An economist at the movies

Although movies dealing with themes of economics and high finance are common, it is rare to see films with economists cast in starring roles.  This past week I managed to see two.

In Freakonomics: The Movie, the economist is portrayed as hero.  Based on the book of the same name by economist Steven Levitt and journalist Stephen Dubner, Freakonomics showcases the work of Levitt and a number of his co-authors as they apply the toolkit of modern economics to age-old (and not so old) questions, challenge the conventional wisdom, and seek solutions to pressing social problems.

Do people cheat?  Yes, when faced with the right incentives, even those we might ordinarily think of as being honest—schoolteachers and sumo wrestlers, for example—will succumb.

Does you realtor have your interests at heart when she tries to sell your house?  Yes, although after examining the data, Levitt concludes that she is less inclined to fight for that last $10,000 for you than she is for herself.

Can you bribe ninth graders to work harder in school with a “pay for good grades” scheme?  Possibly, although in the film’s last segment, the authors wonder whether their experiment would be more successful if they brought it to a preschool setting.

Freakonomics was an enjoyable movie, which presents an already accessible book in an even more accessible format.  And I was happy to see an economist portrayed as a hero.

Inside Job is a less enjoyable, in the sense that the news is all bad, although very well done film.  In it documentary filmmaker Charles Ferguson presents his version of the origins of the subprime crisis.  And economists don’t come out looking so good.

Ferguson argues that the financial deregulation that began during the Reagan era was the prime culprit behind the subprime crisis.  He points to several key events in the sequence leading to the crisis: (1) Reagan-era deregulation of the savings and loan industry; (2) the passage of the Gramm-Leach-Bliley Act in 1999, which effectively ended the Glass-Steagall Act’s 65 year-old separation of commercial and investment banking; (3) and the decision by the government not to regulate derivatives, such as Collateralized Debt Obligations (CDOs) and Credit Default Swaps (CDSs).

Ferguson is, in fact, correct in concluding that financial deregulation contributed to the subprime crisis, particularly the government’s decision not to regulate the financial derivatives market.  And he is right in noting that the devotion of many economists to the ideal of the free market contributed to the mess.

Of course, Ferguson takes much of the story out of context.  The “financial lockdown” under which finance operated during the years between the Great Depression and 1973 did keep the financial system free from financial crisis.  In fact, the developed world has never—neither before nor after—seen such a prolonged period of financial stability.

However, that lockdown proved to be unsustainable in the wake of the surge in inflation that occurred during the late 1960s and the 1970s.  The strict control of all aspects of banking—including interest rate ceilings—led to severe credit crunches in the late 1960s.  In response, the government began to loosen the constraints on the financial system and, not surprisingly, trouble soon ensued.

By loosening the constraints, it was hoped that the financial system would be able to “earn its way” out of the hole it had dug for itself and save the taxpayer the cost of cleaning up the mess.  This strategy was a politically astute, since taxpayers have a strong aversion to shelling out money for things they perceive as being someone else’s fault.  As economic policy, the strategy was a loser.

Ferguson completely ignores the consequences of irresponsible fiscal and monetary policies undertaken during the administration of George W. Bush and the chairmanship of Alan Greenspan.  On the fiscal side, we began two wars—which entailed a lot of extra spending—and cut taxes at the same time.  On the monetary side, Greenspan’s Fed kept interests rates far below what standard economic models suggest they should have been.

The fiscal and monetary stimulus inflated the housing bubble to dangerous levels.  Certainly, the deregulation of the financial system contributed, in the sense that it removed an important source of restraint.  However, had the incentives to profiteer not been so strongly inflated by reckless fiscal and monetary policies, the bubble would have been less pronounced, and its collapse would have had less severe consequences.

Ferguson’s assertion that the financial industry is out of control rings a little bit false to me.  Financiers, economists, baseball players, and documentary filmmakers are all influenced by incentives (one of the conclusions of Freakonomics).  By artificially pumping up the economy, the incentives for risky behavior reached new heights.  By weakening the regulations that hold such incentives in check, the government bears substantial responsibility for the crisis.

Ferguson also raises concerns that some economists may be influenced by who is paying their consulting fees.  Without accepting Ferguson’s charges against anyone in particular, given that many economists frequently take trips through the revolving door between government, finance, and academe, universities need to establish safeguards to insure that academic work is—and is seen to be—just that.  Of course, that is easier said than done.

These movies show that economists can be cast as either heroes or villains, although most of us are neither.  The subprime crisis serves as a potent reminder to the profession that we still have a lot of work to do.