Last Call

Ezra Klein is pretty sharp, but this particular analogy he finds for the financial crisis is terrible.

The problem has been coming up with a mechanism. In his essay for American Interest, however, Tyler Cowen proposes one: The finance sector.

The story of the current run-up in income among the very rich is, Cowen says, basically a story of people involved in the financial sector making a ton of money. And so many of them are making so much money because so many of them are betting the same way at the same time. The way they're betting is "long on volatility," which put more simply means against unexpected things happening.

Cowen gives the example of the Washington Wizards: If you bet every year that the Wizards wouldn't win the championship, you'd pretty much always make money. If everyone bet that way every year, everyone would pretty much always make money. If everyone borrowed lots of money so they could make bigger bets on the Wizards losing every year, they'd make even more money. But if the Wizards then won, everyone would then go bust, and they'd go bust all at the same time, losing lots of borrowed money, and wreaking untold havoc on the economy.

Well, not "untold." That's pretty much what happened in 2007. In this story, one of the things to watch for when we see very high levels of inequality is whether that money is coming from the financial sector. If it is, it probably means there are a lot of people on the same side of a bet. And if there are a lot of people on the same side of a bet, the prospects for a major financial crash are pretty good. Maybe not this year, or the next year. But eventually, even the Wizards win.

Umm, guys...no.  You're completely missing the point.

If this analogy was true, the bookies would have come looking to collect the money from the people who bet on the Wizards to tank because the bookie would now be the richest guy on the planet.  The bookie would then proceed to get his money any way they can.

In other words, the people betting against the Wizards?  There's risk involved if they lose the bet, mainly an angry bookie and his goons kneecapping you.

In the financial crisis, the people betting that the housing market would never, ever drop and the people who borrowed more and more money to leverage bigger and bigger bets in that direction knew that there was no risk because of the sheer number and size of the bets.  The bookie in this case was Uncle Sam.  When all the banks lost that bet (except for Goldman, who won on their hedge) Uncle Sam paid them off anyway because if they didn't, well gosh the economy would have exploded into little pieces.

The bet was made by the banks.  The bookie, Uncle Sam, assumed the risk.  That's where the analogy breaks down, and that's why the financial crisis can't be compared to a bet gone wrong.  the entire betting system was rigged.  Bets assume risk.  There was no risk if the bets were large and leveraged enough.

That's the problem:  moral hazard.  Forgetting that key component to the equation is a major disservice.  The analogy is valid up to a point, but it's really the moral hazard that defined the financial meltdown.