The Role of Defective Mental Models in Generating the Current Financial Crisis


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October 2009

The Role of Defective Mental Models in Generating the Current Financial Crisis
Prepared for the Cornell Workshop on the Global Implications of the Financial Crisis
Thomas D. Willett*
1. Introduction
Many economists and political scientists have been skeptical about the roles that ideas and ideology play in the formation of policy. Some argue that ideas and ideology are just used as masks for interests. And this is often true. But it surely cannot be the whole story for it is only through our mental models of the world that we perceive our interests. On some issues virtually everyone shares the same mental model so that interests are largely self-evident. But in many instances this is not the case. Actors may differ not only on their values and objectives but also about how the world works. Modern medicine, for example, seldom goes in for blood letting these days. Differences in economists’ recommendations on such issues as macroeconomic and exchange rate policy frequently have much more to do with their beliefs about how the world works (for example, are Keynesians or new classical models more correct) than about differences in objectives.

Of course, there is considerable evidence that people often tend to allow their normative wishes to color their positive views of how the world works. Thus there are times when strong normative or ideological biases influence the implicit or explicit positive mental models we adopt to interpret the world. Still there are occasions when evidence either of direct perception of events or from the results of scientific studies generate major changes in the views of actors about how the world works. For example, the depreciation of the Thai baht in 1997 generated what Morris Goldstein has called a wake-up call that broke the mental model of many lenders and borrowers that Asian governments would not allow major depreciations on their currencies. This in turn led to quite rational scrabbles to cover financial positions open to exchange rate exposure. The results were runs a number of Asian currencies.(See Willett(2000) and Willett et al (2005)).

This paper makes a similar type of argument that the current global financial crisis that started in the US subprime market was to a considerable extent the result of deficient mental models or beliefs by many actors in both the public and private sectors. I certainly do not claim that this was the whole story. Greed undoubtedly played a major role. But as an economist, I believe that greed is usually with us, albeit not always coupled with as much blatant dishonesty as occurred at times in the US housing market. But greed does not always generate financial crises. The many studies already completed make clear that a wide range of factors contributed to the generation and the breadth and depth of the crisis. Deficient mental models are only part of the story. But they are an important part. This paper traces out some of the important ways in which deficient mental models interacted with other factors such as perverse incentive structures and limitations on market information gathering and analysis to generate the erosion of credit standards in mortgage lending and excessive risk taking and leverage in many segments of the global financial market.

The first of the three deficient popular mental models that are considered are beliefs that house prices never fall. This drove much of the perverse behavior of the private sector. Most of the loosening of lending standards that look so absurd in hindsight wouldn’t have generated major problems if house prices had kept rising. Some lending practices were disgraceful even with continuing rising prices – but defaults wouldn’t be a serious problem for the lenders because of the increasing value of the collateral.

A second faulty mental model was that market discipline would automatically lead to self-regulation of the financial markets so that little regulatory oversight was needed. This view was most famously associated with Alan Greenspan, chairman of the Federal Reserve. His golden reputation at the time and his position as Fed chairman gave his views great weight with legislators and other regulators.

This view was encouraged by developments in the mathematical modeling of risk that led to a revolution in the financial engineering of complex financial instruments and over confidence that risk management models would allow risk to be precisely measured and managed, thus leading to a virtual conquering of financial risk. While these models were often excellent for managing risk during good times, they were generally poorly equipped to deal with bad times and by offering a false sense of security, they facilitated the generation of excessive risk in the financial system. The last section of the paper turns to analysis of the implications of this interpretation for strategies to improve future financial regulation and private sector risk management.

2. The Whopper – House Prices Never Fall.

This was likely the false mental model that caused the most severe damage, although had the old style structure of financing that the lender keeps the mortgage still been predominant, the damage would have been much less. Both the demand for housing and the supply were heavily influenced by this belief that became increasing widespread as the housing bubble grew. It’s, of course, not surprising that real estate agents would strongly disseminate this view, but it was also unfortunately supported by statements by leading public officials such as Alan Greenspan that in the post war period housing prices had never fallen in nominal terms on a nation wide basis.

