Liveblogging World War II: October 30, 1940
Kevin O'Rourke Says: Here Comes the European Double-Dip...

A Response to Justin Fox...

Earlier this month, I wrote "It Does Not Seem to Me That Charles Ferguson Has Gotten It Right..." in response to Charles Ferguson's attempted take-down of Larry Summers because--well, because it did not seem to me that Charles Ferguson had gotten it right.

Now Justin Fox joins the conversation, and I believe that I am the "strangely touchy economist" whom Justin refers to in this:

Economists respond to incentives: Here’s my short take, following on Barbara’s post Wednesday, on economists:

  1. The single most valuable and durable lesson of economics is that incentives matter. Monetary incentives don’t always matter more than other motivations, and sometimes people’s behavior regarding money is a little nutty. But as an organizing principle for a social science, incentives matter is pretty good.

  2. Economists respond to incentives, too. Real and potential financial awards affect what they choose to study, how they go about it, and what conclusions they draw. This doesn’t mean all economists are evil sellouts. It means they’re human beings.

  3. For people who purport to believe that incentives matter, economists can be strangely touchy when anyone brings up point No. 2.

So since I am the strangely touchy economist here, let me reiterate my points.

When Charles Ferguson writes:

Summers rose up from the audience and attacked [Raghu Rajan], calling him a "Luddite," dismissing his concerns, and warning that increased regulation would reduce the productivity of the financial sector...

he has gotten the mood and some of the substance of the discussion wrong.

I know.

I was there--not only for the formal session recorded in the transcript, but for the patio-coffee and the lunchtime and dinnertime conversations that followed.

Larry did not "dismiss" Raghu concerns. He said that in a modern economy with sophisticated financial markets we were likely to have more and bigger financial crises than we had before, just as the worst modern transportation accidents are worse than the worst transportation accidents back in horse-and-buggy days. He said that Raghu's "paper is right to warn us of the possibility of positive feedback and the dangers that it can bring about in financial markets." Indeed, for twenty years one of Larry's conversation openers has been: "You really should write something else good on positive-feedback trading and its dangers for financial markets."

What he complained about was that he thought Raghu was setting forth the wrong cures for the disease. Raghu suggested the job could be done by (a) reform of compensation schemes to give financiers not just skin in the game but vital organs in the game, and (b) by viewing financial innovation with grave suspicion. Larry pointed out that (a) hobbling financial innovation does have serious costs as well, (b) plain-vanilla banking systems do not seem to be any less vulnerable to getting wedged through financial crisis, (c) the LTCM crisis is just the latest episode telling us that reforming financial compensation won't do the job because more often the problems are overleveraged institution or herd groupthink, and (d) transparency and exchanges so that people know what each other's positions are is a better road to pursue.

If you think that the published comment or Larry's other remarks represent a "dismissal" of Raghu's concerns, you do not understand what the word "dismiss" means.

And if you think that Larry pulled his punches in August 2005 on the importance of reforming compensation schemes because fourteen months later he was going to take a job at the hedge fund of D.E. Shaw, you attribute an extraordinarily degree of precognition--back in August 2005 I thought Larry had weathered the storms at Harvard and would be president until 2010 or so.