Martin Wolf’s The Shifts and the Shocks; and my friend, patron, teacher, and (until the last reshuffle) office neighbor Barry Eichengreen ‘s Hall of Mirrors. Read and grasp the messages of both of these, and you are in the top 0.001% of the world in terms of understanding what has happened to us–and what the likely scenarios are for what comes next.
Pointer from Mark Thoma.
These are ultra-Keynesian treatments of the financial crisis and its aftermath. The all-purpose causal variable is a glut of savings and a dearth of government spending.
I cannot prove that this view is wrong. However, I am more convinced by Jeffrey Friedman and Wladimir Kraus, Engineering the Financial Crisis. The easiest way to summarize the book is that (with a nod to a different Kraus) risk-based capital regulations were the disease that they purported to cure.
The Friedman-Kraus story is one in which regulators suffer from the socialist calculation problem. With risk-based capital regulations, regulators determined the relative prices of various investments for banks. The prices that regulators set for risk told banks to behave as if senior tranches from mortgage-backed securities were much safer than ordinary loans, including low-risk mortgage loans held by the bank. The banks in turn used these regulated prices to guide their decisions.
In 2001, the regulators outsourced the specific risk calculations to three rating agencies–Moody’s, S&P, and Fitch. This set off a wave of securitized mortgage finance based on calculations that proved to be wrong.
Friedman and Kraus challenge the basic mindset not only of DeLong but of 99 percent of all economists. That mindset is that the socialist calculation problem, if it matters at all, only matters for full-on socialists, not for regulators in an otherwise capitalist system. In the conventional view, regulators can fail for ideological reasons, or because they are manipulated by special interests. But Friedman and Kraus offer a different thesis. When information discovery is vital, regulators, like socialist planners, are doomed to fail because they are unable to mimic the market’s groping, evolutionary approach to learning.
In Friedrich von Hayek’s Nobel Lecture, The Pretence of Knowledge, he concludes,
The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society–a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.
What Friedman and Kraus claim is that well-intended but now well-informed bank regulations were the destroyer, not of an entire civilization, but of a financial system. Like Hayek, they offer a profound critique of mainstream thinking. Like Hayek, they are sadly likely to be ignored.
I think you mean “well-intended but NOT well informed…
Great post. Thoughts:
(1) Didn’t Merton Miller call banking “a 19th century technology”? I think he said mark-to-market finance ought to replace banking altogether.
(2) Having capital risk weight regulations and three credit rating agencies is a recipe for textbook “regulatory arbitrage”, and all the trouble that follows. Once the Govt states that X=Y when in fact the market says they do not, everyone will sell the overvalued and buy the undervalued, etc.
(3) I’m agnostic about macro, but when someone writes “you are in the top 0.001% of the world in terms of understanding”, it sounds to me like the writer thinks he is omniscient. How do you know?? As Milton Friedman would say. An honest blogger would instead say, “Read Wolf and Eichengreen and you’ll understand perfectly the Keynesian interpretation (not *the truth*), which we believe is correct.”
(4) The Keynesian explanation is as much of an explanation as are Ptolemy’s epicycles. Or “the gods are angry”.
Cart meet horse. Banks were already adopting these guidelines and just needed government regulation to formalize the practice and its imprimatur, but even then this did vary across institutions. Regulation isn’t blue sky but the adoption of what the premier institutions want and the following of it by exploitation of its weaknesses. In this, there is no market independent of government or government independent of market.
Aren’t you rather making AK’s point for him? If the “premier institutions” are getting it wrong, then isn’t it time (recognised only in hindsight) for some groping evolution, driven perhaps by unexpected players outside the premier institutions and unknown to regulators? Government was needed to make a credible attempt at carving the wrong ideas in stone.
Thermodynamics applies whether you think it does or not.
Information and computability limits apply whether you think they do or not.
Bryan Willman – Very true. Also, Jack.
This is another searingly brilliant piece from the always thought-provoking Arnold.
Short, concise, blunt.
It’s hard not to absorb somehow a deeply fatalistic, almost cynical worldview as I continue my journey of discovery into society, politics, and economics, via the classical liberal tradition.
I stand sometimes almost in awe of the positive thinkers out there who declare that everything is getting better, and to enjoy the world and one’s life. I wish often that I could absorb some of that.
If the next recession comes in a timely manner, is it going to be because of an AD shortfall and a dearth of government spending and/or monetary policy being too tight?
The political pressure was to make it easier to get a mortgage. But it seems to me that the misunderstanding of the risks wasn’t so much about the one-off risk of the mortgage securities, which were still comprehensible, but instead was about the various derivative risk management instruments piled on top, which were not. The banks were in trouble because AIG was in trouble.