If housing prices were indeed bound to keep going up then there was much less need for lenders to demand substantial down payments to ensure reasonable risk levels on mortgages. As long as the owners could meet their payments for the first few years, then even with a zero down mortgage they would soon have considerable equity in their house. Teaser rates could be justified by beliefs that by the time the higher interest rates kicked in, the owner would have enough equity to refinance. And even if default occurred, the value of the collateral would have likely appreciated enough to cover the various costs of foreclosure.

Clearly there were a number of cases where aggressive salesmanship and speculative purchases went well beyond even the widest limits of appropriate behavior, but such abuses appear to have been of lesser importance than the general frenzy of buying and selling. It is fairly easy to see how real estate agents and relatively uninformed buyers could get caught up in a mania of extrapolative expectations but such views spread to many supposedly cool headed analysts as well. This belief that at the national level housing prices could only go up became widespread. Many of the models used by the ratings agencies and large financial institutions had no provisions for dealing with price declines, and such possibilities were not included sufficiently in stress testing.

Nor were such rosy scenarios challenged by large numbers of the participants in the financial markets that provided such a large share of mortgage financing through the purchase of mortgage-backed securities. It’s not hard to see why originators would substantially lower their standards if they collect their fees while passing on the risks to purchasers of the MBSs. But then the question becomes why would investors be willing to buy securities based on potentially toxic assets. Strong market discipline by purchases of MBSs would force the originators to keep up standards. Belief that such market discipline would be forthcoming and that hence there would be little need for strong regulatory oversight is a second major mistaken belief or false minded model that contributed importantly to the crisis and to which we now turn.
3. The Belief that Markets Would be Self-Regulating

A key problem with the self-regulation view most famously associated with Alan Greenspan was that it was based more on faith than careful analysis of the incentive structures needed for the market to provide effective discipline over financial behavior.

As we noted above, financial innovations had led to an enormous change in incentive structures with respect to mortgage lending. With the development of the widespread use of securitization and the originate and distribute model of mortgage lending, the direct incentives for lenders to carefully monitor the quality of the loans was sharply diminished.

This in itself might not have presented serious problems if the prospective purchasers of the securities had been demanding about what they bought. Careful attention to quality by purchasers would have forced continued discipline by lenders in their originations in order to be able to distribute profitably. Unfortunately, buyers showed little discrimination. They relied heavily on certification by the ratings agencies and the herding instincts that this must be the smart thing to do since all the big sophisticated investors were buying.

The ratings agencies played a key role in the breakdown of market discipline by offering disgracefully high ratings on a high proportion of sub-prime and other bad mortgages. What happened was that a potentially valuable innovation in financial engineering was taken and drastically oversold. The good idea was that with the benefits of diversification and slicing and dicing allowed by securitization, the top proportion of a large group of sub-prime securities genuinely deserved AAA ratings. But while this might have appropriately applied to 10 or 20 percent of the total package, the ratings agencies were convinced by mortgage securitizing clients to rate well over half of many of these bundles as AAA.

To some extent, this reflected the bad mental models of risk management that will be discussed in section 4. But also important were the gross conflicts of interest generated by the development of a market structure where the payments for ratings came from those being rated. It doesn’t require one to be an advanced student of economics to see the conflict of interest problem that this generated. But the money was rolling in and neither the players nor apparently the regulators wanted to rock the boat. The regulators and politicians got what they wanted – increased home ownership by the poor and the ratings agencies, real estate firms, and financial institutions were raking in huge profits. The problem was that this was a game that wasn’t sustainable.

While the rating agencies had an oligopolistic structure favored by government-erected barriers to entry, on both the supply and demand side the market for securitized mortgages was highly competitive. The problem was that this is a market where information costs are high and knowledge is quite asymmetric. While we can fault buyers of these securities for being lazy and relying too much on the ratings agencies, a careful look at the information structure in this market suggests why the ultimate purchasers did not provide strong oversight. The information costs of doing so were high.

While it may be true, as advocates of this financial alchemy argued, that securitization allowed risk to be transferred to those in better positions to bear it – little attention was given to the problem that the incentives to obtain good information were sharply diminished. In the old hold-to-maturity model of mortgage lending, the institutions that could most efficiently gather the relevant information and act on it had the incentives to do so. With widespread securitization, the initial lenders’ incentives to obtain relevant information about the borrower dropped drastically, while diversified investors held little access to direct information. They relied on the middleman evaluations of the ratings agencies that turned out to be highly biased. So the level of effective information with which the system operated deteriorated markedly.

