The Madoff Problem

Bernard Madoff will plead guilty, sparing the nation the soap opera drama of a trial. But while the Madoff story has gotten a lot of coverage, I think the broader Madoff problem in the economy has gotten very little attention. A complicated modern economy operates largely on issues of branding and trust. You don’t personally verify what’s in the can labeled “Diet Coke,” you assume that the Coca Cola company puts more value on maintaining its brand and the consistency of its product than it would put on the possibility of earning fifty cents by selling you a bum can of soda. People assume that a well-regarded investment manager isn’t ripping his clients off. But Madoff was ripping his clients off. And it seems that Allen Stanford is also a fraud.

I think a typical agent with bounded rationality and the capacity for heuristic reasoning needs to rethink a lot of things in light of these events. For one thing, where there are two crooks there are likely to be more. For another thing, the regulatory agencies charged with monitoring such matters don’t seem to have done a very good job. For a third thing, the financial press doesn’t seem capable of breaking major news stories. And for a fourth thing, it’s generally the case that where there are illegal scams, there’s other behavior that, while not necessarily rising to the level of a criminal fraud, is also basically a scam.

Under the circumstances, is it so surprising that banks are having trouble raising private capital? That nobody wants to invest in anything other than T-bills and FDIC insured accounts? Part of what’s changed is the business outlook, sure. And part of what’s changed is people’s attitude toward risk. But in addition to becoming more risk-averse, I think people have lost confidence that the brands and institutions governing the financial system actually work. Beyond stimulus, beyond bank rescue plans, I think this is another factor the world is going to have to address to get to recovery. In part, that’ll be the responsibility of the Obama administration and the congress. In part, it’ll be the responsibility of foreign governments. But in part it’s the responsibility, I think, of big players in the “real” (i.e., non-financial) economy who have a strong interest in ensuring that some new, credible financial institutions come into being or that existing credible ones grow in size and prominence.