Dan Ariely

I just received this letter from a friend in the banking industry. He prefers to remain anonymous (you’ll see why soon enough).

Dear Mark,

There’s been a lot of ballyhoo recently about your IPO and your choice of investment bankers. Indeed, a war was fought by the banks to win your “deal of the decade.”  As reported in the press, the competition was so intense banks slashed their fees in order to win your business. Facebook is “only” paying a 1% “commission” for its IPO rather than the 3% typically charged by the banks.

Congratulations, Mr. Zuckerberg! On the surface it appears your pals in investment banking have given you a quite a deal!… Or have they?

Let’s take a closer look and see what you’re getting for your money.

To start, your bankers have the task of selling 388 million Facebook shares to the public. In return, these banks will receive $150 million for their efforts.  Morgan Stanley will get the largest share of that amount—approximately $45 million. But is $45 million all that Morgan Stanley makes off your deal?

Before we answer this question, let’s first dissect the sales pitch that Morgan Stanley probably gave you to justify “only” the $150 million fee. We’ll look at what they told you, and then what that actually means.

1) We will raise the optimal amount of money for the company, for our 1% fee. (Translation: How great is it that Zuckerberg believes he got a great deal by getting us down to a 1% fee! We can’t believe he got hoodwinked into agreeing to any level of what are actually variable commission fees.)

2) The definition of a successful deal is having a good price “pop” on the first day of trading. This will make all parties happy and you, Mark, look like a rock star. (Translation: No one benefits more than us if Facebook’s share price rises significantly on day one. That first day price “pop” will take money directly out of your pocket and puts it in ours and those of our “best friends”—not yours or the public stockholders. We will, at almost all costs, make this happen.)

3) This is a very complicated process, especially for such a large company, but we are here to successfully guide you through it. (Translation: It actually takes the same amount of work to do a large IPO as a small one. Thus for approximately the same amount of work we’re doing for Facebook, we sometimes get only $10 million—$140 million less than we’re making on Zuckerberg’s IPO.)

4) We will perform due diligence on your company to make sure the business and its finances are as they seem. (Translation: While it certainly does take some time and effort to perform reasonable due diligence, Facebook is a very large and well-known company, and we have done this same procedure hundreds of times.)

5) We will write a prospectus that outlines Facebook’s strategy, business plan, financials, and risks, and we will get it approved by the SEC. (Translation: Per the regulatory guidelines, a prospectus is largely a boilerplate document; for the most part, it’s just a lot of cutting and pasting.)

6) Once this prospectus is completed and with input from the Facebook team, we will come up with “the range” or the approximate price we think your IPO shares should be sold at to the fund managers. (Translation: The price of your IPO will be determined by where and how we can best optimize our (secret) profits on the deal.)

7) We believe the best shareholders are large fund managers, as they will become long-term holders of Facebook stock.  However, at your request, we will allocate 25% of the IPO shares to sell to individual investors. (Translation: There are 835 million Facebook users worldwide. One could argue that what is best for Facebook would be to let all of Facebook’s legally eligible customers enter orders to buy Facebook stock. Then through the broker of their choosing, they could enter the quantity of shares they want to buy and the price they want to pay, just like the fund managers do—or are supposed to do. More on this scenario below.)

8) Our 10-day sales process will begin. For this important “road show,” you will be introduced to our large fund manager clients. These fund managers will receive our pitch for why they should buy your stock, and we will assess their interest and at what price. (Translation: Far from being long-term holders, many of our large fund manager “best friends” will, as soon as Facebook shares start trading, sell (or “flip”) for a windfall profit on all the underpriced shares we’ve given them. We’ll enable this by creating a perceived “feeding frenzy” for the stock by putting out an artificially low initial estimate ($28 to $35 per share) for where we think the IPO will be priced.  We will then raise that estimate during the road show. Rumors about this begin to circulate over the next day or so.)

9) At the end of the road show on the night before the IPO, we will review the overall supply and demand for the stock and then “price” the shares. This is the price at which the large fund managers will receive their “winning” Facebook shares. (Translation: The price of the stock is already known. For the past few years, Facebook shares have been actively trading on such venues as SecondMarket and SharePost.)

