rational model of this regime shift by asset holders. First, these asset holders were believers in the underlying trend and as prices rise, they become more sure that they are on the right side of the market. Being long is rewarded at this stage. Being longer, can be even more rewarding. To purchase more of the collateral, asset holders borrow frequently overnight in the repo market. Their assets grow (both because of rising prices in a mark to market world create higher balance sheet values) but perhaps even more importantly, because access to the repo market creates seemingly unbounded opportunities to leverage their portfolios of what will become risky assets at a later stage. The essential question to ask is why asset holders allow their leverage to grow to such high levels Their behavior is not strange. The same behavior was observed in the underlying housing market. A borrower who watches his house rise quickly in value can easily sell the house and buy a bigger and better house by taking on a larger mortgage. Alternatively, new buyers, not previously accorded credit, find mortgages easy to obtain.

Where do the new mortgages generators come from They come from a pool of house buyers who previously couldnt qualify for a mortgage. But to create more qualified buyers, credit standards are reduced. As some writers on the crisis put it, as long as the buyer could fog a mirror held in front of his (her) mouth, they could get a mortgage. It was a self re-enforcing process. Another way to say this is that the leverage in the household sector rises sharply, and the same leverage expansion takes place in financial markets that deal in mortgages. At some point, the system begins to run out of fresh buyers and home prices begin to level out. That is a trigger to a sharp decline in housing prices and the decline triggers a fresh appraisal by collateral holders of the quality of their collateral. Haircuts rise on these derivative assets, creating a demand for cash collateral by financial intermediaries who have overly indulged on risk. The market begins to price risk much more sharply. Market players begin to think there is a black swan in their future. Housing markets never decline, right Wrong assumption!

Leverage is a two way street. In the beginning, increased leverage leads to high earnings on the same equity base. Earning increases by financial intermediaries are reflected in the share prices of these intermediaries. Intermediaries such as investment banks, commercial banks, and companies that provide shadow markets for this collateral seemingly benefit. Earnings for the financial sector have been rising, even in spite of modest interest rate increases. Finance becomes King of the Mountain.

The growth of the financial sector, in terms of the percentage of corporate profits, was one of the highlights of the first decade of this millenniumuntil the finance sector developed the major infarct of 2007- 8. Then the story shifted to one of Government rescuing the overindulgence in risk and the excessive leverage by large financials. We learned that rescue can occur in a somewhat indiscriminate fashion. Beneath those struggling financials was a long history of abnormally low interest rates, stimulated by the Feds fear of deflation and deficient corporate governance by each of the monitors of our corporate system.2

One particularly sad note in this history is the elevation of too big to fail, as national financial policy. Financials that significantly enlarged their assets were in fact being subsidized by the implicit rescue embedded in this too big to fail doctrine. Of course, if one listens to the politicians and the current government regulators, they will tell you that Dodd-Frank and its huge regulatory apparatus is designed to prevent another financial calamity. The government now says it will not underwrite financial firms that get into trouble through excessive leverage and ignoring the risks of future black swans. Do we really believe that another Lehman will occur We think that is nonsensical. What politician or regulator is willing to agree to a financial bigger than Lehman to fail the next time. This contention is a diversion from the real difficulties. Government produced the underlying drivers that led to 2007- 8. In particular, Government has never applied stringent liability standards that attach to the various corporate monitors supposedly acting in the interest of shareholders. There is no punishment to fit the crime when it comes to monitoring failure. That is a huge failure in political governance, and one not likely to be soon rectified.

Effective corporate governance depends upon transparent political governance. Given the lobbying done by large financial institutions and politicians continuing need for funding their electoral campaigns, what has evolved in the United States is a form of crony capitalism. That is precisely the opposite of what is needed, but that is another story that needs to be told. The first step is to realize that there are Black Swans (rare events that are not impossible) and that rare events do occur, often more frequently than we can foresee. Our focus must be on the incentives that poor policy often provides. To paraphrase a former President, its the economy [economic incentives], Stupid.

  1. See Gorton & Ordoez Collateral Crises AER Vol 104 Number 2 February 2014 and Gorton’s account of the collapse of the repo market in “Understanding Financial Crisis” (2012) []
  2. See our book Disorganized Crimes (2013) particularly Chapters 1-5. See also Chapters 6-15! []