Note: This article is a companion to an essay in Search that was excerpted from Shermer's recent book The Mind of the Market. For the excerpt, click here.
I wrote the excerpt before the financial crisis struck, so we must consider the moral aspects of what happened. There are many causes, but I want to focus on one related to behavioral economics and risk aversion. Research shows that on average most people will reject the prospect of a fifty-fifty probability of gaining or losing money unless the amount to be gained is at least double the amount to be lost. That losses hurt twice as much as gains feel good has now been observed in fMRI brain scans.
Since corporations and financial institutions are run by people, they should show normal risk aversion with money and loans. Normally they do, but over the past decade something happened to remove or delay risk: a combination of government intervention into the financial marketplace and private repackaging and selling of loans to organizations too distant from the risk to feel averse to potential losses. It began in the spring of 1999 with a pilot program launched by Fannie Mae and Freddie Mac, which are largely government-run organizations that do not make loans directly to customers—they buy loans from banks who make those loans. Already the risk was removed a step from the brains of risk assessors, but risk aversion was further attenuated by government interference with the pricing mechanism that normally adjusts for risk.
In that pilot program, the nation’s largest underwriter of home mortgages came under pressure from President Clinton in his drive to achieve an “ownership society,” along with insistence from the Department of Housing and Urban Development that Fannie and Freddie increase their portfolio of loans made to lower and moderate-income borrowers from 44 percent to 50 percent by 2001. That meant granting loans to higher risk customers.
There’s nothing wrong with corporations taking higher risks, as long as they adjust by charging more. The higher price acts as a risk signal to both buyers and sellers, triggering a loss-aversion emotion. This is what Fannie Mae was doing by only purchasing loans that banks made charging three to four percentage points higher than conventional loans. But under the new program in 1999, higher-risk borrowers with lower incomes, negligible savings, and poor credit ratings qualified for mortgages only one point above conventional thirty-year fixed-rate mortgages. The normal risk signal sent to high risk consumers—you can have the loan but it’s going to cost you—was removed. Lower the risk signal and you lower risk aversion.
The result is what we have today. And the economic recovery package will only make matters worse regarding risk aversion, because it signals to the marketplace that if the system fails, the government will bail it out, just as it did when it rescued the savings and loan industry in the 1980s. The solution: laissez faire! The government should not be in the business of deciding what risks corporations should take. By doing so it confounds the normal risk signals that keep the market in balance. People and corporations have to be able to fail in order for risk aversion to operate.
Michael Shermer is the founding publisher of Skeptic magazine, the executive director of the Skeptics Society, a monthly columnist for Scientific American, and an adjunct professor of economics at Claremont Graduate University. His latest book is The Mind of the Market, on evolutionary economics.