10) And finally, we will put a mechanism, called a Greenshoe, in place that “supports” your share price after the IPO. (Translation: Thank God Zuckerberg doesn’t understand one of the greatest investment banking profit enhancing creations of all time—“The Greenshoe.” The Greenshoe will likely be our most profitable part of this deal.  It’s a secret windfall, and although we market it to Facebook as a method to stabilize its share price, it’s really just another way for us, with little effort, to make huge amounts of money.)

We’re not done yet, Mark. Now, I’d like to dig a bit deeper into what’s going to happen and show you all the additional ways your banker friends and their large fund manager clients are going to make oodles of money off your deal.

1) Morgan Stanley only gives Facebook shares (“golden tickets”) to their best client “friends.”  In other words, it’s no coincidence that Morgan Stanley’s biggest fund manager clients get the bulk of the shares offered in this kind of deal.

2) How do you become best friends with Morgan Stanley?  There are lots of ways, such as trading tens of millions of shares with them or using the firm as your prime broker.

3) I’m sure there are a lot of conversations going on right now between Morgan Stanley’s salespeople and their clients. These conversations are probably along the lines of (wink-wink) “before we allocate our Facebook shares, we’d like to ask first if you plan to do more trading with us over the next week to six months….”

4) Let’s assume that 50 of Morgan Stanley’s “best friends” trade an extra 2 million shares so they can get access to more shares of the Facebook IPO. Let’s also assume that the average commission these clients pay to Morgan Stanley is 2 cents per share. Well, those extra trades will dump an additional $2 million dollars into Morgan’s coffers.

5) Now comes the part where Morgan Stanley actually gives free money to its friends. If the Facebook IPO is like the majority of other recent Internet offerings, here’s what Morgan Stanley will likely do.  They know Facebook will be a “hot” deal. Especially, with all of the “5% orders” coming in, there will be huge demand for Facebook shares.  My prediction is that Morgan Stanley will “price” Facebook at approximately $40 per share.  This is the price at which Morgan Stanley’s “best friends will be able to buy the bulk of the 388 million shares offered.

6) Now let’s now assume that Facebook shares open for trading at $50—a lower percentage premium than Groupon’s opening share-price “pop.”

7) Let’s assume that one of Morgan Stanley’s “best friends” decides to sell 3 million shares right after the opening at $50 per share. That “best friend” will instantaneously make a $30 million profit.  That’s right, a $30 million profit.

8) Here’s a question for you Mark. If Morgan Stanley’s “best friends” are selling Facebook shares at $50, who’s buying them? The answer is your “friends,” individual investors, most of whom are your customers.

9) Now for the final insult—the Greenshoe. Technically speaking, the Greenshoe gives your investment banks a 30-day option to purchase up to 15% more stock from Facebook than was registered and sold in the IPO. In layman’s terms, this means that, over the next 30 days, your “best friends” at the investment banks are able to buy approximately 50 million of your shares at $40 per share.

10) As in our example above, let’s say Facebook shares do trade at $50 soon after the IPO. Now I am a simple person, but if I were given the opportunity to buy something at $40 that I could immediately sell at $50, I would do it all day, every day…. And so will the investment banks.  The Greenshoe actually gives these banks the ability to do this for 50 million of your shares.

11) So let’s assume that Morgan Stanley and its other banking “friends” buy 50 million shares at $40 per share and then sell these shares at $50.  Morgan Stanley and its banking “friends” will make an additional $500 million- yes, $500 million- a HALF BILLION DOLLARS off your company.

So let’s now do a tally to see how much money all of your banking friends are going to make just for the privilege of doing your IPO.  Let’s also see where this money comes from.

“Discounted” fees/commission: $150 million

Greenshoe profits: about $500 million

Extra trading commissions from large fund managers: approximately $10 million

—————

Investment Bank Profits:   $660 million

As the lead bank on your deal, Morgan Stanley is likely to get 30% of the overall take. This means that your closest investment banking “friend” will make a bit more than $200 million from your IPO.

