James Grant And Nouriel Roubini on Macro Risk

James Grant and Nouriel Roubini square off at the Octavian Institute:

Oliver Hart and Bengt Holmstrom Share the 2016 Nobel Price in Economics

The Nobel committee announced today that for their work in contract theory Oliver Hart and Bengt Holmström won the 2016 Sveriges Riksbank Prize in Economic Science in Honor of Alfred Nobel. Charles Duxbury and Mike Bird report on it in the Wall Street Journal today. Moreover the Journal reported in a video:

Evan Peterson, "Why Bengt Holmström, is An Economist You Should Know," Open Markets, October 21, 201.

The Making of the Big Short (the Movie That Is.)

Michael Lewis' book, The Big Short: Inside the Doomsday Machine is one of the best on the financial crisis.  No one writes about finance like Lewis, the journalist who started as a bond trader with Salomon Brothers.   His book chronicles the outsiders who bet against the housing bubble. It short be read with Gillian Tett's book, Fools Gold, which follows the tribe of geeks who invented the credit default swaps in the first place. My favorite moment in the book is when Paulson's analysts are at a Deutsche Bank conference.  They are baffled at why the bankers are so ready to sell them credit default swaps after he had been pulling teeth to buy them months earlier. 

Adam McKay directed the movie based on the book.  Here is a Wall Street Journal Cafe interview with him: 



Oddly enough, John Paulson, who made the biggest killing–the biggest short–is not in the movie.  Richard Thaler is.  He is the Ralph and Dorothy Keller Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business.  He presented a paper at the 1985 FMA meetings in New York which presented evidence against the efficient market hypothesis.  That was my first professional finance meeting and I had the pleasure of discussing the paper.  I sympathized with his difficulty at the time publishing such heresy.  Times change.  Now you can see he is at the pinnacle of the profession. Thomas Kuhn taught us that a scientific orthodoxy is finally finished only when the last member of that school dies.    

When Will They Ever Learn? II

“The Big Picture” blogger and Fusion IQ CEO Barry Ritholtz looks back at the events of 2008 and makes the case for the true legacy of the financial collapse and ask, "Did Anyone Learn From the Financial Crisis?"

Is Capitalism Moral? Is Wall Street Capitalism?

George Gilder has a new edition of his justly famous Wealth & Poverty. (Available in print form and audio book.)  I would argue that the case against capitalism is a failure of imagination.  Gilder goes a long way to address that void.

He makes the case that seeing capitalism as the blind pursuit of self interest is myopic.  Capitalism is moral in a way that socialism is not: the entrepreneur wants to help people and is utterly dependent on others. As Schumpeter stressed, greed is not what motivates entrepreneurs and entrepreneurs are the ones that make an economy dynamic.

It has been said that Gilder's book was the economic bible of the Regan revolution.  In this new edition, he addresses more recent phenomena such as the financial crisis.  Far from being entrepreneurial capitalism, he sees Wall Street as the corrupt collusion of big government and big finance. The financial crisis was the inevitable result of "the usurpation [by] crony capitalism of real capitalism."  He exponds his views in this interview that runs close to ten minutes:

Deleveraging: When Will They Ever Learn?

The recent recession was caused by the overexpansion of credit.  Part of the financial recovery from a bubble is the reduction of debt on a society's collective balance sheets (businesses, financial institutions, households, and governments.)  This reduction is referred to as "deleveraging."

The Economist's Buttonwood columnist worries that "the US is the only nation where it's possible to argue that any deleveraging has occurred."  For most developed countries, overall debt to GDP ratios are higher now than during the financial crisis.

Even that is not enough, he says: "Nevertheless, if you think the system was overgeared in 2007, at the height of a credit boom, then it's hard to argue it's not overgeared now. " "Gearing is British for levering.  Americans convert the noun, "leverage," into a verb for the same purpose.

Tom Hoenig Nominated to Be the Vice Chair of the FDIC

Wow!

I do not know to what party Dr. Thomas Hoenig belongs, but he has been great on the FOMC (the Federal Open Market Committee that determines monetary policy.)  President Obama has nominated him to be the number two official at the Federal Deposit Insurance Corporation (FDIC) which guarantees bank deposits.  The FDIC also is one of the agencies that examines banks for soundness.

