Romer should know. He and actual economics Nobel laureate George Akerlof published a brilliant analysis of the S&L crisis of the 1980s, titled “Looting: The Economic Underworld of Bankruptcy for Profit” which analyzed how some wealthy executives extracted tremendous sums of money from the S&Ls that they “led” while knowing that their decisions would lead the companies to bankruptcy. Romer and Akerlof conclude:

“If you think of the financial system as a whole,” Mr. Romer said, “it actually has an incentive to trigger the rare occasions in which tens or hundreds of billions of dollars come flowing out of the Treasury.”

What if, instead of being a surprising one time disaster, this outcome was a predictable and routine outcome of our political process? Future economics Nobel laureate Paul Romer explains :

Roberts’ quip (from his excellent article “Gambling with Other People’s Money” ) above explains why Americans across the political spectrum are disgusted. A few hundred individuals in the financial services industry who might otherwise have been worth tens of millions of dollars managed instead to get their hands on hundreds of millions of dollars as they destroyed our financial system. Now we are all suffering higher taxes, higher unemployment, fewer new business starts, tighter capital markets, and lower rates of charitable giving so that a few hundred individuals can buy larger islands and bigger yachts. It is a disgusting sight, inconsistent with all moral codes and political philosophies.

“In this crisis, average Americans have sent hundreds of billions of dollars to some of the richest people in human history.” Russ Roberts

If our best economists knew in 1993, in a widely published article that bankruptcy for profit could occur when government guarantees a firm’s debt obligations, why is it that the U.S. government continue to guarantee debt obligations? Indeed, not only it continued the guarantees, but it expanded them – by means of numerous actions supported by both Democratic and Republican Congressmen expanded the scale of its debt obligations through the deliberate growth of Fannie Mae and Freddie Mac. And note that bankruptcy for profit is merely the most extreme case of moral hazard due to government guarantees; there are plenty of deep moral hazard issues due to government guarantees that could lead to similarly catastrophic outcomes well before we get to the case of outright looters. (See both Roberts and Macroeconomic Resilience, a brilliant anonymous blogger he cites; see the analysis here, here, and here).

Akerlof and Romer ask the key question at the end of their 1993 paper:

“The S&L fiasco in the United States leaves us with the question, why did the government leave itself so exposed to abuse?”

They then get part of the answer right:

“Part of the answer, of course, is that actions taken by the government are the result of the political process. When regulators hid the extent of the true problem with artificial accounting devices, when congressmen pressured regulators to go easy on favored constituents and political donors, when the largest brokerage firms lobbied to protect their ability to funnel brokered deposits to any thrift in the country, when the lobbyists for the savings and loan industry adopted the strategy of postponing action until industry difficulties were so large that general tax revenue would have to be used to address problems instead of revenue raised from taxes on successful firms in the industry-when these and many other actions were taken, people responded rationally to the incentives they faced within the political process.”

If Akerlof and Romer saw so clearly that looting had taken place because “people responded rationally to the incentives they faced within the political process” did they then recommend a dramatic re-evaluation of the political process to prevent a similar financial catastrophe from happening in the future? Unfortunately not; rather than question the political process, they succumbed to wishful thinking:

“The S&L crisis, however, was also caused by misunderstanding. Neither the public nor economists foresaw that the regulations of the 1980s were bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself.”

Here we are, twenty years later, with a much larger and more damaging catastrophe. Although he was not a regulator, David Andrukonis, Freddie Mac’s chief risk officer, warned of the dangers that Freddie Mac was taking on in 2004 with a remarkable level of detail and foresight:

In an interview, Freddie Mac’s former chief risk officer, David A. Andrukonis, recalled telling Mr. Syron in mid-2004 that the company was buying bad loans that “would likely pose an enormous financial and reputational risk to the company and the country.”

– and support for him was so “lukewarm” that he was let go. As Arnold Kling points out, Syron, the Freddie Mac CEO, has close ties to Barney Frank, the relevant committee chairman. Why, exactly, would Akerlof and Romer believe that people like Andrukonis would be treated differently the next time around? Why should any of us believe that future Andrukonis will be treated differently twenty years from now?

Arnold Kling, Russ Roberts, and other economists are pointing to the government guarantees as the essential problem that must be removed in order to prevent a similar recurrence of financial catastrophe. Ron Paul promoted such a policy move in 2003, with remarkable foresight and wisdom: