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’s 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’t 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.

Comments

[scott]

Why weren't there more Roubinis among the professors of finance? I wonder if the answer is already stated above:

"They are involved in the financial markets as consultants, investors, and sometimes money managers."

Their incentives are no different than the people in the businesses who do not want bad news.

[Camilo Telles]

Dear Posner,

I think that Nicholas Taleb have to be remembered in this crisis. He predicted what happened with FNMA in his book "The Black Swan"

Camilo

[Dan]

I would be terrified of a financial counterpart to the CIA. The potential for such an agency to be used to manipulate, to leak trade secrets, to play favorites -- and to be incompetent, as the CIA has been on occasion (remember the failure to predict either the Soviet invasion of Afghanistan or the Iraqi invasion of Kuwait?) should give pause.

The Rand and Brookings models already exist to allow the gov't to use think-tanks to help develop policy, and many analysts at these and other organizations have security clearances.

I think that this crisis is a call for economics to do some rigorous soul-searching. I posted a few weeks ago that my perception is that economics is too often the handmaiden of free market ideology.

The weak fundamentals of the U.S. economy have been appearent even to non-economists such as myself for a long time. The middle class has been eviscerated, we are over-dependent on imported energy, hyper-consolidation (viz. Walmart) has undermined entrepreneurial impulses and rewarded groupthink corporate personality types at the expense of independent thought and initiative.

And my god, American mothers can no longer afford to stay home and raise their children. Middle class standard of living is out of reach for the vast majority of single-income households.

Much has been said about the loss of manufacturing base in this country and the shift to a "service economy." The "value added" by the pride of the U.S. economy -- IBs like Lehman Bros, etc. -- turns out to have been the invention of exotic securities that just crashed the world financial system like so many virus emails and trojan horses let loose on the Internet.

BLS economic indicators like inflation rate and unemployment are widely seen as too politicized to be of real use. The CPI cannot be used to meaningfully compare standard of living over time. And on and on.

In the absence of a financial CIA to eavesdrop on bank transfers and listen in to corporate retreats, accepting as a given that gov't will always be malleable for political ends, I would submit that only the discipline of economics itself is in a position to convene and build a consensus on hard-and-fast standards for economic indicators to be used by governments around the world. "More substance with less art."

[Don the libertarian Democrat]

Maybe because the government had given an implicit guarantee to intervene in such a financial crisis.

[St. Darwin Assisi's Cat]

For a person of your stature to say I don't know is impressive to me. Appreciate being introduced to Roubini and Wohlstetter. Enjoyed hearing you on Radioeconomics. I find these 'sophisticated financial instruments' (e.g., deriviatives) to be a fancy form of STEALING. The odd thing is 'they' are stealing from nothing, thin air. What did the man say recently on 60 minutes about physicists designing all of these instruments for the future...a financial OZ.

[Jack]

Posner sez: "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."

........... ahh yes "free market ideology" In talking to young students of economics they all seem to have been infused with this faddish theory and I suppose ideology often blinds one to looking at the features of the landscape.

A diesel engine seems a good metaphor for capitalism. Those familiar understand that as more fuel is injected into a diesel more air is automatically taken in, as long as you keep pouring the fuel to a diesel it will put out more HP and do more work, until it melts.

So every diesel has a device called a "governor" along with systems to ensure that it is not over-fueled if something malfunctions as overfueling can create a dangerous runaway that spits internal parts in every direction.

The "Roubini's" don't surprise me as much as does a whole caste of economists, and those with fiduciary responsibilities to their firms and investors NOT getting it.

Take a quick look at this simple housing graph (and there are some down below for the "hot" markets that are interesting.)

http://mysite.verizon.net/vodkajim/housingbubble/

Looking at the long term trend line wouldn't any economist or banker note that their is a relationship between the median home price and median income? Roughly speaking our median HH income points to the $160K home price as we can buy a home that costs no more than 3X our income.

So someone's alarm should have gone off not long after the trend line was left behind. Questions like WHY have we left the trend line? What is fueling such a departure?

While your looking at the charts, it's suggest there is a predictive element to them. Since median income has not improved, or put another way, today's young couples can not afford to purchase the homes of their parents, I'd expect median home prices that soared to $250K to revert to the trendline which is still some 20% below where we are now.

If there is a stiff recession coupled with the downward price momentum I'd not be surprised to see home prices break through the trend line.

One more thing that seems predictable? The first 20% drop created a "lost value" triangle of a certain size that is the subject of today's bail out. The next 20% drop creates a lost value trapezoid that is FAR larger, which fits well with a Deutsche Bank estimate that next year some 40% of US home owners will be underwater, or 40% of 51 million loans for a problem of 20 million loans ranging from slightly under to 40% or more under.