Tom Hoenig has been a staunch critic of the "Too Big to Fail" syndrome in American bank supervision.  He has been seemingly a Cassandra warning of the bubble in farmland prices.  Hopefully his arms will not be chained when he raises them to prays for policies to address the problem. 

On the FOMC, Hoenig has voted for raising rates.  Knowing that we are creating new bubbles rather than stimulating new investment in real projects creating real jobs, he has dissented from the prevailing majority.  What business owner in its right mind would invest in a risky business project when there is free money to lever up holdings of financial assets made risk free by the Bernanke put?  Why subsidize investment banking bonuses? And he has not kept quiet.  As Michelle Lucci pointed out over a year ago, "Kansas City Federal Reserve Bank President Thomas Hoenig has been recently speaking publicly about his desire for an increase in the federal funds rate, sooner rather than later, and also about his concern for community banks and the drag on earnings from commercial real estate loans."

Scott Canon at the Kansas City Star warns "Hoenig is ... a provocative selection to join [the FDIC's] board of directors."  Three cheers for President Obama on this one.  Even Ron Paul should be cheering. He would be available should a President Cain need a Fed Chairman.

Jamie Dimon Calls Basel III "Anti-American"

Tom Braithwaite in New York and Patrick Jenkins in London report JPMorgan Chases' CEO, Jamie Dimon, "was supportive of forcing banks to have more capital but argued that moves to impose an additional charge on the largest global banks went too far, particularly for American banks"  in an interview in the Financial Times.  Read why our favorite banker is always good copy.

He also answered some tough questions in another and was particularly critical of the strident narrative prevailing in Washington and the media about banks and the financial crisis in a third article.

All three stories articles are worth reading.

FT interview with Carmen Reinhart, co-author of This Time is Different, about the crisis in Greece

This Time Is Different:
Eight Centuries of Financial Folly
Carmen M. Reinhart & Kenneth S. Rogoff

Joseph Count de Maistre once wrote of "history, which is empirical politics."  I find it makes for good empirical economics and finance as well.  Carmen Reinhart and Kenneth Rogoff have written a history of eight hundred years of financial crises.  I am remined of the Pete Seeger song, "Where Have All the Flowers Gone?"  The refrain is:

"When will they ever learn? When will they ever learn?"

On May 5, 2010, Aline van Duyn, the Financial Times' U.S. Markets editor, interviewed Carmen Reinhart, co-author of This Time is Different.  In this first video, they talk about the history of financial crises and their patterns (4m 41sec).

Then the hangover

What happens after a crisis has happened?  In this second video, they talk about the aftermath of financial crises  (4m 55sec)  To my simple-minded ears, the consequences of financial crises sound awfully much like Austrian unemployment rather than Keynesian unemployment.  How heretical!

I Owe, I Owe, It's Off the Cliff We Go!

In this next video, the discussion turns to the role of debt and monetary policy. (3m 13sec) Maybe the economy hasn't read the textbooks?

Was it a Greek who said there was nothing new under the sun?

And then, in this last video, they turn to the crisis in Greece, and the possibility for contagion and restructuring .(4m 11sec) Note this was done over a year ago.

Stephen Roach: Unconscionable Policy Blunders

Stephen Roach, the chairman of Morgan Stanley Asia on the bittersweet taste of vindication and China's role in the economic crisis:

Myron Scholes on Financial Innovation and Regulation

Myron Scholes is a Nobel Laureate for his work in financial innovation, the Frank E. Buck Professor of Finance, Emeritus, at the Stanford Graduate School of Business, and the chairman of Platinum Grove Asset Managemen. The seemingly esoteric mathematical model he and Fisher Black developed for pricing options is now checked on every trading floor and is used even by stogy accountants. The Economist interviews him on why innovation must lead, how markets should be regulated, and why taking huge risks became so comfortable going into the financial crisis.

Where There Is a Way, Is there a Will?

Not too long ago George Melloan asked on the Opinion pages of the Wall street asked a troubling question:

"Federal Reserve Chairman Ben Bernanke assured readers of this page (“The Fed’s Exit Strategy,” July 21) that he has the tools to prevent the huge reserves he’s pumped into the banks from generating an inflation that would abort an economic recovery.

"But does the Fed have the guts to use those tools?"

There You Go Again, Mr President!