Morgan Stanley and the rest of the investment banks involved will also make sure that their favorite fund manager client “friends” are given lots of free money. Assuming that these “friends” are given 75% of the total number of IPO shares, or a total of 291 million shares, and assuming that the stock does rise from $40 to $50, then these fund managers will collectively, in one day, make $2.9 billion dollars in realized or unrealized profits.  That’s right, 2.9 BILLION DOLLARS.

Mark, by now you must be asking yourself the obvious question. “Where and out of whose pocket does this money come from?”

Well, just think of it this way… Let’s assume you own a very expensive piece of waterfront real estate, and you hire a broker to sell it for you. After exploring the market and after getting indications of interest, your broker advises you that $10 million would be a great price for your home.  You meet with the potential buyers and decide to sell it for $10 million.  After the $1 million commission you have to pay your broker, your net proceeds are $9 million. An hour later, you drive by the house and see your broker in the driveway shaking hands with some different people. You pull over to see what’s going on, and you find that the people you just sold the house to for $10 million are very close friends of your broker.  To your dismay, you also find out that those friends just sold your (former) house to somebody else for $15 million.

The same exact game is going on here, Mark. You’ll be selling 388 million shares of Facebook stock in your IPO. A likely scenario is that your broker “friends” are telling you to sell your shares at $40 per share. You’ll take their advice and sell at $40 per share, and the buyers will be Morgan Stanley’s biggest fund management clients. By the time you drive around the block, these folks will have sold their shares at $50 per share. In other words, using the same real estate scenario, you’ll have sold something of yours for $15 billion that is really worth $19 billion. And for that “unique” privilege, you’ll be paying your “friends” at the banks $150 million as a fee.

Makes you wonder who your real friends are…

————-

End of letter

————-

I find the points that my (real life) friend makes here highly disturbing, but I suspect that they also fit with what we now know about dishonesty.

First, although there are many ethically questionable practices occurring here, it’s not clear that anything illegal is going on.  Second, I think that while this banking industry’s IPO process is artfully designed in such a way that, although overall it’s good for the bankers and less so for the companies, no single individual believes he/she is doing anything wrong.  Third, I also suspect that since this is such a common practice, the bankers most likely truly believe that mechanisms such as getting a first-day IPO “pop” is great for Facebook and that the Greenshoe is fact put in place to stabilize the Facebook stock price, and not simply to generate more windfall profits for themselves.  Forth, they probably believe in their own definition of a “successful” IPO, which in their terms is one where the stock is priced at $40 and quickly trades up to $50. In the case of Facebook, this process simply redistributes $4 billion from Facebook to the banks and the large fund managers. For Zuckerberg and his team, I have to wonder whether the emotional value of a first day share price “pop” is worth $4 billion.

I am not sure about you, but I find all of this very depressing.

Irrationally yours,

Dan

Reflecting back on our recent economic history bring to my mind a two sad surprises.

Even as a behavioral economist who generally believes in the prevalence of irrationality in our every day life, I place some stock in the main mechanism that should have maintained the efficiency of the financial markets: competition. In principle, the drive for competition among individuals, banks, and financial institutions should get the actors in the market to do the right thing for their clients as they fight to outdo their competition. After the Wall Street fiasco, I expected and hoped that in the spirit of competition some financial institutions would change their way given the new information about the risks they were talking and self-impose restrictions on themselves. I did not expect that they would do so because they were benevolent, but because they wanted to get the business of those who have lost trust in the financial institutions.

Surprise one: Sadly, the forces of competition do not seem to have any effect on the functioning of our financial institutions and Wall Street seems to be back to is pre-fiasco structure.

We are now discussing the possibility of health care reform, which arguably is even more messed up than our financial institutions (about 18 percent of GDP, bad incentives, bad intuitions, and the leading cause for bankruptcy before the current housing problem). When I look at the health care debate, it seems to be fueled by ideological beliefs about the importance of competition and freedom of choice on one hand, and the evilness of regulations and limits on the other. As someone who loves data beyond theories, it is surprising to me how little we know about the effectiveness of different versions of health care, and how sure people are in their own beliefs — which makes it an ideological and not a very useful debate (this is just a small surprise).

