The turmoil in the housing finance market raises fascinating questions. I shall offer some brief thoughts on the principal ones.
1. Surprise. I have been preoccupied in recent years with the subject of intelligence failures, about which I have written several books. The subprime mortgage "crisis" follows a classic pattern that should help us to understand the inevitability of intelligence failures (Pearl Harbor, the Tet Offensive, the Egyptian-Syrian surprise attack on Israel in October 1973, 9/11, and so on ad nauseam). These failures typically are not due to lack of essential information or absence of warning signs or signals, but to lack of precise information concerning time and place, without which effective response is impossible except at prohibitive cost. Alarms over risky mortgage practices had been sounded for years, and ignored for years. Someone, whether a home buyer or an investment bank buying home mortgages, who had heeded the warnings when they were first made, or indeed until years later, would have left a good deal of money on the table.
2. Bubbles. There were two bubbles: a housing bubble, and an investment bubble. The bubble phenomenon is related analytically to the phenomenon of surprise just discussed. A bubble begins when prices, in this case of housing, begin rising at a rate that seems inexplicable in relation to demand. No one knows how high they will rise. In conditions of uncertainty, there is a tendency to base expectations on simple extrapolation: if prices are rising, they are expected to continue to rise--for a time, but no one knows for how long a time. There is a reluctance to act as if they will not continue rising, for by doing so one is leaving money on the table. As a bubble expands, the rational response is to reduce risk, without forgoing profit, by getting in and out of the market as quickly as possible. The increased trading may keep the bubble expanding.
3. Ignorance. It has been argued that the people who took out subprime mortgages with adjustable interest rates did not understand the risks they were assuming, and that the banks that bought mortgage-backed securities did not understand the risks they were assuming. I am skeptical. Suppose you have a low income, you'd like to own a house, and a mortgage broker offers to arrange a mortgage that will cover 100 percent of the price of the house. What do you have to lose by accepting such a deal? Since you haven't put up any capital, you have no capital to lose if you lose the house because you cannot make your monthly mortgage payments. As for the banks, they rode the bubble for too long; but, to repeat, had they got out too early, they would have left a lot of money on the table.
4. Asymmetry of Risk. Bubbles are more likely to occur when downside risk is less than upside risk. My example of the asset-less home buyer illustrates the point. The savings and loan "crisis" of the 1980s was exacerbated, or perhaps even created, by the fact that federal deposit insurance was not experience-rated: savings and loan associations paid the same rates regardless of the riskiness of the loans that they made with the depositors' money. Since the potential loss to depositors was truncated, there was an incentive to take excessive risks. CEOs of banks, as of other large, publicly owned firms, face asymmetrical risk too. If the bank is profitable, the CEO's compensation soars. If his investment gambles fail, he may be fired, but he will be consoled by receiving tens or even hundreds of millions of dollars in deferred income, stock options, or severance pay. This may have been a factor in the decision of many banks to try to ride the bubble to the top.
5. Psychology. Economists have become increasingly sensitive to the findings of cognitive psychology, which teaches that emotions and cognitive quirks afflict all of us and lead to behavior that often deviates from simple models of rational choice, important as those models are. Among the psychological tendencies that are relevant to an understanding of bubbles are the following: optimism bias, and a related belief in luck (there is no such thing--some people are lucky, but that is a product of randomness, not of a thing--"luck"--that people possess in different proportions); herd behavior; excessive discounting of future costs; and difficulty in thinking sensibly about probabilities.
6. What Is to Be Done? In my opinion, nothing. There have always been bubbles. There will always be bubbles because of the factors that I have been discussing. The Federal Reserve Board, though ably led and staffed, missed the mortgage bubble just as it missed the tech-stock bubble that exploded in 2000. The proposals now on the table for resolving the subprime mortgage "crisis" or preventing future such fiascos include, first, requiring that more information be given to prospective borrowers and, second, that mortgage interest adjustments be frozen or other measures taken to reduce foreclosures. Information is not the problem, as I have argued; and bailing out the borrowers, which is to say truncating downside risk, will set the stage for a future housing bubble. Nor is it a good excuse for the second class of measures that we must at all costs avoid a recession. A major depression, such as we last experienced in the 1930s, imposes immense social costs in the form of lost output. A recession involving some temporary unemployment may impose lower social costs than governmental interventions designed to head it off.