Often we can count on the market to turn up its nose at investment opportunities about which there’s little knowledge. That would have forced discipline back on the lender. But with the combination of the misleadingly high ratings and the fee-driven sales pushes from major financial institutions, MBSs became viewed as a smart thing to have in one’s portfolio and the herd rushed in. A largely similar phenomenon developed with the booming market for credit default swaps. Little attention was paid to counterparty risks and institutions were allowed to, in effect, offer insurance without accountability for having reserves to meet potential obligations.

In many industries a reasonable degree of competition is all that is needed for market discipline to work well. Where there are substantial differences between private and social costs and benefits competition is not enough, however. This is easy to see with polluting industries, but the potentially important divergences between private and social costs and benefits in the banking sector aren’t as readily apparent.

Two major functions of a productive banking system are liquidity transformation and promotion of the effective allocation of investment. These two functions are mutually reinforcing. Real investments are encouraged by secure longer term sources of financing, while both firms and individuals have a need for liquidity, the quick availability of funds at low cost. Bank deposits have for centuries been a major source of such liquidity. Long ago, however, bankers discovered that seldom if ever will all depositors want their money at the same time. Thus under normal circumstances bankers could safely lend out a substantial fraction of their deposits longer term, thus facilitating real investment. This was one of the first major examples of financial alchemy. This substantially lowered the cost and increased the availability of financing for longer-term investments in total while the desire to be repaid gave the bankers strong incentives to monitor carefully their loans and thus contribute to an efficient allocation of capital.

The Achilles heel of this system was that in panics the typical depositor couldn’t easily discover which banks were sound and which weren’t. Thus there were strong incentives for runs on all banks. Because of their liquidity transformation, even solidly solvent banks couldn’t meet huge increases in demands for liquidity by their depositors since by their nature many of their longer term investments could be liquidated quickly only at huge discounts, if at all. As a result, most economists have concluded that modern banking systems could not manage themselves and that there was a strong case for governments to act as a lender of last resort, allowing the crucial function of liquidity transformation to continue to operate while reducing the risks of financial crises.

As long as governments followed Bagehot’s advice to lend only to solvent institutions and at penalty rates, no major problems of moral hazard were generated by this increased role of government in the economy. Often, however, solvency is not so easy to judge, and especially with large institutions, governments may have strong political incentives to bias their judgments in terms of solvency or even to ignore this constraint all together. Hence was generated the too big to fail source of moral hazard. As a counter, governments tended to adopt capital requirements to offset the incentives for excessive risk taking generated by this moral hazard. This is probably economists’ favorite explanation for excessive risk taking in financial sectors and it has often been important. It is not so clear, however, that this was a tremendously important factor in the crisis of 2007-2008.

My interpretation is that defective mental models, internal management problems within financial firms, and changes in the structure of financing and perverse effects of competitive pressures combined to cause most of the problems without any need to involve moral hazard considerations generated by governments. As partial evidence in support of this proposition, we can invoke the huge wealth losses that the crisis generated for most of the top managers of the large financial institutions. While their creditors and institutions might be bailed out, most had considerable portions of their wealth tied up in the stock of their institutions and these took huge hits. The enormous golden parachutes that several ousted leaders received were the result of private contracts not government intervention.

Several insider analyses of the internal decision making within several of the large financial institutions that contributed to the crisis have now been published.1 These strongly suggest that over the period when the most risky investments were being made, many of the top managers of the big managers had little conception of the true risks that were being taken. While many of the top managers can certainly be faulted for not doing due diligence, and in some cases being grossly out of touch with what was going on, many of them seem to have been as misled about the safety of the asset backed securities as the purchasers of the exotic instruments that they created. Some appear to have believed in those AAA ratings of mortgage-backed securities (MBSs) as much as did ordinary investors.

Within the ratings agencies themselves a strong case can be made that the risk analyses performed were as much or more a mask for greed than of true beliefs in defective mental models. Certainly a number of examples have come to light of employees who had severe doubts about the adequacy of many of the risk assessments being offered. For the analysts their technical analysis was likely primarily a source for plausible deniability when things went bad rather than genuine errors. Some did express concerns to higher ups, but, perhaps blinded by all the money rolling in, top managers didn’t want to have their boat rocked.