But what is the most surprising to me is that the tremendously expensive lessons we have experienced about the efficiency of markets and self interest do not seem to carry to the health care debate. As a society, we still seem to be enamored with the ideology of free markets, and have not seemed to update our beliefs in their efficiency despite the evidence. On the bright side, it looks like behavioral economists will have a lot of work for the foreseeable future.

Before the financial crisis of 2008, it was rather difficult to convince people that we all might have irrational tendencies.

For example, after I gave a presentation at a conference, a fellow I’ll call Mr. Logic (a composite of many people I have debated with over the years) buttonholed me. “I enjoy hearing about all the different kinds of small-scale irrationalities that you demonstrate in your experiments,” he told me, handing me his card. “They’re quite interesting-great stories for cocktail parties.” He paused. “But you don’t understand how things work in the real world. Clearly, when it comes to making important decisions, all of these irrationalities disappear, because when it truly matters, people think carefully about their options before they act. And certainly when it comes to the stock market, where the decisions are critically important, all these irrationalities go away and rationality prevails.”

Given these kinds of responses, I was often left scratching my head, wondering why so many smart people are convinced that irrationality disappears when it comes to important decisions about money. Why do they assume that institutions, competition, and market mechanisms can inoculate us against mistakes? If competition was sufficient to overcome irrationality, wouldn’t that eliminate brawls in sporting competitions, or the irrational self-destructive behaviors of professional athletes? What is it about circumstances involving money and competition that might make people more rational? Do the defenders of rationality believe that we have different brain mechanisms for making small versus large decisions and yet another yet another for dealing with the stock market? Or do they simply have a bone-deep belief that the invisible hand and the wisdom of the markets guarantee optimal behavior under all conditions?

As a social scientist, I’m not sure which model describing human behavior in markets-rational economics, behavioral economics, or something else-is best, and I wish we could set up a series of experiments to figure this out. Unfortunately, since it is basically impossible to do any real experiments with the stock market, I’ve been left befuddled by the deep conviction in the rationality of the market. And I’ve wondered if we really want to build our financial institutions, our legal system, and our policies on such a foundation.

As I was asking myself these questions, something very big happened. Soon after Predictably Irrational was published, in early 2008, the financial world blew to smithereens, like something in a science fiction movie. Alan Greenspan, the formerly much-worshipped chairman of the Federal Reserve, told Congress in October 2008 that he was “shocked” (shocked!) that the markets did not work as anticipated, or automatically self-correct as they were supposed to. He said he made a mistake in assuming that the self-interest of organizations, specifically banks and others, was such that they were capable of protecting their own shareholders. For my part, I was shocked that Greenspan, one of the tireless advocates of deregulation and a true believer in letting market forces have their way, would publicly admit that his assumptions about the rationality of markets were wrong. A few months before this confession, I could never have imagined that Greenspan would utter such a statement. Aside from feeling vindicated, I also felt that Greenspan’s confession was an important step forward. After all, they say that the first step toward recovery is admitting you have a problem.

Still, the terrible loss of homes and jobs has been a very high price to pay for learning that we might not be as rational as Greenspan and other traditional economists had thought. What we’ve learned is that relying on standard economic theory alone as a guiding principle for building markets and institutions might, in fact, be dangerous. It has become tragically clear that the mistakes we all make are not at all random, but part and parcel of the human condition. Worse, our mistakes of judgment can aggregate in the market, sparking a scenario in which, much like an earthquake, no one has any idea what is happening. All of a sudden, it looked as if some people were beginning to understand that the study of small-scale mistakes was not just a source for amusing dinner-table anecdotes. I felt both exonerated and relieved.

