The Financial Crisis: Why Were Warnings Ignored?--Posner
When Becker and I blogged on the financial crisis last Sunday, the bailout had just been announced. The reaction of the stock markets and of senior government officials here and abroad suggests that the premise of the bailout--that the financial crisis is a liquidity crisis that can be resolved by the government's buying the assets of troubled banks at prices equal to the value the assets would have if there were a market for them (that is, if there were adequate liquidity to enable transactions)--was mistaken. The crisis appears to be one of solvency rather than (or perhaps along with) one of liquidity; banks, along with insurers of bonds and other securities, are undercapitalized and so, as I suggested last week, require a capital infusion rather than just a purchase of frozen assets.
All of which merely underscores the enormous cloud of uncertainty that has enveloped the crisis and left economists struggling to understand the causes, magnitude, future course, and cures of what is shaping up as the biggest economic bust since the Great Depression of 1929 to 1933. Last week's stock market crash may also reflect doubts about the government's competence to deal effectively with the crisis. There is a sense that its reluctance to take an equity stake in the banks reflects a doctrinaire hostility to public ownership.
But here is the biggest mystery of all: why was the crisis not foreseen? An article on the front page of the business section of yesterday's New York Times attributes that blindness to "insanity," more precisely to a psychological inability to give proper weight to past events, so that if there is prosperity currently it is assumed that it will last forever. This explanation is implausible--often people fail to adjust to change because they expect the future to repeat the past--and unhelpful, especially when one remembers that the academic specialty of Federal Reserve Board chairman Bernanke is the Great Depression.
We can get more help in answering the question of unpreparedness, or neglect of warning signs, from the literature on surprise attacks, notably Roberta Wohlstetter's great book Pearl Harbor: Warning and Decision (1962). As she explains, there were many warnings in 1941 that Japan was going to attack Western possessions in Southeast Asia, such as the Dutch East Indies (now Indonesia); and an attack on the U.S. fleet in Hawaii, known to be within range of Japan‚Äôs large carrier fleet, would be a logical measure for protecting the eastern flank of a Japanese attack on the Dutch East Indies, Burma, or Malaya. Among the factors that caused the warnings to be disregarded are factors that may also have been decisive in the neglect of the advance warnings of the financial crisis now upon us: priors (preconceptions), the cost and difficulty of taking effective defensive measures against an uncertain danger, and the absence of a mechanism for aggregating and analyzing warning information from many sources. Most informed observers in 1941 thought that Japan would not attack the United States because it was too weak to have a reasonable chance of prevailing; they did not understand Japanese culture, which placed a higher value on honor than on national survival. Securing all possible targets of Japanese aggression against attack would have been immensely costly and a big diversion from our preparations for war against Germany, deemed inevitable. And there was no Central Intelligence Agency or other institution for aggregating and analyzing attack warnings.
Much the same is true of the warning signs of the current financial crisis. Reputable business leaders and economists had been warning for years that our financial institutions were excessively leveraged. In mid-August of this year the New York Times Magazine published an article foolishly entitled "Dr. Doom" about 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." By August of this year, when the Times article was published, Roubini's predictions had come true, yet he continued to be ignored. 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. Bernanke had repeatedly stated that it was unlikely that the mortgage defaults that accelerated after the housing bubble burst in mid-2006 would spill over to the financial system or the broader, nonfinancial economy. In May of 2007, for example, he said: "Importantly, we see no serious broader spillover to banks or thrift institutions from the problems in the subprime market." It has been more than two years since the housing bubble burst. One might have thought that that was enough time to enable the experts to discover that our financial system was in serious trouble.
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. Borrowing and then lending the borrowed funds is inherently risky, because you have fixed liabilities but (unless you invest in risk-free assets such as short-term Treasury Bills) risky assets. But it was believed that the risks of borrowing had been reduced and therefore that leverage (the ratio of borrowing to capital) could be increased without increasing risk. Bayesian decision theory teaches that when evidence bearing on a decision is weak, prior beliefs will influence the decision maker's ultimate decision.
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--and then Congress or the Administration would have been blamed for the fall in home values and the increase in defaults and foreclosures. In addition, it is very difficult to receive praise, and indeed to avoid criticism, for preventing a bad thing from happening unless the probability of the bad thing is known. For if something unlikely to happen doesn't happen (as by definition will usually be the outcome), no one is impressed; but people are impressed by the costs of preventing that thing that probably wouldn't have happened anyway. This is why Cassandras--prophets of doom--are so disliked. It usually is infeasible as a practical matter to respond to their warnings--but if the prophesied disaster hits, those who could have taken but did not take preventive action in response to the warnings are blamed for the disaster even if their forbearance was the right decision on the basis of what they knew.
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. The cost of a disaster has to be discounted (multiplied) by the probability that it will occur in order to decide how much money should be devoted to reducing that probability. No one knew the probability of a financial crisis such as we are experiencing. Even Roubini did not (as far as I know) attempt to quantify that probability.
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. Little bits of knowledge about the shakiness of the U.S. and global financial systems were widely dispersed among the staffs of banks and other financial institutions and of regulatory bodies, and among academic economists, financial consultants, accountants, actuaries, rating agencies, and business journalists. But there was no financial counterpart to the CIA to aggregate and analyze the information--to assemble a meaningful mosaic from the scattered pieces. Much of the relevant information was proprietary, and even regulatory agencies lacked access to it. Companies do not like to broadcast bad news, and speculators planning to sell a company's stock short do not announce their intentions, as that would drive the stock price down, prematurely from their standpoint.
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.
Of all the puzzles about the failure to foresee the financial crisis, the biggest is the failure of foresight of professors of finance and of macroeconomics, with a few exceptions such as Roubini. Some of the media commentary has attributed this to economics professors' being overly reliant on abstract mathematical models of the economy. In fact professors of finance, who are found mainly in business schools rather than in economics departments, tend to be deeply involved in the real world of financial markets. They are not armchair theoreticians. They are involved in the financial markets as consultants, investors, and sometimes money managers. Their students typically have worked in business for several years before starting business school, and they therefore bring with them to the business school up-to-date knowledge of business practices. So why weren‚Äôt there more Roubinis? I do not know. And why, if not more Roubinis, not more financial economists who took the warning signs sufficiently seriously to investigate the soundness of the financial system? I do not know that either.