The editors of Wall Street Journal wonder if Ginnie Mae is "The Next Fannie Mae?" Specifically they worry, "Ginnie Mae or the Government National Mortgage Association, which will soon join them as a trillion-dollar packager of subprime mortgages." They explain, "Ginnie’s mission is to bundle, guarantee and then sell mortgages insured by the Federal Housing Administration [the FHA], which is Uncle Sam’s home mortgage shop. Ginnie’s growth is a by-product of the FHA’s spectacular growth. The FHA now insures $560 billion of mortgages—quadruple the amount in 2006. Among the FHA, Ginnie, Fannie and Freddie, nearly nine of every 10 new mortgages in America now carry a federal taxpayer guarantee."

In August, 2008, I deplored the Financial Industrial Complex, the lobbyists and investment bankers that have Congress wrapped around their fingers, in "Fannie Mae and Freddie Mac: Look Past the Jargon, and You Find a $5 Billion Scandal." The federal government's takeover of Fannie and Freddie effectively transferred private sector and foreign government losses to the American taxpayer. Now the Administration is continuing that practice on what promises to be a grand scale using Ginnie Mae. The lobbyists, their congressional clients, and the administration are happily portraying this fiscal folly as "feeling the homeowners' pain" and "dealing with the foreclosure problem."

No doubt the administration's complicity in the renewed supply of dodgy debt will keep the Chinese happy (they have a huge exposure to American mortgage backed securities) and it indirectly bails out the Fed (have you looked at the Federal Reserve Bank of New York's balance sheet lately?) The Financial Industrial Complex, which you think would be hiding in disgrace, is riding high. I past a car yesterday, and it was not a Mercedes or an SUV, which had written on its window in soup: "Honk, if I am paying your mortgage."


Mark Twain once boasted, "We have the best Congress money can buy."

Yes, Virginia, the Fed Does Have An Exit Strategy

It seems literally Providential that Dr. Ben Bernanke was chairing the Board of Governors when the financial crisis hit. He, as a young researcher at Princeton, demonstrated how the financial crises in the 1930s were the missing link that converted the mild cyclical downturn of 1929 into the Great Depression.

In today's Wall Street Journal (see also below), he explains the Fed's exit policy. I have a very big worry about what he says. He argues the Fed has plenty of tools to fight inflation. He never mentions asset price bubbles.

The Wall Street Journal accuses him, in a former stint as a Governor, of being at the housing bubble's birthing. He helped support the intellectual case for not fighting the emerging bubble. At the December 9th, 2003 Board meeting he argued that the Fed could continue its negative real interest rate policy. His focus was on consumer price inflation and the output gap.

There are two problems with the Chairman's perspective: If a bubble allocates resources in the real economy, there will be cyclical unemployment that reflects these structural distortions. This unemployment will require a longer period of adjustment than ordinary cyclical unemployment. Thus the output gap will underestimate the economy's inflationary potential. Secondly preventing a bubble is just as important as preventing consumer price inflation.

Some of the comments share my concern. I particularly appreciated Avery Goodman's comment (reproduced below.)


The Fed’s Exit Strategy by Ben Bernanke (WSJ: July 20, 2009)

The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. The Federal Open Market Committee, which is responsible for setting U.S. monetary policy, has devoted considerable time to issues relating to an exit strategy. We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.
The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.

But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.

To some extent, reserves held by banks at the Fed will contract automatically, as improving financial conditions lead to reduced use of our short-term lending facilities, and ultimately to their wind down. Indeed, short-term credit extended by the Fed to financial institutions and other market participants has already fallen to less than $600 billion as of mid-July from about $1.5 trillion at the end of 2008. In addition, reserves could be reduced by about $100 billion to $200 billion each year over the next few years as securities held by the Fed mature or are prepaid. However, reserves likely would remain quite high for several years unless additional policies are undertaken.

Even if our balance sheet stays large for a while, we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.

Congress granted us authority last fall to pay interest on balances held by banks at the Fed. Currently, we pay banks an interest rate of 0.25%. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate.

Banks generally will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.

Thus the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed.

Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. For example, the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility. Even as that central bank’s liquidity-operations substantially increased its balance sheet, the overnight interbank rate remained at or above its deposit rate. In addition, the Bank of Japan and the Bank of Canada have also used their ability to pay interest on reserves to maintain a floor under short-term market rates.

