How the same practices that led to the economic crisis are being implemented in our schools

Today’s New York Times has two articles relevant to the education policy debate in NYC – but they aren’t about schools. Instead, they deal with the sudden collapse of the financial system and its causes.

Joe Nocera has a riveting analysis in the Magazine section called Risk Mismanagement --about how Wall St. financiers failed to see the crash coming, because of their over-reliance on a single mathematical formula called VaR (for Value at Risk), that was supposed to accurately quantify the risk of financial losses:. “VaR’s great appeal is that it expresses risk as a single number, a dollar figure, no less.”

But the formula, in all its simplicity, was severely flawed, and investors placed undue confidence in it. As a result, they failed to respond in time to the catastrophe that was upon them. Aside from being overly simplistic, the formula was based upon only a few years worth of data – which in a bubble, are unable to predict possible future declines.

… because it is a very short-term measure, [VaR] assumes that tomorrow will be more or less like today. Even what’s called “historical VaR” — a variation of standard VaR that measures potential portfolio risk a year or two out, only uses the previous few years as its benchmark. As the risk consultant Marc Groz puts it, “The years 2005-2006,” which were the culmination of the housing bubble, “aren’t a very good universe for predicting what happened in 2007-2008.”

According to the article, another major flaw is that VaR was relatively easy to manipulate:

… VaR could be gamed. That is what happened when banks began reporting their VaRs. To motivate managers, the banks began to compensate them not just for making big profits but also for making profits with low risks. That sounds good in principle, but managers began to manipulate the VaR by loading up on … “asymmetric risk positions.” These are products or contracts that, in general, generate small gains and very rarely have losses. But when they do have losses, they are huge.

Ironically, it turns out that one of the best ways to minimize risk, at least in the way the formula was written, was to load up on credit-default swaps; And we know how that turned out.

In an op-ed entitled The End of the Financial World as We know it, Michael Lewis and David Einhorn discuss other reasons for the crash. They cite a litany of problems, including deregulation, in which the SEC essentially ceded all controls concerning the amount of leveraging and/or debt that companies could accumulate. These companies also focused almost exclusively solely on short-term gains, at the expense of a more rational long-term investment strategy, based on how their employees were rewarded.

Lewis and Einhorn are particularly good at explaining the many “wacky incentives” that led to poor decision-making– the faulty compensation structures that led to the bubble, and the way in which the ratings agencies like Moody’s and Standard and Poor’s were led to give high marks to corporations that were hugely overleveraged like MBIA –though it had “only $7.2 billion in equity against an astounding $26.2 billion in debt.” Why?

These oligopolies, which are actually sanctioned by the S.E.C., didn’t merely do their jobs badly. They didn’t simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: rather than expose financial risk they systematically disguised it.

In short, Moody’s and Standard and Poor’s gave triple-A ratings to companies that are now regarded as nearly worthless, because their own financial success was dependent upon the very companies whose instruments they were supposed to objectively assess. As Lewis and Einhorn point out, this was true of the SEC as well.

… the S.E.C. itself is plagued by similarly wacky incentives. .. anything the S.E.C. does to roil the markets, or reduce the share price of any given company, also roils the careers of the people who run the S.E.C. Thus it seldom penalizes serious corporate and management malfeasance — out of some misguided notion that to do so would cause stock prices to fall, shareholders to suffer and confidence to be undermined. Preserving confidence, even when that confidence is false, has been near the top of the S.E.C.’s agenda.

So what does this have to do with the NYC public schools?

All these same elements are central to the policies being pursued by the DOE:

• A system of deregulation, with principals let loose (or as the DOE likes to put it, “empowered”), to spend money and run schools as they like, with very little supervision or support, as long as they achieve continual gains in test scores.

• A “wacky” incentive system that provides merit pay to principals, teachers and students, all based on one-year gains in standardized test scores.

• An overly simplistic and inherently unreliable formula devised to give letter grades to schools -- again, based predominantly on the one year’s gains or losses in scores. DOE has vehemently refused to develop a more complex and accurate assessment that would be based on more than one year’s data, and/or would include more measures of a quality education, like class size and/or the level of arts education being provided.

• Like the manipulation of VaR by investment bankers, more and more “gaming” of the system has occurred, as our public schools become increasingly focused on driving up test scores to the exclusion of all else – through an overwhelming amount of test prep, resorting to more cheating, and/or excluding or discharging low-achieving students – all of which practices have been ignored or denied by DOE.

• Just as the SEC mistakenly believed that its primary goal was to bolster stockholder confidence in the financial system by ignoring negative consequences of current practices, the DOE acts as though it is its mission to spin the data to make it appear that its own flawed policies and objectives have been uniformly successful.

Thus, Tweed educrats and their PR machine continually ignore, minimize, or misstate all evidence of the contrary – including flat NAEP scores, rising class sizes, worsening overcrowding in many schools, increasing discharge rates – and even violations of the law.

It is ironic that just as our society has lost confidence in the flawed ideology and practices that led to the current financial catastrophe, including the notion that deregulation and unleashed competition would lead to all boats rising, and that simplistic formulas could be devised that would minimize any risks to investors and the economy as a whole, the political establishment seems to be intent on implementing eerily similar policies in our schools.

What will the inevitable crash look like in this case? Will we even be able to witness its full dimensions? Or will the cost in terms of students’ lives go unreported? Please post your predictions in the comments area.