We are not short of causes for our current economic crisis. The basic machinery of capitalism, including the process of making loans, did not work as it was supposed to. Capital flows around the world proved much more destabilizing than even before (and we’ve seen some damaging capital flows over the past 200 years.) And there are plenty of distinguished individuals with something to answer for, including anyone who thought they understood risk and how to manage it.
But perhaps the real problem lies even deeper, for example, either with a natural human tendency towards bubbles or with how we think about the world. All of our thinking about the economy – a vast abstract concept – has to be in some form of model, with or without mathematics. And we should listen when a leading expert on a large set of influential models says (1) they are broken, and (2) this helped cause the crisis and – unless fixed – will lead to further instability down the road.
This is an important part of what my colleague, Daron Acemoglu, is saying in a new essay, “The Crisis of 2008: Structural Lessons for and from Economics.” (If you like to check intellectual credentials, start here and if you don’t understand what I mean about models, look at his new book.) To me there are three major points in his essay.
1. The seeds of the crisis were sown in the Great Moderation (the low inflation, relatively stable last 20 years or so). Everyone who patted themselves or others on the back during that time was really missing the point (p.3). The same interconnections that reduced the effects of small shocks created vulnerability to massive system-wide domino effects. No one saw this clearly.
2. The predominant view was that the US and other relatively rich countries had pretty good institutions (i.e., rules, laws and practices underpinning economic transactions) and that these institutions would prevent powerful people from the kind of abuse that endanger social systems in many parts of the world (pp.4-5). That view was incorrect. (Speaking personally, I had no illusions about the power of the strongest on Wall Street – particularly after my experience on the SEC’s Advisory Committee on Market Information in 2000-2001. But I didn’t have the right mental model of how this power aggregated up, i.e., the way in which these people, and the firms they controlled, had created or recreated a deeply unstable system.)
3. The way we think about reputation, including how it is acquired and maintained, is way off base (pp.6-7). This is fundamental for both formal economics and how you go shopping. You walk into a grocery store with a mental model that is based on the premise that the individuals all through the production chain operate in a control structure designed to build brands and make you think their products are healthy and tasty. Such reputations are costly to build and not readily squandered. But, Daron points out, this is too simple. In particular, we should no longer make the mistake of saying “the company” wants this or that. There are no companies in any kind of behavioral sense. There are people, struggling to get ahead, and it is their interactions that can lead – particularly in finance – to products that are really terrible for you and your neighbors (and even quite bad for themselves).
Daron also urges that we not lose track of longer term economic growth issues in the current policy debate. If the bailout process – including the evergreening of credit by the Federal Reserve – slows down or even freezes the reallocation of resources out of the financial sector, we have a problem. We need to move, at least somewhat, out of a bloated financial sector and back into the kind of nonfinancial technology-developing sectors that have primarily driven growth in the US since the 1840s.
This is not an argument against a comprehensive stimulus package. But it recognizes the legitimacy of any backlash both against the models that brought us here and many of the sweet deals for leading financial figures (received so far and no doubt currently pencilled in). Beginning with designing, arguing about, and implementing the stimulus, we need to think more clearly about the economics and politics of how we rebuild the financial system. If we recreate something fundamentally unfair and unstable, that will also undermine growth.
The Baseline Scenario 
Two thumbs for Acemoglu’s essay. This hand wringing about what caused the current economic crisis is pointless and distracting. Any idiot can see that the cause of crisis was massive fraud by financial institutions (the creators and marketers of derivative securities as well as the ratings agencies)and widespread corruption (on the part of regulators, rating agencies and the economics profession more generally).
The current crisis the oldest story in the world. A lot of clever, well-connected, well-healed unethical people saw an easy path to riches and took it. To accomplish their crooked ends, they bought politicians, placed their cronies in critical positions at regulatory agencies, bribed academics with consultancy fees and directorships, floated a massive PR campaign as a camouflage (promoting the ridiculous notion that unregulated capitalism leads to a fair, stable and efficient allocation of resources).
The great moderation, low interest rates, globalization of financial markets, etc… were enabling factors that made financial fraud easier to propagate, but they were not the causes. The causes were widespread fraud and corruption, that is all.
The big question today is to figure out how to clean up the mess created by this massive global wave of fraud. One big question, at least in my mind, is whether large banks have completely lost the capacity to make prudent responsible loans,i.e. to efficiently allocate capital. If that is the case, as I suspect, we are in for a very long period of economic first contraction and stagnation as the major economies learn how to build a new honest and efficient financial plumbing system to move money from savers to credit worthy borrowers.
