On Emulation

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I’ve been thinking about bank regulation recently, so I’ve been reading a lot of Edward J. Kane. Kane, who earned a PhD from the Massachusetts Institute of Technology in 1960, is today professor of management at the Carroll School of Management at Boston College.  For decades he has been among the most persistent critics of the banking industry. Given how much money banks have to spend on purchasing political influence – lobbying regulators, hiring them, going over their heads to legislators – regulatory capture is inevitable, he says.

And in “Unmet Duties in Managing Financial Safety Nets,” Kane states with unusual clarity one side of the argument about what happened in 2007-08:

First, procedures adopted at private firms and federal agencies for supervising securitization activity at commercial banks, investment banks, and government-sponsored enterprises inappropriately shortcut due diligence by outsourcing the monitoring and policing of the safety-net consequences of potential defects in the securitization process to private parties.

Second, when the adverse consequences of this imprudent arrangement emerged, officials falsely claimed that the difficulties that short-funded, highly leveraged firms were facing in rolling over debt reflected a shortage of market liquidity rather than a shortage of economic capital at key firms. Among knowledgeable parties, this raised severe doubts about the integrity and competence of the officials in charge of rescuing the industry.

Finally, the panicky way that the Treasury and President re-characterized the nature and extent of the industry’s accumulated losses in September 2008 created an extreme urgency that subsequent delays in implementation revealed to have been dangerously exaggerated. That authorities and financiers callously violated common-law duties of loyalty, competence, and care they owe taxpayers is a massive incentive breakdown in industry and government.

Kane is right about most of this, I think, though he leaves out whatever considerations  are exculpatory.  It will be the work of many years to build out the narrative and clarify the question of how best to redesign the markets for financial intermediation. But it was Kane’s memorial essay on his teacher, “Charles P. Kindleberger: Impressionist in a Minimalist World,” in the Atlantic Economic Journal, that snapped my head around when I read it last month. It called to mind a principle that I think has important applications in the present day.

I don’t mean Kindleberger’s Law of Alternatives, though I was certainly happy to be reminded of it.  Kane recalls how he heard its classic formulation during his first year in graduate school:  the answer to every sensible either-or question that can be formulated in economics is “Both.” Was the problem solvency or liquidity?  Raise taxes or cut spending?

No, it was the Principle of Emulation that I thought might turn out to be especially important in the present day. Kindleberger believed that emulation was one of the most powerful forces in social life, and so did Adam Smith. The Theory of Moral Sentiments places it near the center of Smith’s analysis. By observing the response of those around us to various forms of conduct, Smith wrote, we learn “general rules of what is fit and proper either to be done or to be avoided.”

Kane emphasizes the emulation of opportunism that drives promoters to create bubbles.   Kindleberger himself wrote that, he notes.  And in his “Impressionist in a Minimalist World” paper, Kane sets out to show that rogues not only play a critical part in all bubbles, but that they are at work at other times, as well.

This is surely true – as far as it goes.  But I know from frequent conversations with him that Kindleberger (1910-2003) thought that emulation was a powerful force for good in the world, too. He had worked for Gen. George C. Marshall and many others involved in the reconstruction of European economies after World War Two, and he believed that emulation of good character was an even more important force. As Kane writes of Kindleberger,

He was a man of such admirable moral standards that he preferred to think that rigorous recruitment procedures assured that the standards of most top corporate and government officials were equally high.  On many occasions, both in conversation and in correspondence, Charlie advised me that he found it aesthetically unpleasant to place lying and other dishonorable activities—as I am wont to do—at the epicenter of models of corporate and (especially) government behavior.

During my student days, my fascination with incentives for tax and regulatory avoidance and my insistence that traders in forward markets possess a potentially valuable option to renege led him to wonder how I could possess such a devilish mindset.  About a year before he died, the two of us finally agreed on the compromise proposition that—at least in recent years (though not necessarily in other trying times)—legal and cultural controls against faithless managerial, regulatory, and trader behavior seem to have lost a great deal of incentive force.

Right again.  And the recent crisis and its dreary fiscal dénouement would seem to have vindicated Kane’s cynicism once and for all. James Stewart, whom The New York Times hired last week to write a column on its business page, builds out a similar argument in a new book, Tangled Webs:  How False Statements are Undermining America, from Martha Stewart to Bernie Madoff. A veteran financial reporter, Stewart wrote Den of Thieves, about the insider-trading scandal of the1980s, nearly twenty years ago. It was recently re-issued with a new introduction.

Yet these things do change, and sometimes the change begins before a cataclysm forces the issue. (I have been reading Eric Foner’s Pulitzer Prize-winning The Fiery Trial: Abraham Lincoln and American Slavery. It is striking how well-prepared was Lincoln to lead the North by a prior decade of politics.)  I cannot pretend to any disinterest here. I have touted Barack Obama since early in his presidential campaign.

But more than ever it strikes me that Obama’s persistent appeal to the high ground is the most important development in American politics since Ronald Reagan began his crusade against government more than forty years ago. I know his opponents – Charles Krauthammer or the editorial page of The Wall Street Journal – experience this as demagoguery.  But perhaps this is mainly because they are on the losing ends of several arguments – the nature of the mixed economy, the necessity of governmental supervision of health care, the consequences of greenhouse gas emissions, to name only the most obvious.

Obama’s refusal to demonize his opponents makes it harder for the rogues to rise. His continuing demonstration of good character, seemingly peripheral but instead a surprisingly puissant force, is, as much as anything, the mechanism on which rests the United States’ hopes for a successful outcome of an epic twenty-first century test.