Shall we call Paulson's deal "Rescue I?" with R-II coming in late spring?

One more observation? Mortgages in the US are held on average just under seven years. I see the trendline much like stocks in "strong hands", as those buying pre-2000, paid trendline prices and typically have fixed loans more than seven years old.

Those since 2000 have paid the higher prices and have mortgages less than seven years old. Even w/o the curious "features" in many mortgages they've little in pay downs so nearly all homes purchased in the since 2000 are problems. The exception would be those who put 20% down to avoid paying Private Mortgage Insurance premiums, and some fair number of those will be underwater as well.

Lastly, it's interesting that extending either the inflation adjusted, or the nominal trendline out to 2009 they both point to a median home price of $170K.

[RK]

Warnings were ignored because the proceeds of the 2004, 2005, 2006 and 2007 bonus pools, were used, as they always will be, to
trump any attempts at interference, to the extent of overruling,
firing, discrediting or buying off any resistance that happens to stand in the way. It's just bigger and more complex than its ancestors, the Drexel Burnham phenomenon and the S & L crisis.

[Old Curmudgeon]

The real puzzle is how so many bright people, in and out of academe, could believe that lending large sums of money to people who hadn't a prayer of repaying the loans, and doing so on a vast scale, would lead to anything other than a financial disaster. I can understand the loan brokers and "packagers" who could take their cut up front and run, but what about the real lenders?

Conversely, how could so many would-be homeowners take out loans they could not possibly repay? Their excuse was the irrational belief that home prices would keep on rising indefinitely, but that does not make rational their belief that they could maintain monthly home payments which they plainly couldn't.

[David Heigham]

Now that the re-capitalisation of the banks is at last under way, the crisis will begin to sort itself out.

As the dust settles, it will become painfully evident that regulatory action to force counter cyclical provisioning on the banks, and to insist that capital should be provided against off-balance sheet vehicles, would have averted any acute systematic problem other than temporary liquidity shortages. It will be evident because one medium sized country facing a property boom relatively greater than that in the USA took these measures and has sailed through contrary to most market expectation. The central bank that got it right is the Bank of Spain - a central bank in the euro zone and therefore with apparently less room for manoevre than the Fed or the Bank of England.

My current hypothesis as to why the major central banks did not do as the Spaniards did is that they fell into a CIA-type error - superb analysis and mastery of much of the detail coupled with loss of over-all perspective. The deeply intelligent and impressive research papers from the Fed, the ECB, the Bank of England and the BIS in recent years have greatly improved our ability to understand and - in posse - to regulate the international financial system. But they omit the central banking basics: - a risk is a risk is a risk, however you account for it; and risks always tend to accumulate in the system.

How we might institutionalise attention to the basics, to what Rudyard Kipling called the Copy Book Headings, is an issue which I hope Judge Posner will address.

[David Heigham]

Now that the re-capitalisation of the banks is at last under way, the crisis will begin to sort itself out.

As the dust settles, it will become painfully evident that regulatory action to force counter cyclical provisioning on the banks, and to insist that capital should be provided against off-balance sheet vehicles, would have averted any acute systematic problem other than temporary liquidity shortages. It will be evident because one medium sized country facing a property boom relatively greater than that in the USA took these measures and has sailed through contrary to most market expectation. The central bank that got it right is the Bank of Spain - a central bank in the euro zone and therefore with apparently less room for manoevre than the Fed or the Bank of England.

My current hypothesis as to why the major central banks did not do as the Spaniards did is that they fell into a CIA-type error - superb analysis and mastery of much of the detail coupled with loss of over-all perspective. The deeply intelligent and impressive research papers from the Fed, the ECB, the Bank of England and the BIS in recent years have greatly improved our ability to understand and - in posse - to regulate the international financial system. But they omit the central banking basics: - a risk is a risk is a risk, however you account for it; and risks always tend to accumulate in the system.

How we might institutionalise attention to the basics, to what Rudyard Kipling called the Copy Book Headings, is an issue which I hope Judge Posner will address.

[Michael Panzner]

You wrote: "But here is the biggest mystery of all: why was the crisis not foreseen?"
Actually, it was foreseen. I published my book, Financial Armageddon, in March 2007 and correctly anticipated much of what has happened so far. In fact, chapter 6 is entitled "Systemic Crisis." (Sound familiar?).
I guess the economics establishment -- which essentially missed the boat on all of this -- assumed that because I was not one of "them," but merely a 25-year student of the markets, I did not know what I was talking about.