In the end, I suspect, it will be the unwillingness of the U.S. to honestly face what has happened and to competently repair its financial system that will prevent the U.S. economy from recovering quickly.
While this article starts to move toward a broader look at the causes of our current situation, it ignores what many continue to ignore. Millions of Americans and millions more Asians, Europeans, and others did not get lured into this bubble and did not hand their money over to people and banks with little idea of what they would do with it.
To say that there is a natural human tendency toward bubbles is rubbish. Millions of people actively chose not to purchase over-priced real estate, not to participate in bloated stock markets and not to hand over their money to individuals who clearly were playing dangerous games with it. These people weren’t just lucky. They made good choices based on sound logic. They’ve known for years that interest rates were too low, that financial institutions were poorly managed and that reputation was a valuable asset not easily earned but easily lost.
While it is never easy to analyze a crisis while you are still in the midst of it, this essay does move forward to a broader analysis. But we have a long way to go in understanding the variety of causes and choices that have led us to where we are.
Once again, thank you for this website.
I think a fundamental problem here is that we can have many voices but very few can affect policy. Powerlessness. As we move to a globalized market, governments too are among the dinosaurs that are failing but are “too big to fail.” We need to reconnect the individual citizen to a scale of government that the individual voice can affect. Independent regional governments of a few million citizens each would be about right, perhaps 3000 such entities worldwide. Does the political will exist to do this? Of course not. We are in for a world of trouble.
Pat J, just because millions of people didn’t actively participate in this bubbles does not mean that they wouldn’t participate in bubble behavior and that is the issue. Change the scenario and you’d still readily get people to participate in a bubble. That’s the human component.
Your friend Daron may have impeccable economic credentials, but he would be well served to retain the services of a good editor.
So A for content, B- for grammar, diction, and style.
Yes, not only is the economy in crisis but economics is in crisis. At the heart of macroeconomics is the claim that we do understand the global economy and can therefore manage it by pulling policy levers, “top down and from the centre”. Evidence shows this is not so. Obama’s latest proposals, for example, might address the US if it existed in isolation, but the US is only a part of the problem.
An alternative view is that the global economy is a complex adaptive system. Like ant colonies, cities and the human brain, it has the ability to learn in its parts and as a whole. As fast as we make new regulations, players in the economy will find ways to circumvent them. Just as the brain exhibits emotions so stock markets display “market sentiment”.
We can manage complex adaptive systems but only indirectly, “bottom up and at the edges”. This is the secret of Grameen Bank’s success.
When physical assets lose their value, all we have left are human assets. The key to liberating value from people lies in improving the quality of dialogue at every interface in the system (unhealthy neurons cause brain dysfunction; healthy neurons restore it).
How do you begin to manage “bottom up and at the edges”? You make it safer to talk.
You are right to say: “The way we think about reputation, including how it is acquired and maintained, is way off base. This is fundamental for both formal economics and how you go shopping.”
The origins of toxic debt and toxic eggs are similar (see http://yalaworld.blogspot.com/2008/10/toxic-eggs-and-toxic-debt.html).
I do not understand why an economist would be surprised that large, responsible firms with strong concern for their reputation would nonetheless engage in risky opportunistic behavior. Consider a firm whose (smaller? less honest?) competitors are benefiting significantly from risky behavior. In an efficient market, that firm has two choices: It can imitate the opportunistic behavior, regardless of the possible long-term risk to its reputation. Or, it can choose to forego the opportunistic behavior. In the latter event, its profits will drop in comparison to its competitors, as will its stock price. And it will accordingly lose its more aggressive, and some of its better, top employees, starting a vicious cycle in which it continues to lose financial and human capital. Hence, the pressures to adopt the opportunistic behavior are likely to be strong and increase over time, unless the downside risk is readily apparent, appreciable, and imminent. It is not a question of whether failure is punished severely, or even at all; it is primarily a question of immediacy of punishment. If the punishment is not immediate, market efficiency will, I should think, inevitably drive conservative firms to match the behavior of their more risk-tolerant competitors, lest they be driven out of business.
[…] They have a nice summary of Daron Acemoglu’s paper which has a focus on behavioural (mental/perceptual) reasons for the financial crisis. […]