While this is a very depressing time for the economy as a whole, and for all of us individually, the turnabout on Greenspan’s part has created new opportunities for behavioral economics, and for those willing to learn and alter the way they think and behave. From crisis comes opportunity, and perhaps this tragedy will cause us to finally accommodate new ideas, and-I hope-begin to rebuild.

Paul Krugman published an op-ed yesterday about exec salaries.

The very sad conclusion he comes to is that because the financial markets seem to be on an improving trajectory (although it is hard to know if this reflects a real improvements in the economy yet) the push to reform the banks could die off.  As Krugman puts it: “In 2008, overpaid bankers taking big risks with other people’s money
brought the world economy to its knees. The last thing we need is to
give them a chance to do it all over again.”

We are now in a unique point in time where we just realized the mess we got ourselves into by assuming that the markets will be perfectly rational — and I sure hope we are not going to forget this painful lesson just because the market seem to be slightly higher these days.  In fact, I suspect that what we need to do is take this lesson to heart and expand our search for other markets that are just waiting for similar disasters (and the health market looks to me to be heading is similar direction..)

Adam Smith first coined the term “The Invisible Hand” in his important book “The Wealth of Nations.” With this term he was trying to capture the idea that the marketplace would be self-regulating.  The basic principle of the invisible hand is that though we may be unaware of it, an unseen hand is constantly prodding us along to act in line with what’s best for the whole economy. This means that when this invisible hand exists, when we all pursue our own interest, we end up promoting the public good, and often more effectively than if we had actually and directly intended to do so.  This is a beautiful idea, but the question of course is how closely it represents reality.

In 2008, a massive earthquake reduced the financial world to rubble. Standing in the smoke and ash, Alan Greenspan, the former chairman of the Federal Reserve Bank once hailed as “the greatest banker who ever lived,” confessed to Congress that he was “shocked” that the markets did not operate according to his lifelong expectations. He had “made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders.”
We are now paying a terrible price for our unblinking faith in the power of the invisible hand.

In my mind this experience has taught us that Adam Smith ‘s version of invisible hand does not exist, but that a different version of the invisible hand that is very real, very active, and very dangerous if we don’t learn to recognize it. Perhaps a more accurate description of the invisible hand is that it represents human irrationality. In terms of irrationality the hand that guides our behavior is clearly invisible — after all recent events have demonstrated that we are largely blinded to the ways rationality plays in our lives and our institutions.  Moreover it is also clear that irrationality does shape our behavior in many ways, pushing and prodding us along a path can lead to destruction. Whether we’re procrastinating on our medical check-ups, letting our emotions get the best of us, or letting conflicts of interest and short term time horizon ruin the financial market, irrationality is certainly involved.

In Adam Smith’s world the invisible hand was a wonderful force, and the fact it was invisible made no difference whatsoever. The irrational invisible hand is a different story altogether – here we must identify the ways in which irrationality plays tricks on us and make the invisible hand visible!

Sometimes asking someone to do something for nothing is more powerful than paying them.

In a research paper entitled “Effort for Payment: A Tale of Two Markets,” James Heyman and I that people are willing to help move a couch or perform an experiment just by being asked. Moreover, these individuals feel good about their “gift”. Most interestingly, the experiments show that contrary to standard economic theory, paying a small incremental incentive does not increase effort, but actually lowers it — because meager compensation profanes the gift effect and disincents the giver.

Bringing money into the relationship takes the giver’s work out of “gift” market, and brings it into the “pay-for-effort” market. When it was done for nothing, the protagonist was a “donor.” When small money was on the table, he or she became an underpaid employee. The easiest way to think about this is to imagine if at the end of Thanksgiving dinner you asked your mother-in-law how much you owed her for cooking such a wonderful meal. Would that increase or decrease her effort the next time you came by? (Assuming, of course, she would still invite back you after such an insult.)