Despite this logic and experience, the federal-funds rate has dipped somewhat below the rate paid by the Fed, especially in October and November 2008, when the Fed first began to pay interest on reserves. This pattern partly reflected temporary factors, such as banks’ inexperience with the new system.

However, this pattern appears also to have resulted from the fact that some large lenders in the federal-funds market, notably government-sponsored enterprises such as Fannie Mae and Freddie Mac, are ineligible to receive interest on balances held at the Fed, and thus they have an incentive to lend in that market at rates below what the Fed pays banks.

Under more normal financial conditions, the willingness of banks to engage in the simple arbitrage noted above will tend to limit the gap between the federal-funds rate and the rate the Fed pays on reserves. If that gap persists, the problem can be addressed by supplementing payment of interest on reserves with steps to reduce reserves and drain excess liquidity from markets—the second means of tightening monetary policy. Here are four options for doing this.

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.
—Mr. Bernanke is chairman of the Federal Reserve.

Avery Goodman's Comment:

Dear Mr. Bernanke,

There is nothing that I would like better than to see you proved correct. But, all the evidence shows otherwise.

The primary dealers of the Fed have received huge wads of almost-free-cash, in one way or another, as a part of your balance sheet expansion, as well as the fact that you have traded Treasuries for toxic waste held by the banks. So far, the cash you've handed out is not being used to fund productive industry in America. Instead, it is being used to fund speculation.

These primary dealers appear to be making loans mostly to client-speculators including hedge funds, and, also, supplying their own trading divisions. Since speculation thrives in time of volatility, price instability has resulted. The markets, in turn, have become Fed-driven, rather than free and independent,

We have seen an explosion in prices, as well as the overall level of speculation in the stock, oil, gold, silver, and commodities markets. A new bubble in asset prices is now being formed, and it has every prospect of eventually exceeding the previous one. We have seen little actual improvement in the U.S. economy, however.

Oil, in particular, has roared back in price, even though it is in serious oversupply. This is because people are buying everything that tends to rise in inflationary times. The wild speculative buying impairs the potential for the economy to recover.

Meanwhile, the dollar is currently in a free-fall, and the Chinese, Russians, Indians and even the Brazilians are threatening to settle trades in other currencies. Gold and silver, in contrast, are soaring into the stratosphere. Foreigners clearly do not have confidence in your policies.

You had better make it very crystal clear, when you testify, that you intend to take very strict and affirmative action to reduce the Fed balance sheet back to $900 billion or less, or this situation will continue to deteriorate.

I would love to be proven wrong. However, the result of your easy money policies has been rampant speculation. This speculative activity is being encouraged by, or directly participated in, by the big banks you have bailed out. We are now seeing a falling dollar, rising stock, gold, silver, and commodity prices, and a continuing hollowing out of the American economy.

It would have been better to allow the insolvent banks to fail, while allowing the FDIC to do its job of replacing whatever deposit money was lost. There would have been no repeat of the Great Depression, because of the existence of the safety net provided by FDIC insurance. The market share lost by the failed banks would have eventually shifted to their competitors, who would become bigger.

Instead, the Federal Reserve has attempted to micro-manage the economy in a manner similar to the Politburo of the old Soviet Union. This has brought us ever higher levels of moral hazard. Such policies are unwise, but since you apparently intend to continue to pursue them, I wish you the best of luck. You, and we, are going to need it.

It's Abut Time Someone Did: Asian Officials Push Back Against Savings Glut Theory

On July 3rd, Andrew Batson at the Wall Street Journal reported: "Asian officials and scholars are pushing back against the notion that their countries' high savings helped cause the financial crisis by flooding the world with money, arguing that lax U.S. financial regulation bears the brunt of the blame."

Alan Greenspan and then Governor Bernanke made these arguments when the Fed was keeping the federal funds rate negative.

Can the Fed Go Belly Up?

During the bubble years, we worried that investment banks got overlevered running up leverage ratios (ratios of assets to equity) of thirty and forty times. We all know what happened then.

The Federal Reserve Bank of New York's Consolidated Balance Sheet shows its leverage ratio was 37.5 times at year end 2007. Its President in 2008 was a Timothy Geitner (now Secretary of the Treasury.) At the end of 2008, the Fed of New York achieved a leverage ratio of 112.5 times.