[dearieme]

Perhaps the essential lesson is that when economists are not busy writing footnotes to Smith and Ricardo, their efforts are largely intellectually vacuous. I also wonder whether some of them resemble some of the climate scientists, starting off merely as inept modellers and drifting slowly towards downright deceit.

[joebek]

"Many economists and political leaders are heavily invested in a free market ideology which teaches that markets are robust and self-regulating." But even more are absolutely committed to the non-free market ideology of central banking. To write an article about why the crisis what not foreseen and not even mention the "Greenspan put" or "Helicopter Ben" is to engage in mystification. Just as the mystifiers became even more astounded by developments in the '30s so too is it likely to be in the next decade, now that we are all disabused of free market ideology. The way is open once again for triumphs of the will.

[Jim]

Ravi Batra's 1996 book,"The great American Deception", pointed out some reasonable warning about boom and bust not the least of which was that for a variety of reasons the ever increasing diversion of wealth between wage earners and executives would lead to depression. One of his arguments was that only the wealthy can speculate in risky investments. I can hear you discounting that argument with "a large percentage of the NINJA mortgages were not for the "wealthy". That is true but the securitized mortgatges were risky investments made by the small percentage of the population with assets to risk (top 1%). The lucky folks who bought homes with no money down took no risk at all. No one paid any attention to professor Batra then and I suspect Judge Posner is correct in saying no one will pay attention to any Jeramiah and that I also suspect is a weakness in human nature which argues for more cautious and conservative public policy.

My own personal bias is that there is no "unified field theory" in economics and that the resulting complexity leads to unacceptable levels of uncertainty and confusion and allows those with selfish, greedy and stupid agendas to be obscured.

The last time we welched on our debt was in 1971 when we inflated the dollar and then refused to redeem it in gold. Now we are going to redeem the dollar with "derivatives"????? with most of the funny assets purchased on margin. Were there any economists who waved the red flag about that degree of leverage?

[Brian Davis]

Jack Bogle (Vanguard's founder) lives in the perform-or-die real world of mutual fund investing. Add Mr. Bogle to the list of gloom-n-doomers from long ago, beginning from about the time of the dot-com mania. He told CNBC's flacks time and again how difficult it was becoming to select investment mixes for Vanguard's funds that would yield a respectable return, protect principal, and minimize expenses. But they blew him off time and again because Vanguard's funds consistently outperformed the market indexes. Monkey see, monkey do. Like the proverbial cab driver trading stock tips. A few quick bucks and everybody's suddenly a Bogle, or a Buffett - and those guys aren't even high-flyers by lifestyle. If you could say your deals or your trades were "accretive" or producing "gains" or you were just plain "making money," LOTS of money, you became somebody's Pied Piper. The villain in all this supposedly is housing - a meteoric house price run-up fueled by irresponsible financial underwriting - chiefly in the U.S. That's part of it. But it comes up short of telling the whole story. Distressed home builders, developers, financiers, and purchaser-debtors alone wouldn't be taking down the banks and stock markets worldwide, wouldn't be wiping out sensibly-diversified investment portfolios, and wouldn't have national governments socializing financial intermediaries - not only banks but insurance organizations.

[AndrewBW]

Others outside of the economics/finance field did try to warn of failures in the mortgage/lending market, to no avail. See from Business Week, "They Warned Us About the Mortgage Crisis."

(http://www.businessweek.com/magazine/content/08_42/b4104036827981.htm?chan=top+news_top+news+index+-+temp_news+%2B+analysis)

[Aram]

I believe credit is due to Hyman Minsky, a major influence of Noriel Roubini. His theories on debt accumulation and business cycles are very pertinent to our current situation. A lot of economists have had prescient insight into our condition.

[lark]

Prof Thoma has a clip up of an MIT panel discussing the financial crisis and honestly they seem shockingly obtuse and ideological. I was appalled. I hope they do not represent the economics profession, and yet, perhaps they do, for it seems economists have led us to an economy that does not work for the average American. I don't trust your theories or opinions much, anymore.

Link: http://economistsview.typepad.com/economistsview/2008/10/mit-panel-discu.html

[Tom Grey]

As Becker says, 'too many false alarms'. Even when you know houses are 'too expensive', you don't know when to sell and hold cash.

By the time you DO know, the peak has passed and prices are in free-fall.

It's really too bad there weren't more explicit probabilities on house prices dropping. That should probably be a new requirement for the IMF and the World Bank, and perhaps post-class action suit rating agencies.

Won't there be suits against the rating agencies who, essentially, lied when they rated crappy MBS instruments as AAA?

