Misunderstanding Financial Crises: Why We Don’t See Them Coming
William Graham Sumner (1840–1910), a Yale professor and expert on banking, was describing the half century prior to the U.S. Civil War. The next seventy or so years aft er the Civil War were marked by repeated financial crises until federal deposit insurance legislation was passed during the Great Depression, and could be described similarly. Th e global fi nancial crisis of 2007–8 suggests that the lessons were probably never learned. What are the lessons?
One is that fi nancial crises are inherent in the production of bank debt, which is used to conduct transactions, and, unless the government designs intelligent regulation, crises will continue. Th is is not understood. Prior to the financial crisis of 2007–8, economists thought that no such financial crisis would ever happen again in the United States. Economists thought that a crisis could not happen. Then the unthinkable happened; the inconceivable happened. How could economists, myself included, have been so wrong? Economists misunderstand financial crises, what they are, why they occur, why we didn’t have one in the United States between 1934 and 2007, and a host of related questions. But the real question is: What are the origins of this misunderstanding? Th is is a question about the epistemology of economics, about how economics produces knowledge. That is our subject.
This small book began as an essay that was originally prepared for the Academic Advisory Panel of the Board of Governors of the Federal Reserve System, for a meeting in May 2011. Th e question posed to me as a topic was: “What will the future fi nancial landscape look like aft er Dodd-Frank?” Because Dodd-Frank is very complicated—the legislation requires 243 rulemakings and sixty-seven studies in order to implement its various parts—and hinges on the discretion of regulators, it is extremely hard to answer this question. My response: “Who knows?”
I also said that I thought that a more important way to think about the question was to focus on the word “look.” What the future “looks” like depends on the observer and what the observer is capable of “seeing.” What is the actual process of seeing in economics? Think of economists and bank regulators looking out at the financial landscape prior to the fi nancial crisis. What did they see? They did not see the possibility of a systemic crisis. Nor did they see how capital markets and the banking system had evolved in the last thirty years. They did not know of the existence of new financial instruments or the size of certain money markets, like the sale and repurchase market. Th ey did not know what “money” had become. Th ey looked from a certain point of view, from a certain paradigm, and missed everything that was important. As Sherlock Holmes put it to Dr. Watson: “You see, but you do not observe.”
The blindness is astounding. Th at economists did not think such a crisis could happen in the United States was an intellectual failure. Why did this happen? How could this have happened? Non-economists agree this is an important question and have leveled all sorts of criticisms at economics and economists to explain it. Economics, they argue, is too mathematical, too rational, and so on. Former chairman of the Federal Reserve System Paul Volker essentially blames economists for the crisis, in so many words. Here’s his opening sentence in an article in the New York Review of Books : “It should be clear that among the causes of the recent fi nancial crisis was an unjustifi ed faith in rational expectations, market effi ciencies, and the techniques of modern finance” (“Financial Reform: Unfi nished Business,” November 24, 2011).
Never mind that Nobel Prizes in economics were won for rational expectations and the techniques of modern fi nance. Yet most well-known of the economists’ critiques is that of 2008 Nobel Prize–winner Paul Krugman: As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. Th at vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. Th e renewed romance with the idealized market was, to be sure, partly a response to shift ing political winds, partly a response to fi nancial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess. (Krugman 2009)
I. INTRODUCTION 3
II. CREATING THE QUIET PERIOD 10
III. FINANCIAL CRISES 29
IV. LIQUIDITY AND SECRETS 45
V. CREDIT BOOMS AND MANIAS 59
VI. THE TIMING OF CRISES 74
VII. ECONOMIC THEORY WITHOUT HISTORY 87
VIII. DEBT DURING CRISES 98
IX. THE QUIET PERIOD AND ITS END 125
X. MORAL HAZARD AND TOO-BIG-TO-FAIL 134
XI. BANK CAPITAL 151
XII. FAT CATS, CRISIS COSTS, AND THE PARADOX
OF FINANCIAL CRISES 165
XIII. THE PANIC OF 2007–8 182
XIV. THE THEORY AND PRACTICE OF SEEING 200
Bibliographic Notes 213
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