Maybe their old boss can bail them out if they go bust now that some banks are buying back TARP stock.

The White Paper Outlining Regulatory Reform

Yesterday in a series of public interviews and announcements, the administration in Washington put forth its proposed reform of U.S. financial regulation. The proposal itself is embodied in an 89 page White Paper, "Financial Regulatory Reform: A New Foundation." It is a combination of the "art of the possible," America's penchant for committees, and ratification of the de facto reality.

Otto von Bismark declared, "Politics is the art of the possible." President Obama is realistic about what he can get through Congress and what he can not. Simplifying and consolidating the patchwork quilt of prudential and financial services regulation would provoke a huge turf war that would stall this legislation and much of the rest of his agenda.

The Fed is a big winner. It gains authority to regulate any firm which is a systemic threat to the financial system. A GE Capital or an American Express could come under its prudential regulation if it is big enough and/or interrelated enough to be a source of systemic risk. The New Deal left investment banks largely outside the circle of prudential regulation. The financial crisis drove the main investment banks either out of business or into bank holding companies as permitted under Gramm-Leach-Bliley. Thus the remaining major investment banks are already under the Fed's regulation. Other large or potentially system threatening firms could be designated "Tier 1 Financial Holding Companies" (Tier 1 FHCs) even though they do not hold subsidiaries that issue deposits. Importantly the Fed will regulated these Tier 1 FHCs on a consolidated basis. Bear in mind that the Fed is the only agency that has the firepower to deal with systemically threatening businesses.

Although the Fed will be the prudential regulator for Tier 1 FHCs, it is not clear who will put up the capital for non banks that need to be resolved in a liquidation. It appears the Treasury is to resolve these situations, but will it require a prior Congressional appropriation such as TARP did?

It looks like Tier 1 FHCs will be required to hold to more stringent capital requirements. It is not clear whether that is more stringent that non Tier 1 FHCs or more stringent than pre-crisis requirements.

The Treasury will chair a Financial Services Oversight Council. The Office of Thrift Supervision disappears, but there will be a new Consumer Financial Protection Agency.

Securitization and such derivatives as Credit Default Swaps were at the heart of the financial crisis. Firms issuing securitized obligations will have to have some "skin" in the game much like European income bonds or the Federal Home Loan programs. Excellent idea!

The proposal calls for more comprehensive regulation of derivatives. I will need to dig into the details before I can determine how much beef there is in the rhetorical receipe. The Fed gains authority over "systemically important payment, clearing, and settlements systems."

The split in authority between the SEC and the CFTC continues, but the Financial Services Oversight Council can adjudicate disputes. Will it intervene when neither does its job? Remember Enron?

Some thoughts:

Bigger capital requirements on the big boys is effectively a tax on their ROE. It is not necessarily a bad thing that Wall Street shrinks and the small fry gain, but Wall Street has its lobbying clout to be delt with.

The proposal seems to call for a pullback from Basel II and greater capital requirements for risky assets. At the same time it calls for "a simple, non-risk based capital measure to limit the amount of leverage built up in the international financial system." This sounds like squareing the circle to me.

There is a call for less procyclical capital requirements. Spain is the star in this credit crisis. By adopting capital requirements that go up in a boom and are smoothed in a bust, Spain's banks (much like Brazil's) come out of the crisis is relatively good shape. Spain was not saved from a housing bubble, however. It would be impolite to point out that the Fed, the White Paper's big regulatory winner, caused the bubble in the first place.

There are considerable words about firm value accounting and transparancy. The White Paper requires that accounting be looked into again. I seem to remember that mark to market accounting was at the heart of the Enron debacle. Enron and WorldCom led to financial institutions' being subject to greater market to market accounting. Those commissioned to look into these issues will find the conflict between fair market accounting and banks' function of intermediation illiquid loans a difficult nut to crack.

How Business Schools Have Failed Business

Why not more education on the responsibility of boards?

Wall Street Journal: April 24, 2009


By Michael Jacobs
As we try to understand why our economy is so troubled, fingers are increasingly being pointed at the academic institutions that educated those who got us into this mess. What have business schools failed to teach our business leaders and policy makers? There are three profound failures of sound business practices at the root of the economic crisis, and none of them have been adequately addressed by our business schools.