[Idler]

The academic problem lies deeper than "free market ideology". A hint as to the underlying problem is in this phrase: "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 ..."

It is precisely because the profession treats macroeconomics and finance as separate fields, that the problem could not be understood. Macroeconomists study money, whereas finance professors study credit. In the real world money and credit are frequently indistinguishable. Only a rare bird like Roubini was capable of choosing to do work that fit into neither field, but in fact encompassed both of them.

As long as the academic world continues to favor specialists over generalists, the models that are used to divide a profession into fields will constrain research and no one should expect academics to have the skills necessary to foresee crises. A bit like Keynes' bankers, who are careful to fail only when every other banker is failing too, academics know that their careers will be safe as long as they are careful to err in concert with their colleagues.

[Unsympathetic]

Seriously?

You two are professors at the single institution responsible for the "intellectual" backing of the Neocon ideology (Leo Strauss) and you have the gall to wonder why there weren't MORE of your peers publically describing the problems in the economic system?

What did you THINK would happen when his team actually gained control of the ship?

The irony writes itself.

There were plenty of professors, regulators, and economists stating that there was a housing bubble - but political pressure is always to keep the good times rolling and ignore the "few" who bother to investigate such things like "price to income ratio." It's much easier to get votes when you're a Pollyanna of Prosperity than a Dr. Doom.

Besides, Kudlow is on CNBC! He must be accurate - both his suits and his voice are very loud!

[Dan]

Unsympathetic:

Q: Will the Obama government have the political will to preside over a rate increase in 12-18 months or will the stage be set for a future bubble that will take down our solar system plus Alpha Centauri and Betelgeuse?

[neilehat]

All of this is reminescent of "Tales From My Childhood". Specfically, "Noah's Ark" and "Peter and the Wolf". As for old Noah, everyone thought he was just plain crazy. Until it rained forty days and forty nights. In Peter's case, it become so much fun to raise the alarm and terrorize everyone that everyone became enured to the game and stopped listening. Too bad for Peter when the wolf really did show up.

Now I know why my Great Grand-mother had me sit down and read the stories.

So the issue becomes, "How do we keep it from occuring in the future"? Or are we condemned to repeat our failures simply because of our inability to learn from past mistakes. Or do we need to put Economics and Finance on a truly Scientific basis instead of the Ideological one it is now based on?

[Andrew P]

Surely everyone could see that the real estate boom of the early 2000s was a bubble. I could see it and so could all those people who bought houses only to "flip" them. The business media (i.e The Economist) could see it too since there were many stories about the bubble. The big problem with bubbles is that it is hard to know when the music stops until it actually does, and in this case who the ultimate bagholders for all the bad debt will be. And we still don't know the answer to the last question, because it isn't over yet. There may be many more surprises to come.

Now, people can't do quantitative projections of what the risks were unless there is a model to run that fits reality. We will only solve this one when the US Govt learns how to send signals backwards in time and creates the cross-temporal internet. Then the CIA will have direct knowledge of the future, and be able to act on it - for the government's own profit, and the profit of CIA officials. Will the general public benefit? Probably not.

[Jamison Davies]

I think a closer reading of Wohlstetter's work and the subsequent literature about surprise attack can be even more instructive. Important to Wohlstetter's argument is the concept of the "signal-to-noise" ratio, i.e. the amount of useful information being taken in compared to the information that is false, misleading, or irrelevant. It turns out that earlier concerns about inflationary spikes may have just turned out to be background "noise" (calculated by the GDP deflator, not the CPI, for reasons outlined by a poster above) as well as other economic issues, but ex ante it is extremely difficult to tell what data will be predictively useful and what is just noise. The later literature also examines another related problem which I think is particularly instructive. The difficulty in early warning, among other things, is that if you give correct warning and act in response to that warning, the attack will likely not materialize (i.e. if the US knew Japan was about to attack Pearl Harbor our defensive preparations would prevent Japan from following through). This means that successful warnings are under-counted because the catastrophe never emerges. This tends to weaken early warning systems as they are perceived to be ineffective even though they may have averted serious problems.

The economic analogy is regulation. Regulations were seen as unnecessary and dismantled because there had been no crises, but policymakers failed to consider that there may have been no crises precisely because of the regulation.

Finally, an historical aside. The argument that we believed that Japan would never attack the US has been disproved since Wohlstetter wrote. The declassification of documents relating to the US breaking the PURPLE Magic Japanese diplomatic code shows that the US knew something big was coming, but could not figure out where the attack would land. A lot of decoded Japanese missives indicated attacks on various different places; only 2 mentioned Pearl Harbor. The US knew an attack was coming, but there was not enough "signal" to figure out where it would land.