Even without the prospect of government bailouts, economists have analyzed how managers who fear that their institutions may be insolvent will have incentives to gamble for redemption. However, as with directly government induced moral hazard, this doesn’t appear to have played a major role in generating the subprime crisis2. Over the period when most of the bad investments were made, no evidence has surfaced of top-level internal concerns about solvency in any of the major financial institutions. By the time some insiders did begin to worry about this, it was already likely too late. A number of warnings about excessive riskiness were given to and generally ignored by top management earlier on, but these appear to have been motivated by concerns to avoid large losses, not about the viability of institutions.

A stronger candidate for explanation is competitive pressure in markets where short-run returns are accurately measured and longer run risks are not. We are all familiar with the tendency for what can be easily measured to be over weighted in decision-making relative to what can’t be. We also know that immediate effects tend to be weighed more heavily than future ones. As analysts such as Nassim Taleb (2007) have emphasized, where what is at issue is a perceived small probability of large future losses, short-run competitive pressures are likely to generate insufficient attention to such risks and consequently result in excessive risk taking. Prudent investment managers who abstain from such activities will be outperformed in the short-run and lose income if not their jobs.

Robert Frank (2008) argues that this is a general feature of situations where performance is judged on a relative rather than an absolute basis. This tendency is exaggerated where the risk aspect of risk-return tradeoffs cannot be adequately measured at the time of decision making. Of course, as will be discussed in the following section, where the standard risk evaluation methods tend to understate true risk as the popular value at risk method did, then the problem becomes even more pronounced. Behavioral biases can also contribute to this problem. We often see what we want to see and overlook what we don’t want to see. Confirmation bias seems to have played a considerable role within major institutions with many top executives not paying attention to warnings that high earnings were coming from excessive risk taking3.

Easy money also played a considerable role, both by facilitating financing and through changing the incentives facing many financial decision makers. As rates of return fell in response to the flood of global liquidity, many investment managers felt strong competitive pressures to keep up returns. The easiest way to do this was to take on more risk and one of the easiest ways to take on more risk without this being immediately apparent to one’s bosses or clients is to increase leverage. Such increases in leverage in turn not only fueled the bubbles but also increased the damage to the economic system when the crash came.

From this perspective principal-agent problems between shareholders and the major financial institutions were likely not a major cause of the excessive risk taking by the institutions. There are important principal-agent problems in some areas of banking. Executive compensation is a prime example. Many large firms, and not just financial ones, have had cozy arrangements between top executives and directors, with relatively little effective oversight being provided by the small number of outside directors and by stockholders, who typically faced a number of institutional impediments to effective oversight. Many analysts argue that this structure contributed importantly to high salaries of executives (see, for example, Posner [2009]). There is a push for reform in this area, but there is little basis to believe that high salaries in themselves, as opposed to compensation structures that gave too little weight to risk relative to return, contributed importantly to the excessive risk taking. Given the difficulties of ascertaining “true” longer-term risk positions and the limited incentives for diversified investors to invest their time and resources in gathering and analyzing what information is publicly available, it seems likely that the majority of shareholders would have penalized rather than rewarded institutions that held back from increasing leverage and risk while others were increasing it and hence producing greater short-term returns.

One indication that this is likely true comes from the hedge fund managers who believed correctly that the rapid increases in the values of the companies were a bubble and bet against it in the early and middle stages. As the bubble continued they underperformed in the short-run and lost investors. Some like George Soros made large losses and eventually gave up. Being right in the long run isn’t always an effective short run survival strategy in financial markets.

