Is moral hazard easier to hide when the risk-premium is low?

It is easy to be angry and blame the "fiendish monsters" on Wall Street for the financial crisis and the broad economic downturn. It might even be easy to blame the financial geniuses, the founders of modern asset pricing theory and Long Term Capital Management--you know, Merton, Scholes, Engle, and the legion of financial economists and econometricians that used their ideas and extended their tools to develop and price an exploding array of financial derivatives.

This blame comes too easy. While it is easy to blame, it's much harder to fully understand.

I do not believe the root cause of this crisis was deliberate fiendishness or obvious stupidity. I expect there were few Madoffs on Wall Street. The question is what facilitated opportunities for the explosion of derivatives trading and Madoff types. Why were so many very smart people fooled into this frenzy?

An instinct of mine is that a lot of it has to do the with the large equity premium, the puzzle that Merha and Prescott discovered and no one has been able to satisfactorily explain. The puzzle is that, despite current events, stocks earn a large premium over safer investments like treasury bills. That risk comes with a reward isn't such a puzzle. The puzzle is that the premium risk earns is so large that it simply cannot exist in any known model of an economy with at least a few reasonably risk tolerant and non-liquidity constrained people.

Some financial economists, unable to explain this risk premium, decided to try capitalizing on it. At a very basic level, the thing to do if you have a reasonable tolerance for risk is to borrow all the money you can and invest it in stocks. You may win sometimes and you may lose sometimes, but in the long run you will surely make good return. If you could borrow a trillion or two at 4% and make the long run market return of 8, 9, or 10% on the market, you get astoundingly rich very quickly.

This simplifies things a bit. But just a little. The financial "geniuses" thought this was money lying on the table that needed to be picked up. In picking it up it would make financial markets more efficient, spreading risk wider and better, and simultaneously facilitate financing of homes and business enterprises never financed before because risk tolerance was so low. I'm sure these guys thought they were doing the world a favor by making a gazillion dollars.

I'm completely serious here. In theory, these guys were right.

In trying to exploit this risk premium the risk premium shrank. That's what a bubble is--it's asset prices rising so high that expected future dividends become smaller relative to price. During the bubble, the premium probably shrank to about the levels our textbook models would suggest. Some might say it shrank more than that, but it's hard to tell.

Anyway. It now seems financial markets need a big risk premium in order to operate well. I wonder if when the risk premium gets too low, moral hazards (fiendish Madoff behavior) is easier to hide. This is because when low returns are expected amid great volatility, it's harder to tell whether, after a bad year, managers of mutual funds, hedge funds and firms just got unlucky or whether they raided the cash register.

Whether or not managers actually raid the cash register isn't necessarily important. Because if people fear they might be raiding the cash register, and thus fear the expected returns are not really the low but reasonable return they expected, but actually something much lower, they will pull their money out and put it back in the slightly lower-return safe investment.

And as those nervous types withdraw their money from risky assets, asset prices fall, and more get nervous about managers raiding the cash register and so they withdraw, causing asset prices to fall further, and so on.

The key thing here is that the temptation to commit moral hazards and the ease of hiding moral hazards is going to be much greater the lower the risk premium is. And for this reason, low risk premiums are not sustainable. On the other hand, high risk premiums are not sustainable either because financial types will see the money lying all over the floor and start to pick it up.

We might like to think there was a nice stable equilibrium in the middle with a medium return on risky assets. But is that necessarily true? I'm not so sure it is. Because it could be that the incidence of moral hazard is extremely sensitive to the size of the risk premium. And this could make markets extremely unstable around that happy medium if it does exist. So the economy cycles between low risk premiums and huge risk premiums. We boom and we bust. And those who time it right get insanely rich. The rest of us live with the cycle.

Sorry, I had to throw that out. I'll try to stick on topic with Greed, Green, and Grains...