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.
How Were All These Systematic Errors Possible?
The obvious question is, How were so many unsound decisions in so many countries made? A number of specific answers can be given, ranging among hypotheses about home prices, the weak transparency of mortgage securities, corporate malgovernance, excess subsidies to housing, and excessively loose monetary policy. Although these answers may have merit in explaining particular aspects of the crisis—given that bubbles have burst in just about every asset market and in many countries—they do not seem sufficiently fundamental.
Once we liberate ourselves from applying the law of large numbers to entrepreneurial error, as Black urged us, another answer suggests itself. Investors systematically overestimated how much they could trust the judgment of other investors. Investment banks overestimated how much they could trust the judgment of other investment banks. Purchasers of mortgage-backed securities overestimated how much they could trust the judgment of both the market and the rating agencies as to the securities’ values. A commonly held view was that although financial institutions had made large bets, key decision makers had their own money on the line and thus things could not be all that bad. Proceeding on some version of that assumption, most market participants (and regulators) held positions that were increasingly vulnerable to systemic financial risk.
In this regard, an indirect link exists between the current crisis and the massive investment fraud perpetrated by Bernie Madoff. The point is not that all banking is a fraud but, rather, that we rely on the judgments of others when we make our investment decisions. For years, Madoff had been a well-respected figure in the investment community. His fraud was possible, in large part, because he was trusted by so many people. The more people trusted Madoff, the easier it was for him to gain the trust of others. A small amount of initial trust snowballed into a large amount of trust, yet most of that trust was based on very little firsthand information. Rather than scrutinize the primary source materials behind Madoff’s venture, investors tended to rely on the identities and reputations of those who already trusted Madoff. In the run-up to the current crisis, a similar process of informational “cascades” led a great many investors to put excessive trust in highly leveraged banks and other business plans.
In a strict rational expectations model, we might expect some people to overtrust others and other people to undertrust others. Yet, when it comes to the cumulative and reinforcing nature of social trust, this averaging-out mechanism can fail for at least four reasons.
First and most important, a small amount of information can lie behind a significant social trend, as previously explained. One of the most striking features of the current crisis is how many countries it hit at roughly the same time, which suggests some kind of international peer effect.
Second, market participation involves a selection bias in favor of the overconfident. No one aspires to become a CEO for the purpose of parking the company assets in T-bills.
Third, incentives were pushing in the wrong direction. The individuals who were running large financial institutions had an opportunity to pursue strategies that resembled, in terms of their reward structures, going short on extreme market volatility. Those strategies paid off for years but ended in disaster. Until the volatility actually arrives, this trading position will appear to yield supernormal profits, and indeed, the financial sector was enormously profitable until the asset-pricing bubbles burst.
Fourth, the course of history cemented this bias toward excessive trust. As the world became more prosperous, to rely on the optimistic expectations of others seemed to be increasingly justified.
The notion that the United States was experiencing a real estate bubble was a staple observation among financial commentators at the time. A real estate bubble had formed and burst before—in the late 1980s—and the United States had survived that event with little calamity and only a mild recession. But most people failed to see the new and increased financial risk associated with the bursting of the more recent bubbles.
One view of rational expectations is that investors’ errors will cancel one another out in each market period. Another view of rational expectations is that investors’ errors will cancel one another out over longer stretches of time but that the aggregate weight of the forecasts in any particular period can be quite biased owing to common entrepreneurial misunderstandings of observed recent history. In the latter case, entrepreneurial errors magnify one another rather than cancel one another out. That is one simple way to account for a widespread financial crisis without doing violence to the rational expectations assumption or denying the mathematical elegance of the law of large numbers.
Page 3 of 4 - Go to page 1 , 2 , 3 , 4
This article has originally appeared on morningstar.com.
