A Simple Theory of the Financial Crisis
We are not as shielded from a sudden dose of bad luck as we would like to think.
An enigmatic thinker, Black sometimes wrote in epigrams or brief sentences and did not present his macroeconomic views in terms of a formal model. For that reason, interpreting Black is not always easy. Nonetheless, Black’s writings offer ideas for explaining the current crisis, most notably the idea that a general risk–return tradeoff governs business cycles. Black also stressed “noise traders,” T-bills as the new form of cash, the inability of monetary policy to address many downturns, and the notion that a business cycle is characterized by significant sectoral shifts.
Published in 1995, Black’s Exploring General Equilibrium starts with the idea that entrepreneurs choose a preferred level of risk. Of course, choosing a higher level of risk involves higher expected returns but also a correspondingly greater risk of collapse. That is a common assumption about individual entrepreneurs, but Black’s innovation was to insist that such reasoning could be applied to the economy as a whole.
Black’s account of the business cycle downturn required many different economic sectors to go wrong all at once, through widely held but incorrect assumptions about the real world. At the time, this approach was out of sync with “rational expectations” theories. In favored approaches of the 1980s and 1990s, it was common to admit that individual mistakes were possible but that such mistakes would be governed by the “law of large numbers.” (This view was prevalent before the rise of behavioral economics to its current popularity.) Mistakes could occur in many different and scattered directions, and so mistakes did not suffice to drive the co-movement of many different economic sectors. Although forecasting mistakes would cause some sectors to do worse than average, other sectors would do better than average because of forecasting errors in the opposite direction. Black, however, never accepted this perspective, and he continued to insist that the law of large numbers did not necessarily apply to a business cycle setting. As I will show, some plausible expectational errors are magnified in the aggregate and do not cancel one another out.
Most business cycle analysts offer detailed scenarios for how things go wrong, but Black’s revolutionary idea was simply that we are not as shielded from a sudden dose of bad luck as we would like to think. With that in mind, I would like to consider how we might make sense of the current financial crisis and recession by drawing broadly upon some of Black’s ideas.
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This article has originally appeared on morningstar.com.