In this financial crisis, there has been much discussion about banker’s pay. We think that if President Obama had asked for a group of bankers to take $0, and paid expenses only, it would have brought the discussion back into the gift economy. $500,000 is just low enough to bruise the banker’s egos (after all, they got used to much higher salaries for a long time, higher salaries we can be pretty certain they feel they deserved), but $0 is something to be proud of! In fact, paying these CEOs nothing might remind them about the responsibility they have to the banks they are leading and to the rest of society. The CEO of AIG Ed Liddy is already only taking a one-dollar salary and donating his time to this worthy effort. But his gift is isolated, a drop in the bucket — not part of an overall “corps” of senior financial executives acting in unison to help fix the mess.

Would the best people be willing to work for free? Not all capable bankers could afford it, but many could. We think there would be many willing to pitch in…if asked in the right way. After all, this gift idea was at the core of John F. Kennedy’s brilliant notion, “Ask not what your country can do for you — ask what you can do for your country.” By eliminating pay altogether, these leaders would be giving the nation the donation of their time and skill, improving their level of motivation. Instead of accusing them of being greedy and self interested, people could see them as important actors playing key roles in the stability of our entire economy. This in turn would probably encourage more bankers to see the power of a collective gift and the joy they could feel in donating something so important.

As it stands now, the many good people who are trying to improve things for little or no pay are isolated, their effort drowned out by the outrage over bonuses and salaries. Hence we have the Congress and President involved in legislating the level of executive compensation all the way down to its structure and timing! Congress should not be mired in the details of compensation design. Not only are they bad at it, but the beleaguered public — whose median household income is less than 1/10th of $500,000 — is watching the pay ping pong with collective disgust. The knee-jerk reaction to create a confiscatory 90% tax on the AIG bonuses makes the conservatives among us think we are killing capitalism itself.

When individuals commit acts of personal generosity, it sparks a gift culture that replenishes a store of trust — a resource as multiplicative as any Keynesian monetary policy. This sharing is not done in a communist, carving-up-the-spoils manner, but rather in the tradition of bravery and sacrifice for our collective benefit. When those in power act within a gift culture guided by a spirit of generosity for common cause, it creates a tangible trust asset that supports the flow of credit, money, and markets. By focusing on limiting executive pay, President Obama did the political equivalent of asking his mother-in-law how much he owed her for Thanksgiving dinner — and moved the discussion away from social responsibility, and into the pay-for-effort market, where the negotiations for spoils now dominate the discourse.

We think our bold young President has to improve his request. A gift culture — created at the top — will benefit all of us; and, strangely, will also help strengthen the rapacious markets where self-interest reigns supreme. The good news is, it’s not too late.

By John Sviokla and Dan Ariely

The first chapter of the Bernie Madoff fiasco has come to a close, with Madoff pleading guilty to 11 charges of fraud yesterday.

Madoff’s massive Ponzi scheme was horrific on many levels. But while we watch the next phase of the scandal, it’s important to ask: What lessons are we going to learn from this? I can see three lessons that relate to my work studying human irrationality — and in particular, some non-useful lessons we might learn.

One lesson that individuals and foundations are likely to take from the Madoff scandal is that in addition to diversifying their portfolio across several investments (stock, bonds, equity, cash), they also need to diversify their investments among several advisors. While the idea of diversifying among advisors has some merit — and it could reduce the exposure risk of another Madoff scandal — it will also make the task of managing portfolios much more difficult and much less efficient. Imagine that you have $1,000,000, split among four advisors. You will need a whole new level of coordination among them so they can have the right amount of cash, bonds, stocks etc., across all of your assets.

And I think that people will begin to over-diversify across investors. Why? Because when we have one large and salient instance in our minds, it can be so powerful that we overemphasize it. This same effect is very apparent in what we call “the identifiable victim effect,” and it is the reason that we overemphasize the risks of a shark attack, and underestimate the risks of riding a bike without a helmet. In general, what we find when there’s one single vivid event is that people overweight it — we focus on it too much. So that’s the first lesson: We’re going to learn from the Madoff scandal, but we are going to overdo it.

Another non-useful lesson that I think we will adopt is to start searching with more vigor for other bad apples. On one hand, it is clearly important to prevent more Madoffs, but at the same time I worry that as a consequence of searching for bad apples, we won’t pay enough attention to other financial behavior that might not be as badly wrong but that can actually have larger financial consequences.

