Karl Whelan also delivered a paper to the McGill summer school. I am not going to try to summarise the paper given that the author regularly posts here but I want to open a couple of aspects to discussion and I acknowledge that this may be selectively focusing on issues from a more general paper that contains some very strong insights.
In particular, I think Karl’s talk leaves wide open the extent of the problems that are emerging from credit decisions made by households and their lenders in the context of a much more open credit market during the last ten years. There seems to be some evidence for Ireland, as Karl notes, that older homeowners did not cash in their housing windfall and this, ex post, is a very lucky thing for them. However, as Karl partly acknowledges, the data currently simply does not exist for us to know the extent to which people have overstretched themselves and the potential second-round consequences this will have if a sizeable group of indebted consumers begin to default as their incomes and job prospects decline. The point made in Karl’s paper about the extent to which asset values of households also improved thus mitigating their indebtedness must be seen now in the light of drastic reductions in the value of housing and arguably many other types of household assets.
Again Karl’s paper does talk about potential problems that might arise: “So, the composition of recent changes in assets and debts likely differed substantially across demographic groups and it is the younger cohorts that are most likely to be in trouble now.” But I think we need to put something much more substantive on this statement. This is not a criticism of the paper as the data doesn’t exist so we cannot have expected Karl to incorporate non-existing information into his paper. Perhaps we can tell the story of the causes of the current decline without this information. But I can’t see how we can even begin to talk about its consequences without knowing the extent to which people have become overextended and the likely behavioural and psychological consequences of this.
Karl makes the point in the paper that we should be careful about second-guessing consumer decisions: “I think people need to be wary of moralistic commentators who warn that economic troubles are caused by greedy and feckless consumers. Most of the time, most of us are making the best decisions we can with the information available.“. But is it not long overdue to have a debate in Ireland about the way that financial products are marketed and the extent to which systemic market distortions can be introduced by poorly informed individuals being sold products that exploit limited ability to understand the risks involved and limited self-control? Are we so sure that this distortion isn’t partly at the heart of what happened during the last ten years, particularly if we observe the investment behaviour of high wealth individuals who, instead of adopting a strategy of a well balanced portfolio with a reasonable cushion against market decline, seem to have rushed headlong into a status competition based on the relative size of their property portfolios that left them all ruined and left the taxpayer with an enormous tab. Many US commentators have come to the conclusion that the lesson from the last 10 years is that the assumptions of informed consumers operating in perfect markets against competitive sellers simply don’t characterise financial markets and should not solely be what drives financial regulation. Is this the lesson also from Ireland?
The last part of my post omits the fact that Karl’s paper makes a number of statements about financial regulation including the paragraph below. In the context of the comments that have come from the post, its worth thinking about this aspect of his paper. The behavioural economics literature is currently attracting enormous attention as it potentially offers a way of improving distortions generated by irrational consumer and investor behaviour. Yet perhaps the lesson from Ireland to take from Karl’s paper is that simple application of existing well-accepted principles of bank lending would have been sufficient to avoid the worst of what is happening. Don’t tear up your textbooks just yet?
“The failures in Irish banking regulation thus did not relate to ﬁnancial innovations or regulatory arbitrage but to a failure to enforce the Basle recommendations about supervisory oversight of credit concentration risk. With the widespread belief that the housing market was heading for a soft landing, insufﬁcient attention was paid to the extreme concentration of property development risk that could cause huge losses. And since the development loans that are causing the most problems for the banks are the substantial quantity that were lent out during the ﬁnal years of the boom, an intervention even as late as 2005 to cool development lending could have prevented the upcoming meltdown. Given the likely cost to the Irish taxpayer stemming from the banking crisis, we can only hope that the simplicity of this lesson isn’t lost amid the various complicated debates in the coming years about principles-versus-rules and regulating complex instruments.”