In summary, competitive markets can provide productive discipline only when good information is available and a sufficient number of actors have the incentives to obtain, analyze, and act on this information. In the old days when banks kept their loans on their books, these conditions were reasonably approximated. In the new financial structure based on widespread securitization such discipline broke down. In such a case a general faith in market discipline was no substitute for a careful analysis of market structure and incentives. And these suggest that there was little basis to believe that the financial system would be self-disciplining under the new conditions generated by financial innovation. As long time Wall Street economist Henry Kaufman (2009) puts it, “The structural changes in the financial markets encouraged participants to become short-term oriented...the fervor for profits from securitization...ushered in a host of ...institutional shifts. Senior managers at a growing number of leading financial institutions either lost control of risk management or became its captives… every institution... felt growing pressure to take risks in order to maintain market share” (p. 203) and “the glamour and profit of risk-taking ensured that the risk takers themselves gained more and more power within the structure of financial institutions.” (p. 205) Thus neither internal discipline within the major financial institutions nor the external disciplines of the financial markets or of regulators were sufficient to counter those problems.
4. The Belief That Risk Had Been Conquered

The rapid expansion of the use of the complex financial instruments so many of which turned toxic, was made possible by a combination of advances in mathematical finance and computer power. These likewise revolutionized techniques of risk management4, as sophisticated as they were, however, such models for pricing derivatives, discovering speculative opportunities, and managing risk still had to make a number of important simplifying assumptions in order to be computable.

These advances did bring a number of important benefits. A much greater array of derivative products allowed firms to hedge many more types of risks than before. But as was true of the first financial derivative to become widely used, the forward contract in forward exchange, instruments that can be used to hedge risks can typically also be used to take risks, i.e. speculate. This isn’t necessarily bad, as speculators are often the source of supply for the demands of hedgers. Generally there will be hedging demands on both sides of the market, but these typically won’t initially balance. By stepping into these gaps, speculators can help stabilize the market, provide greater liquidity and reduce the magnitude of price fluctuations. This is the case with stabilizing speculation. But we have learned that speculation isn’t always stabilizing and then we can have problems. Not only is market discipline undermined, but also such speculators, if sufficiently numerous, can destabilize markets.

Most of the innovations in the mathematical modeling of risk in recent decades have been based on the assumption that markets were efficient and liquid and subject to continuous trading. (Of course other types of mathematical models were used to try to discover profit-making inefficiencies in markets.) Even where speculation is stabilizing it can sometimes be in short supply – especially when there is great uncertainty. This can undermine key assumptions of the standard risk models and generate spectacular failures of risk management strategies. This was illustrated with a vengeance in the stock market crash of 1987. Many investors had become sold on the benefits of so-called dynamic hedging, which under the assumptions noted above, would allow investors to limit their losses from stock market declines. These strategies were also based on the assumption that overall market behavior would not be affected by their adoption. This seemed reasonable for the stock market where each investor would normally be a small part of the market. What was overlooked was that if a number of investors started following similar strategies this could begin to significantly affect the behavior of the market. When the market started to fall on the morning of Black Monday, October 19, 1987, all of the portfolios being operated on dynamic insurance programs began to sell. There were few buyers and the one-sided program trading generated a sharp discontinuity in the market with liquidity vanishing and prices plunging.

Despite this fiasco, other versions of profit seeking and risk management programs continued their spread. Even the collapse of Long Term Capital Management due to model failures in 1998 was not sufficient to seriously dampen the rise of widespread faith in these models. A number of economists, financial analysts, and Wall Street quants did point to serious problems with the reliability of these models5 but they were in a distinct minority, both among financial market participants and regulators.

In general these new risk models and the derivative products based on them work well during normal periods. A case in point are the value-at-risk (VaR) models which came to dominate risk management strategies in large private financial institutions and were heartily endorsed by many regulator agencies. Part of their popularity was their collapsing a complex set of considerations into a single number, the largest amount that could be lost on a portfolio over a relatively short period of time, often a day to a month with a certain degree of statistical confidence (often 95 percent). Often this worked quite well and had the important advantage of taking into account the risk reduction benefits of diversification by incorporating the correlations among different components of the portfolio. Unfortunately, however, the precision of the calculations gave many traders and managers a false sense of confidence that risk was being adequately measured and that with the benefits of diversification and the new array of hedging instruments risk could be controlled to a quite high degree. As the Financial Times columnist Wolfgang Munchau (2009) notes, “Some believed that innovation in the financial markets had eliminated all risk for all time. This, of course, was an erroneous belief, but it does give a clear picture of what people were thinking at the time.” (p. 89)

The key problems were not only that the VaR models ignored liquidity, counterparty, and operational risks, but also that they assumed that financial market outcomes were normally distributed and that correlations over the recent past would be a good guide to their behavior in the future. Both of these assumptions are invalidated by massive amounts of empirical experience. It was well known to financial economists and many financial analysts that the distributions of most financial market outcomes have “fat tails,” i.e. that large positive and negative changes occur much more frequently than they would with a normal distribution. See for example, Mandelbrot and Hudson (2004).

