by Henry Farrell on August 15, 2011

Michael Lewis’s recent article brings up again the question of why Germans bought so much toxic financial waste in the run-up to the financial crisis. It seems clear that his ‘because they’re all obsessed with shit’ theory isn’t any better an explanation than his Provo gangsters and fairy rings take on Irish economic disaster. But that still leaves an open question.Peter Frase takes one go at it here, first using Lewis’ earlier work to ding the ‘idiots’ theory of why the meltdown happened:

bq. One popular interpretation of the crisis, and of Lewis’s book, is that the explosion of sub-prime lending and securitization was the result of mass stupidity, and that huge numbers of people simply failed to understand or account for the incredible financial risks they were taking. This is basically the approach Ezra Klein takes when he quotes Larry Summers’ famous remark that “there are idiots” and concludes that the crisis was a consequence of human weakness and error in the context of a system with few regulatory restraints. … Yet idiocy does not stand up as a the central causal factor behind the crisis. For one thing, it seems odd that there would be such a concentration of idiocy in the most lucrative field of the American economy, one which has been leeching the brightest minds out of the rest of the society for decades. Moreover, it is necessary to explain not only the preponderance of idiots, but the tendency for their idiocy to work systematically _in the same direction._ … In academic finance, the technical term for idiots is “noise traders”, and they are thought to provide erratic and irrational actions that may destabilize markets but do not systematically move them in one particular direction. …

bq. Though the financial crisis produced a great deal of institutional calamity … the individual people responsible for the worst decisions of the last decade managed to greatly enrich themselves even as they nearly annihilated the global economy. … it’s undeniable that some of them, particularly toward the end, were getting high on their own supply, taking the the bogus triple-A ratings on toxic subprime garbage at face value even though they had an inside understanding of the con game they represented. …ultimately, these people–who in a just world would be penniless and serving extended prison terms–walked away with millions of dollars. There are plenty of apt descriptions for people like that, but “idiots” isn’t the one I would choose.

and then pointing out that even if everyone wasn’t an idiot, there did appear to be a heavy concentration of them in the investment arms of German banks.

bq. German institutional investors, or as they are called at one point, simply “Dusseldorf”. Lewis never really tries to explain their outsized appetite for murky subprime instruments. … In the language of the “varieties of capitalism” school of comparative political economy, Germany is what is known as a “coordinated market economy” or CME, whereas the U.S. is a “liberal market economy” or LME. The structure of the market in a CME is fundamentally different in that it relies heavily on coordination between firms, based on tight long-term inter-linkages and above all, trust. This contrasts with the more ruthlessly competitive ethic of the LME, in which formal contracts take the place of reciprocal trust relations. So German bankers and investors were a) relative novices at modern securities wizardry; b) steeped in a capitalist culture quite different from the dog-eat-dog rapacity of the American version.

The stylized story that is doing the rounds among comparative political economy of Europe people is a little different than this. It points to how the EU forced Germany to get rid of rules that favored its regional and local banks, obliging these banks to seek new investment opportunities outside the local and _Land_ businesses that had previously provided their bread and butter. And when they went international, they found many people who were willing to sell them unimpeachable investment opportunities, and little internal or external capacity to figure out when someone was trying to sell them a pup …

Here, the suggested problem is an organizational one as much as (or more than) a cultural one – banks which are geared to a certain kind of business, and which suddenly find themselves being pushed out of that market, are likely not to have built up the expertise that will allow them to prosper in new ones. What this explains (and the cultural explanation does not) is why it is that Deutsche Bank (which was far bigger) appears to have done conspicuously well out of the crisis, while its smaller compatriots have done very badly indeed. Of course, this isn’t to say that this theory is _right_ : political scientists often have a poorish enough understanding of what is happening in markets – but if there are better ones, or contradictory evidence for this one, I’d be interested to hear it.