In our research on dishonesty, we found that when we give people the opportunity to cheat, many of them cheat by a little bit, while very few cheat by a lot. In our experiments, we lost about $100 to the few people who cheated a lot — but lost thousands of dollars to the many people who each cheated by a bit. I suspect that this is a good reflection of cheating in the stock market, where the real financial cost of the egregious cheating by Madoff is actually a tiny fraction of all the “small” cheating carried out by “good” bankers.

The risk here is that if we pay too much attention to chasing bad apples, we might pay too little attention to the situations where the small dishonesties of many people can have large consequences (such as paying slightly higher salaries to cronies, making small changes to financial reports, doctoring documents, being slightly dishonest about mortgage terms), and in the process neglect the real economic source of the trouble we are in.

A third bad lesson that I think people will take from this concerns the way we define acceptable levels of cheating. In a study that may parallel Madoff’s egregious dishonesty, we again gave the participants the opportunity to cheat, while solving a puzzle quiz — but this time we hired an actor. This actor, posing as a fellow participant, stood up at the start of the session and declared that he had solved all the puzzles. Now the question is how his behavior would influence the other participants in the room — the ones who were watching him.

What we found is that when the actor wore a plain T-shirt, which made him part of the student group, cheating increased. On the other hand, when the actor wore a T-shirt of the rivaling university, cheating decreased. What this means is that when someone who is part of our own social group cheats, we find it more acceptable to cheat, but when people who are not part of our social group cheat, we want to distance ourselves from these people and cheat less.

Madoff was part of the financial elite — part of an in-group of our financial leaders. Think of all these people who were in his house, who knew him well. So now, when other people in this circle see him cheating, think about the long-term consequences: Would these other people in this financial industry now be more likely to take the immoral path? It doesn’t have to be another Ponzi scheme. It just means that, now that they have been exposed to this extreme level of dishonesty, they might adopt slightly lower moral scruples. Maybe they will start not letting their clients know exactly what they own and what they don’t own, or change a little bit the interest rate that they’re charging them … I don’t think that those in his circle will necessarily become more Madoff-like people, but I do suspect that they will get a substantial relief from their moral shackles. Sadly, that’s his legacy.

So, Chapter One of the Madoff scandal is over, but I worry that the negative downstream consequences of this experience are just starting …

In case you live in NY and have nothing to do on 3/16 at 6-8 PM

I am going to give a short talk on the stock market from the perspective of behavioral economics — on the floor of the NY Stock Exchange

This is hosted by George Washington University, but everyone is invited and there is going to be some free food — so if you have nothing better to do ….

http://www.alumniconnections.com/olc/pub/GEW/events_luther/event_order.cgi?tmpl=events&event=2220180.0

Irrationally yours

Dan

Have a look at this!  it is a rather nice account of the credit crisis

In a story that just appeared in The Atlantic, Gregory Clark, a professor of economics at the University of California at Davis, described some of his concerns with the profession of Academic Economists.
In this story he also used a paper on online dating (one of mine) to show how economists are working on irrelevant topics.  And while I think that the dating market is an important topic to study, and even more to try and improve, I think that his overall criticism is worth paying attention to.

Here is the text:

Dismal scientists: how the crash is reshaping economics
With the chattering classes consumed by concern for the devastated value of their 401K funds, and their suddenly precarious lifestyles, there has been much anger and scorn directed at those former masters of the universe, financiers.

But the shock to the world of finance has been echoed by a shock to the world of academic economics that is just as profound.

In the long post WWII boom, as free market ideology triumphed, economists have won for themselves a privileged place inside academia.

First there is the cash. It astonished some when Washington University, a school with an economics department of modest prestige, hired economists David Levine and Michele Boldrin by offering salaries well in excess of $500,000.  But most high ranked economics departments have professors earning in excess of $300,000.  Not much by the pornographic standards of finance, but a fat paycheck compared to your average English or Physics professor.