Just about everyone agrees that misaligned incentive programs are at the core of what brought our financial system to its knees. Countless individuals became multimillionaires by gambling away shareholders' money. Incentive systems that rewarded short-term gain took precedence over those designed for long-term value creation.

We could chalk this all up to greed, as many pundits have. But first we should ask how many of the business schools attended by America's CEOs and directors educate their students about the best way to design management compensation systems. Amazingly, this subject is not systematically addressed at most business schools, and not even discussed at others.

Secondly, as Washington scrambles to restructure the financial regulatory system, those who still believe in the private sector are asking why corporate boards were AWOL as institution after institution crumbled. Why did it take rumors of nationalization and a drop in Citicorp stock to below $2 a share to inspire Citigroup to nominate directors with experience in financial markets?

American icon General Electric was stripped of its coveted AAA-rating because of problems emanating from its financial services unit. Yet its board has only one director with experience in a financial institution. If it is the board's job to oversee a corporation, it seems logical that there would be a segment in the core curriculum of every business school devoted to board structure, composition and processes. But most programs don't cover the topic.

The third breakdown came in the investment community. Nearly 20 years ago I wrote a book titled "Short-Term America" that warned about the growing chasm between those who provide capital and the companies who use it. The concept is simple: When money provided to homeowners or businesses comes from an anonymous source, possibly half way around the world, there are serious challenges to operating a functioning system of accountability.

Nationally, finance departments at business schools offer hundreds of courses in asset securitization and portfolio diversification. They have taught a generation of financial leaders that risk can be diversified away. But in their B-school days, few investment bankers examined the notion of "agency costs." That concept explains that as the gulf between the provider and the user of capital widens, the risks involved with selecting and monitoring the participants in the portfolio increase. It should come as no surprise that financial institutions amassed securities that consist of a diversified portfolio of deadbeats.

About 70% of the shares of American corporations are held by institutional investors such as pension and mutual funds. These organizations are brimming with MBAs. But how many of these MBAs took a class devoted to how shareholders should exercise their rights and obligations as the owners of America's corporations? Few, if any. When shareholders are uneducated about their obligations, how can a corporate accountability system function properly?

Recently, when I delivered a guest lecture at another school, a distraught-looking student pulled me aside after class. She explained that my talk was very disturbing to her. After investing two years and $100,000, she was only weeks away from receiving her MBA. But prior to our class, she had never heard a discussion about board responsibilities or the rights of shareholders. She said she felt cheated.

By failing to teach the principles of corporate governance, our business schools have failed our students. And by not internalizing sound principles of governance and accountability, B-school graduates have matured into executives and investment bankers who have failed American workers and retirees who have witnessed their jobs and savings vanish.

Most B-schools paper over the topic by requiring first-year students to take a compulsory ethics class, which is necessary, but not sufficient. Would Bernie Madoff have acted differently if he had aced his ethics final?

Could we have avoided most of the economic problems we now face if we had a generation of business leaders who were trained in designing compensation systems that promote long-term value? And who were educated in the proper make-up and responsibilities of boards? And who were enlightened as to how shareholders can use their proxies to affect accountability? I think we could have.

America's business schools need to rethink what we are teaching -- and not teaching -- the next generation of leaders.

Mr. Jacobs, a professor at the University of North Carolina's Kenan-Flagler Business School, was director of corporate finance policy at the U.S. Treasury from 1989 to 1991.

Housing Bubbles & Depressions

Vernon Smith and Steven Gjerstad (Smith a professor at Chapman University and the latter visiting) analyze U.S. housing bubbles and what they wrought in a Wall Street Journal opinion piece. Economist Smith won his Nobel prize for work in behavioral economics. When he started out, economists were able to reproduce bubbles in laboratories. Bubbles seemed so transparent that the economists thought they would never occur in "the real world."

So much for economists being Pollyannas!

Home loans in the US: the biggest racket since Al Capone?

Willem Buiter, in his Maverecon blog on the FT, has some rather nasty things to save about our fetish of protecting homeowners from foreclosures. Hmmm.

In "Home loans in the US: the biggest racket since Al Capone?" he asks: "What are the costs of foreclosure? Who bears them? Are the private costs smaller than the social costs?"

Professor Buiter is Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.