Furthermore, many studies have shown that the correlations among financial variables can vary a great deal over time. They are heavily influenced not just by structural relationships but also by patterns of shocks, which can vary considerably over time. Thus, for example, if interest rates rise because monetary policy is tightened we would expect the country’s currency to strengthen, but if the interest rates rise because of expectations of higher inflation or perceptions of greater risk then we would expect the currency to fall.

Furthermore the methods are essentially backward looking. They ignore many types of warning signs that a crisis could be brewing. This was clearly indicated in the Asian crisis. In the VaR approach, risk was measured by past volatility. Since the Thai baht had been basically pegged to the dollar for over a decade it had displayed little variability. Thus the VaR approach could not pick up the increased riskiness of the baht as the crisis approached. [See Lindo (2008).]

All of these problems were well known to some academics and practitioners but were ignored by many others. Even the real world examples of their potential importance such as the Asian and Russia-LTCM crises were insufficient to overcome the widespread beliefs that risk could now be precisely measured and managed. And of course, it was on this type of analysis that not only the major financial institutions but also the ratings agencies based their analysis. The result was a major contribution to excessive risk-taking. It will likely be impossible to develop a very precise idea of how much of this excessive risk-taking was due to genuine excessive faith in the models, versus senior managers not wanting to pay attention to warnings from analysts, versus cynical use of the models by analysts who understood at least some of the problems, but found it in their short run interests to ignore them. We do have enough documentation to be confident that all these types of behavior occurred, however, and that each type was likely fairly common.

5. Some Lessons from the Crisis

In considering financial reforms for both the public and private sectors, the crisis highlights a number of important lessons. This has been a dismal tale of greed, hubris, stupidity, false assumptions and mental models, and regulatory inattention. Fortunately we can end on a more positive note. If my analysis is correct, then many of the problems that led to this crisis can be substantially mitigated by taking more seriously an economic approach to financial regulation and correcting the defective mental models discussed above.

Of course commentators with strong but differing theoretical or ideological perspectives will tend to draw quite different lessons from the crisis and many explanations have been offered. (For a partial list, see Appendix A.) Many on the right have seen the crisis as resulting from excessive government involvement such as pushing low income and minority loans, while many on the left see the major cause in financial deregulation and free market ideology, while a number of European governments and much of the public places blame primarily on bankers’ greed and their “outrageous compensation.” Obviously people holding these different views would draw quite different lessons about priorities of reform. Furthermore so many factors interacted to produce the scope and depth of the crisis that there is likely to be at least some truth in each of these critiques. There is no silver bullet for providing a sound financial system. I believe, however, that efforts to correct the defective mental models which I have argued played a major, albeit not exclusive, role in contributing to the crisis can make an important contribution to improving financial regulation and the soundness of financial systems.

Even with correct mental models there will still be conflict of interest and major financial institutions and ratings agencies will lobby for legislation that puts their interests ahead of that of the overall economy. In general, however, the use of less faulty mental models is likely to reduce some of these conflicts of interest, especially those resulting from market actors taking on more risk than they realized. Likewise even without new legislation, more widespread recognition that house prices can fall as well as rise should promote less destructive behavior in the markets for houses and their financing.

The crisis should also strengthen the hand of those regulators who want to do their job. While the ideology or mental model that the financial sector needed little regulatory oversight was important, “cognitive capture” of regulators by those being regulated also likely played a major role. This will be hard to reduce but efforts should be made. There is legitimate controversy among experts about whether financial deregulation like the progressive softening and then outright repeal of the Glass-Steagall Act made a significant contribution to the crisis, but it is a widely held view, which I share, that failure to make use of the regulations on the books was a much stronger factor than financial deregulation per se.

