Alas, even elephants cannot fix all of the country’s troubles. An economic policy to designed to stimulate job growth is more important now then ever before but it cannot, nor would it be meant to address the challenges that led to the financial crisis. It would address the resulting eight to nine million U.S. jobs lost during that period but not the cause. The trouble is Dodd-Frank does not either. The spirit of the Act was to identify systemically important institutions, prevent their failure and create a roadmap should they fail. It was also meant to protect consumers from abusive or predatory lending practices. But critics charge that the act fails to accomplish several of these initiatives. Right, left, conservative or liberal, socialist or die-hard free market capitalists, these critics point to the fact the act fails to break up such institutions.
In an interview with Professor Roy Smith, Kenneth Langone Professor of Entrepreneurship and Finance and Professor of International Business at New York University, we discussed his views on what led to the crisis and how the legislation addresses or fails to address these issues. A professor at NYU since 1987, Smith has a way of looking outside the box on these issues.
Smith proposes an alternative, though hardly radical view to how we got into this mess. Instead, he proposes what I’d call a theory of hyper-rationalism or herd-behavior idiocracy. One or the other. In 2006, Rob Zombie released his third album, “Educated Horses.” What does the phrase mean? According to the great American rocker, it was just a term his family, involved in the circus and carnival industry, used to describe trained animals. In this context, it means the distortion of the Adam Smith’s economic principle of “laissez faire.” Turns out what is directly best for the individual is not always best for society. A quick note on the behavior of the equine species. They are flight animals. When they see a predator, they run. Can a herd of half-ton animals take on a half a dozen wolves in a fair fight? Probably but that is not how they operate. Rather than risk sustaining life-threatening injury for the good of the herd, they run. The weakest link gets devoured. It is competition at in its raw form.
Markets are just as competitive. Smith explains the finance industry is performance based. Individuals are generally paid on an incentive or commission basis and failure to perform means not getting paid or losing their job. So when a good idea comes along, like asset-backed-securities, comes along investors jump on it. There is nothing inherently evil about an ABS. It’s a great idea and theoretically should have been safe. In fact, the fundamental flaw with these securities is they were a great idea. The demand for such securities was huge. Pension and retirement funds demanded these securities in droves, as they appeared reasonably safe. “When they saw this demand for securities, they moved heaven and earth to supply it,” Smith said of the packagers of such products. And it got people into houses by allowing banks to get the mortgage they sold off their books, freeing up their capital. Only later did investors start to realize there were toxic assets in the water supply. That is bound to scare people but the bubble would have burst anyway. Actual income doesn’t rise quick enough to support infinitely increasing home prices. The rapidly increasing housing bubble behind these securities couldn’t be sustained, Smith explains. But with historically easy credit, it made sense to jump into the housing market to save on interest low interest rates. The bottom line—too much competition or too many people doing what made sense. That is after all, how bubbles are created. But in a competitive market, the opposite holds true. When it appears the risk will outweigh the gain, we run, which drops prices. The last one out gets eaten, at least in a financial sense.
The housing market, as ingrained as it is into our personal and financial lives is both a great place to invest and a bad place to get it wrong. Cranford-based make-up artist Sally Duvall told me in an interview on Friday for a business profile on her new store, an organic beauty shop, she chose to shift her business focus from New York to New Jersey because three kids was more than she wanted to raise in an apartment. People move for reasons other than investment. While that is nothing new, the question is how do we legislate against the use of rationality in the free market?
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