The Financial Crisis: Why Were Warnings Ignored?

“Prediction is very difficult, especially about the future” – Niels Bohr

Gary Becker an economist and Richard Posner a judge, both at the University of Chicago, write a joint blog. It is frequently very thoughtful and worth reading, although usually long and a bit academic for some.

Their October 12th post The Financial Crisis: Why Were Warnings Ignored? asks a very important question. Here is a summary of their thoughts.

Richard Posner’s Opinion

Posner thinks the problem was a failure to synthesize all of the warnings. His analogy is the failure to foresee the attack on Pearl Harbor, although there were indications from 1941 on that something like that could happen.

He singles out “a perfectly reputable academic economist, a professor at New York University named Nouriel Roubini who for years had been predicting with uncanny accuracy what has happened.”

In September of 2006–two years ago–he had “announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. These developments, he went on, could cripple or destroy hedge funds, investment banks and other major financial institutions like Fannie Mae and Freddie Mac.

Until mid-September, the magnitude of the crisis was greatly underestimated by government, the business community, and the economics profession, including specialists in financial economics.

Why were the warnings ignored rather than investigated? First, preconceptions played a role. Many economists and political leaders are heavily invested in a free market ideology which teaches that markets are robust and self-regulating. The experience with deregulation, privatization, and the many economic success stories that followed the collapse of communism supported belief in the free market. The belief was reinforced, in the case of the financial system, by advances in financial economics, and relatedly by the development of new financial instruments that were believed to have increased the resilience of the financial system to shocks.

Second, doing something to reduce the risks warned against would have been costly. Had banks been required to increase their reserves, this would have reduced the amount they could lend, and interest rates would have risen, which would have accelerated the bursting of the housing bubble…

The deeper problem is that it is difficult and indeed often impossible to do responsible cost-benefit analysis of measures to prevent a contingency from materializing if the probability of that happening is unknown.

Which brings me to the last and most important reason for the neglect of the warning signs, because it suggests the possibility of responding in timely fashion to future risks of financial disaster. That is the absence of a machinery (other than the market itself) for aggregating and analyzing information bearing on large-scale economic risk.

In any event, no effort to determine the probability of financial disaster was made and no contingency plans for dealing with such an event were drawn up. The failure to foresee and prevent the 9/11 terrorist attacks led to efforts to improve national-security intelligence; the failure to foresee and prevent the current financial crisis should lead to efforts to improve financial intelligence.

Becker’s Opinion – Why the Warnings Were Ignored: Too Many False Alarms

Becker has “a somewhat different take than Posner on why warning signals were ignored.”

The period since the early 1980s until the crisis erupted involved both rapid economic growth for most of the world, and unprecedented stability in this growth. Inflation rates were low and fluctuations in real output, as measured by the size and duration of recessions, were modest compared to the past. Economists and central bankers like Greenspan believed that we had learned how to keep inflation low, and also had the capacity to smooth out fluctuations in output and employment.

The second relevant development has been advances in financial instruments, such as derivatives, securitization, credit-backed swaps, and other even more esoteric instruments. These instruments seemed to work quite well in managing, spreading and even reducing the risk of the assets held by banks and other institutions. However, in the process they encouraged greater risk-taking ventures, as reflected by the large increase in the leverage-that is, in the ratio of assets to capital- of banks and financial institutions like Fannie Mae and Freddie Mac. What has been insufficiently understood is that the growing use of these instruments, and the growing leverage of financial institutions, created considerable aggregate risk for the system as a whole that could not be diversified away.

This combination of growing central bank confidence in its ability to iron out various wrinkles in economic performance, and the belief that the new financial instruments would help manage and reduce risk, blinded the vast majority of economists (I include myself), bankers, and government regulators to the vulnerability of the whole system. This vulnerability was especially important for aggregate shocks akin to a classical run on banks. When institutions are highly leveraged, they have great difficulty coping with a massive loss of confidence in the system.

While giving credit to Roubini, Becker lists several disasters during the past several decades that were predicted but never happened:

After the huge one-day stock market collapse in October 1987, Business Week and other magazines and newspapers warned that a Great Depression might soon be coming. These dire forecasts turned out to be completely wrong. Similar highly negative, but wrong economic forecasts, were made during the Asian financial crisis of 1997-98, the internet bubble, and the aftermath of the 9/11 attack.

In an atmosphere where the world economy showed great capacity to withstand difficult shocks, it is not at all surprising that some forecasts of disaster that turned out to be more correct were ignored.

In addition, one should not minimize the great economic achievements of the past 25 years in the form of rapid growth in world GDP, low world inflation, and low unemployment in most countries. Perhaps these achievements will be overshadowed by a deep world recession, but that remains to be seen. If the impact of this financial crisis on the real economy is not both very severe and very prolonged, and time will answer that question, the combination of the past 2 1/2 decades of remarkable achievement, and the economic turbulence that followed, may still look good when placed in full historical perspective.

Conclusion

I appreciate Becker’s perspective that for more than 25 years, the world has seen substantial growth and short recessions. However, this long term success led to overconfidence and excessive risk taking. While everything was working well, investment banks and other financial institutions could achieve large profits. With interest rates so low, borrowing money to increase profits seemed to make sense.

Cassandras are often wrong. The prevailing belief is that markets are usually right in sorting out risks and rewards. (George Soros disagrees with this ideology.)

The problem is that too many people based their decisions on the belief that housing prices could only go up. Unfortunately, too many houses were built and too many people who could not afford the houses were able to get mortgages, often with artificially low “teaser rates.” Now we are dealing with the fallout.

To see how Wall Street took on too much risk, see How Wall Street Became a Giant Hedge Fund.

photo credit: pangalactic gargleblaster