From the standpoint of private risk management, the principal lesson is that the relationships in behavior among different financial assets and liabilities are not the physical constants such as those with which civil engineers deal, but rather reflect a combination of direct economic and financial interdependencies and the pattern of shocks that hit the system. Most of the developments in mathematical modeling and product innovations that go under the heading of financial engineering can have productive uses. What led to such devastating outcomes from these developments was largely a combination of bad incentive structures and false beliefs in the stability of historical correlations. The latter led to greatly exaggerated beliefs about how precisely risk could be measured and managed and how much leverage could safely be accommodated by a high tech financial system. It would be a shame to overreact and abolish all the recently developed programs in financial engineering. But they do need urgently to re-engineer themselves to focus more on financial economics.

This will help both to deflate hubris about the degree of predictability in financial relationships and also focus more attention both within private sector institutions and regulatory agencies on incentive structures. We do not need to get into a debate about whether greed is good or bad to recognize that it is a widespread attribute of the human condition. While we can hope that most people would refuse to engage in some of the most predatory of the practices that have been uncovered in segments of the subprime mortgage industry, a central premise of the economic approach is that we need to design incentive structures that minimize the need for people to behave like saints. This should be a central focus of regulatory reforms.

Critics of regulation such as Alan Greenspan put great store in their judgments that on average we cannot expect financial regulators to match the resources and sophistication of the institutions they are supposed to regulate. This is a judgment with which I concur, but from which I draw a quite different lesson than Greenspan. While much has been made of the laissez-faire attitude toward financial regulation adopted by American regulators, this was far from just being an example of American free-market extremism. The whole set of regulatory principles developed by the Basle group of international regulators relied heavily on the outsourcing of risk analysis to the ratings agencies and the large banks’ internal models. These were indeed highly sophisticated but also deeply flawed. Furthermore regulators largely overlooked the strong incentives to misuse such analyses. To discover these perverse incentives one does not need a high-priced lawyer or a Ph.D. in mathematics. Any run-of-the-mill economist worth their salt would have spied some of these conflicts of interest immediately, and others after some study.

The Securities and Exchange Commission in the United States is not unusual in being peopled largely by lawyers who tend to give insufficient attention to basic economic analysis. This could be easily corrected if the political will is there. Of course it’s not sufficient just to identify perverse incentives. They must be corrected.

One of the most obvious of these conflicts of interest is having ratings agencies paid by those who are issuing the securities they rate. Concern for reputation can place some limits on the degree of fudging that the agencies are willing to engage in, but this game has the same structure as that discussed in Section 3, the returns typically come in the short-term while the risks, whether to reputation or the portfolio, are likely to come only with a lag. This structure needs to be reformed in a major way. The claims of the ratings agencies that they will develop adequate internal safeguards against conflicts of interest are hardly to be believed. The soft treatment of the ratings agencies is perhaps the most disappointing aspect of the generally sensible proposals for reform that have come from the Obama administration. (The failure to propose the creation of a single financial regulatory authority is another aspect criticized by many experts.) It is certainly useful to have well behaved ratings agencies and experts are far from agreed about the best type of reform. It should be remembered, however, that the current structure of paying for ratings was not prevalent in the early days of the industry, clearly demonstrating that alternative structures are feasible. One approach that has attracted considerable support from experts is to abolish all the legislation that requires that a wide range of financial instruments be rated by the small set of agencies that have been approved by the government

In many cases the discovery of optimal incentive structures is well beyond our current capabilities, but great gains can be made just by devising and implementing less bad ones. In this regard we should pay careful heed to the call of Richard Bookstabler in his important book, A Demon of Our Own Design (2007), which predicted the current crisis as the outcome of excessive complexity in our financial structure. Bookstabler’s analysis offers a most convincing warning of the danger of devising complex arrangements that optimize for a particular environment but which may fail badly in another one. He stresses the evolutionary advantages of simpler but more robust arrangements that are optimal in no one environment, but which perform decently in a wide range of situations. As the current crisis vividly – if painfully – illustrates, the financial landscape can be quite variable. This suggests that at least initially regulatory reform should focus on fairly simple regulations such as limitations on leverage for different types of activities. This should not require financial wizards to implement and should have only limited effects in discouraging useful financial innovations. Furthermore while lacking the look of sophistication, it would be more difficult to game. However, this approach does require an important ingredient that is often in short supply – political will.