It is not just the stars.  Journeyman assistant professors in economics routinely come in at $100,000 or more. And, unlike the hard sciences, they do this fresh from their PhDs, without a publication to their name and without years of low pay as post-docs.

The high salaries have been accompanied by dramatic declines in the teaching burden.  The research demands of our advanced science leave little time for the classroom.  In good universities faculty typically teach only two courses a year – one of which has to be a graduate seminar.  The masses in the Econ 1 classes are often abandoned to the tender mercies of graduate students.

Then there is the economics “Nobel” Prize.  Not a real Nobel, but a prize funded by the Bank of Sweden in honor of Alfred Nobel, with all the royal trappings of the Nobel.  That makes economics star players really attractive to universities.  When Edward Prescott of Arizona State won the Nobel he was paraded at half time at a football game.  There is nothing like a Nobel for luster and fund-raising.

Why did academic economics generate so much prestige? Sure, modern economics is technically demanding.  But so, for example, are theoretical physics and archeology, and physics and archeology professors are (relatively) dirt poor.

The technical demands helped limit the supply of economists. But what drove demand was the unquenchable thirst for economists by banks, government agencies, and business schools – the Feds, the Treasury, the IMF, the World Bank, the ECB.  Economics had powerful insights to offer the world, insights worth a lot of treasure.  Economics was powerful voodoo.  Any major university or research institute wanted to arm itself with this potency.

The current recession has revealed the weaknesses in the structures of modern capitalism.  But it also revealed as useless the mathematical contortions of academic economics.  There is no totemic power.  This for two reasons:

(1) Almost no-one predicted the world wide downtown.  Academic economists were confident that episodes like the Great Depression had been confined to the dust bins of history.  There was indeed much recent debate about the sources of “The Great Moderation” in modern economies, the declining significance of business cycles.

Indeed as we have seen this year on the academic job market, macroeconomists had turned their considerable talents to a bizarre variety of rococo academic elaborations.  With nothing of importance to explain, why not turn to the mysteries of online dating, for example.

I myself was so confident of the consensus of the end of the business cycle that I persuaded by wife after the collapse of Lehman Brothers to invest all her retirement savings in the stock market, confident that the Fed would soon make things right and we could profit from the panic of a gullible public.  The line “Where is my money, idiot?” is her’s.

(2) The debate about the bank bailout, and the stimulus package, has all revolved around issues that are entirely at the level of Econ 1.  What is the multiplier from government spending?  Does government spending crowd out private spending?  How quickly can you increase government spending? If you got a A in college in Econ 1 you are an expert in this debate: fully an equal of Summers and Geithner.

The bailout debate has also been conducted in terms that would be quite familiar to economists in the 1920s and 1930s.  There has essentially been no advance in our knowledge in 80 years.

It has seen people like Brad De Long accuse distinguished macro-economists like Eugene Fama and John Cochrane of the University of Chicago of at least one “elementary, freshman mistake.”

It has seen Treasury Secretary Timothy Geithner, guided by Larry Summers, one of the most respected economists of our time, produce a bailout plan for the US financial system stunning in its faltering vagueness.

Bizarrely, suddenly everyone is interested in economics, but most academic economists are ill-equipped to address these issues.

Recently a group of economists affiliated with the Cato Institute ran an ad in the New York Times opposing the Obama’s stimulus plan.  As chair of my department I tried to arrange a public debate between one of the signatories and a proponent of fiscal stimulus — thinking that would be a timely and lively session.  But the signatory, a fully accredited university macroeconomist, declined the opportunity for public defense of his position on the grounds that “all I know on this issue I got from Greg Mankiw’s blog — I really am not equipped to debate this with anyone.”

Academic economics will no doubt survive this shock to its prestige.

Will we be as well paid?  A recent article in the Wall Street Journal suggests the days of the $500,000 economics professor may have passed.

But more importantly, will the focus of academic economics change?  That is hard to tell.  But I would rate the chances of Chrysler producing once again a competitive US automobile at least as high as the chances of academic economics learning any lesson from this downturn.  (What was the price of that Chrysler stock we bought, dear?)