By Michael Prowse
Writers of detective fiction typically waste little time describing the murder. They reserve their ingenuity for the part that grips their readers. Who did it and how? Once the shock of the ghastly event has worn off, the focus naturally shifts to causes and motives.
It is much the same with the financial crisis of 2007-09. We are no longer so much interested in what happened as in why it happened. Who or what caused it? Broadly speaking there are four competing views.
The first is that advanced by many of those responsible for financial policy in the years leading up to the crash. For instance, Alan Greenspan memorably described the crisis as a “once in a hundred years flood” – i.e. something unexpected and unpredictable against which the US could not sensibly have protected itself. It was just one of those financial bubbles that occur from time to time – a product of irrational exuberance for which nobody (except perhaps God in designing us poorly) was responsible. I think we can all agree this is a self-serving and implausible explanation.
The second, and slightly more credible view, is that it was a product of human error. The global financial system was fundamentally sound. But unfortunately the present generation of bankers – unlike their parents and grandparents - was not up to the job. Greedy and incompetent, they foolishly leveraged themselves to the hilt in pursuit of implausibly high returns that ultimately proved a mirage. Governments then had to spend hundreds of billions of dollars bailing them out to prevent the financial meltdown destroying the global economy.
Greed and selfishness obviously played a part. But as Max Weber, the sociologist, observed long ago these attributes of human nature are not a unique product of capitalism. They appear in one form or another in every human society. It is pointless to blame recessions or bubbles on the frailties of human psychology. When we design social rules and institutions we should make due allowance for the flaws in our nature, rather than pretend they do not exist.
This brings us to the third possible explanation. Although bankers and traders behaved badly, the origins of the crisis lie in inadequate regulation. It was the public not private sector that erred most grievously because it failed to establish sensible rules of the game, even when the evidence indicated the existing rules were not working.
Ross Levine of Brown University makes this case as plausibly as anyone in a recent paper for the Institute for International Economic Policy in Washington. Using his own analogies from crime fiction, he argues the financial crisis was a product of “negligent homicide” – culpable carelessness on the part of agencies such as the Federal Reserve and SEC - rather than an “accident” or “suicide”. Accident corresponds to the Greenspan view; suicide to the view that it was all a product of banker greed and incompetence.
Levine’s thesis is that policymakers caused the crisis: it was not just something that happened to them. He cites specific examples of irresponsible regulatory policies.
One is the way that the SEC created the monopoly power of the private ratings agencies and then relied uncritically on their assessments of creditworthiness. Thus it endowed only a few agencies with the status of “nationally recognised rating organisation”, allowed these agencies to sell their ratings to the issuers of securities, and proceeded itself to rely on these assessments when establishing capital requirements. Regulators around the world followed the SEC’s lead in creating a system riddled with conflicts of interest – conflicts that became deadly following the explosive growth of structured financial products.
The Fed’s stance on credit default swaps was another gross regulatory failure. It allowed banks that bought CDSs to reduce their capital reserves on the grounds they had insured themselves against possible losses. This was unwise, argues Levine, because the Fed did not have reliable means of assessing the credit risks of those who sold CDSs to banks. As the CDS market grew exponentially, the systemic risks multiplied, yet the Fed failed to intervene. It aided and abetted regulatory arbitrage.
A third example is the SEC’s amazingly light regulation of the major investment banks. It allowed them to use their own risk models for calculating capital levels – unsurprisingly leverage soared. It then opted to supervise them as consolidated entities, despite their immense complexity, and allocated only seven people to monitor the parent companies of investment banks that controlled over $4 trillion in assets. Levine notes the SEC failed to complete a single inspection of a major investment bank in the year and half before they all failed or had to be bailed out at public expense.
Levine’s paper is a rewarding study of regulatory failure. But it begs one question: why did regulators adopt so lax a posture? Regulators everywhere were lax, not just in the US.
We finally reach the fourth and most profound level of explanation of the financial crisis – the one that George Soros emphasises: bad theory. Governments, central banks and financial regulators adopted a laissez faire stance because they believed in the “magic of the market”. On the whole they accepted the free market ideology of the past few decades, including offshoots such as the efficient markets hypothesis and rational expectations theory. They did not want to intervene much, or impose many rules, because they regarded the market, rather than themselves, as the repository of wisdom.
Private rating agencies would naturally be better at assessing credit risks than mere bureaucrats. Who could know more about capital requirements than bankers: if they said credit default swaps were reducing overall risk, mustn’t that be true? And why supervise Goldman Sachs in more than a token fashion: its executives were the brightest and best – the incarnation of the market spirit. How could they do wrong?
Soros has a particular theory of what went wrong in modern economics – for a brief summary see his paper for the Institute for New Economic Thinking’s inaugural conference. Broadly, it is that economics modelled itself too closely on theoretical physics and thus sought to establish timelessly valid laws that can be used to explain and predict events. Hubristic practitioners thought they had proved that markets always tend towards equilibrium. And in financial markets “quants” – often literally refugee physicists – were certain they could quantify all risks by means of complex mathematical formulae.
This is all mistaken, argues Soros, because the phenomena of economics are entirely different from those of natural science: how people think influences economic events in a way that has no parallel in the hard sciences. His doctrine of “reflexivity” merely holds that the beliefs people have about what will happen influences what does happen, and, conversely, what does happen influences what people think.
But since thoughts are unpredictable and need not correspond to reality, there is no natural tendency towards equilibrium. False beliefs – say about the sustainability of house prices – can appear valid for long periods (if they are shared by others) and thus create bubbles. Eventually the gap between thought and reality will become evident but by then it may be too late to prevent disaster – as in 2007.
Soros is right to stress the differences in the subject matter of economics and natural science although his point is hardly new: German philosophers and historians raised precisely this objection during the 19th century. It also seems likely that bankers would have behaved more prudently if they had realised that risk cannot be quantified in a mathematically precise fashion. The truth is that the future is radically unknowable - how would one quantify, say, the risk of 9/11 occurring?
But Soros is wrong to equate “bad theory” with physics envy. Some of the most committed market fundamentalists – Friedrich Hayek and the “Austrian school” for instance – were sceptical of the use of mathematics in economics. George Stigler, one of the founders of the Chicago School, was not into quantification. Nor was Adam Smith or any of the classical economists. Yet they all believed in laissez faire doctrines. Conversely, Paul Samuelson – one of the principal architects of modern mathematical economics – was a committed Keynesian who rejected free market ideology.
The truth is that bad theory is the ultimate cause of the financial crisis because it lay behind the poor decisions of both regulators and bankers. But the bad theory was simply the notion that unregulated markets are efficient and tend to produce optimal outcomes. Keynesians – whether mathematical or unmathematical - have been arguing this for decades.