Another important lesson confirmed by the crisis is that countries need to worry not only about their own financial soundness, but those of their important economic neighbors, even if these neighbors are geographically separated by thousands of miles of ocean. Earlier episodes of contagion over the past several decades had been primarily regional in nature, with the important exception of the LTCM-Russian crisis which had much more global effects.6

In the early stages of the current crisis, strong effects outside of the industrial countries were generally limited to countries such as Iceland and some of the Baltic and central European countries that were quite vulnerable on normal criteria such as large current account deficits and high levels of short-term foreign debt relative to their reserve levels. However, once the crisis worsened in the US and a wide spectrum of financial markets froze, developing and emerging market countries across the globe began to be seriously affected even if they had strong domestic fundamentals and little direct exposure to the exotic securities that had gone bad. These negative spillovers worsened as the industrial countries began to move into recession and exports to them from the rest of the world began to plunge.7

This implies that developing and emerging market countries have a strong interest in drawing lessons not only for their own financial policies but also in actively participating in discussions of financial reforms in the industrial countries. In this regard the creation of the G-20 (and the inclusion of more countries on the newly created Financial Stability Board) are a major step forward since it allows countries previously excluded from the activities of the Basle groups to have important representation in the discussions and negotiations over financial reform.

As has been emphasized by Simon Johnson8 and others a major difficulty with past efforts at financial regulations has been the enormous political clout of the major financial institutions. And despite widespread public anger at the roles of these institutions in contributing to crisis the early discussions of post crisis reform show that their political clout is still considerable and a number of commentators have begun to express fears that sufficient reform will not be forthcoming.

Traditionally an important function of summit meetings has been for leaders to stiffen each other’s backs to fight harder against domestic trade protectionism. The G-20 meetings could play the same role with respect to banking sector pressures to soften increases in capital requirements and weaken other financial reforms. Over and above the strong direct financial interdependences that have developed among countries, the political benefits of a unified front against the lobbying of the financial sector provides a strong case for collective action in the area of financial reform. Developing and emerging market countries have a strong interest in seeing that the reforms that will regulate the major international financial institutions are adequate to reduce substantially the probabilities of a recurrence of the recent financial excesses.

Appendix A: A List of Suggested Causes of the Financial Crisis

  1. Beliefs that housing prices never fall

  2. Excessively easy money

  3. The Global Savings Glut

  4. Financial innovation (Bhagwati’s destructive creation), securitization of mortgages, CDS’s etc.

  1. Globalization (Soros)

  1. Excessive faith in risk models (and ratings agencies)

  2. Conflicts of interest for ratings agencies

  3. Deregulation

  4. Unregulation – excessive faith in market discipline by Greenspan and others

  5. Irresponsible behavior in financial sector (argued by Greenspan) [Greed, fraud, etc. in housing financing]

  6. Minsky credit cycle

  7. “Reflexivity” – George Soros

  8. Endogenous liquidity (El-Erian), leverage, (capital inflows from US over spending and global savings glut)

  9. Hubris, euphoria, and other psychological biases (behavioral and neuro finance)

  10. Beliefs in the Great Moderation and this time it’s different

  11. Global under-pricing of risk (Greenspan)

  12. Moral hazard - too big to fail

  13. Government sponsored enterprises – Fannie and Freddie and housing legislation

  14. Compensation schemes in the financial industry that rewards excessive risk taking (false alpha). Robert Frank – rewards based on relative performance

  15. Incentives to undertake risky activities to avoid losing market share

  16. Mainstream equilibrium economics – Soros argues “our current troubles can be largely attributed to the fact that current international financial system has been developed on the basis of their paradigm.”
  17. “We got away from the basics – from the fundamentals of prudent lending and borrowing.” (Tom Friedman)

  18. Black Swans

  19. “Termites” (lack of good information rotted out the structure)

  20. Lack of consumer financial education

Reasons for the crisis worsening in the fall of 2008

  1. Inept policy responses led to loss of confidence

  2. Failure of Lehman stimulated increased fear of counter party risk

  3. Growing recognition that there were serious solvency, not just liquidity problems


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* Director, Claremont Institute for Economic Policy Studies, and Horton Professor of Economics, Claremont Graduate University and Claremont McKenna College E-mail:

1 See Cohan(2009), Bamber and Spencer (2008), Faber (2009), McDonald and Robertson (2009), Tett (2009), and Tibman (2009).

2 Several forms of government encouragement for lending to low income and minority home buyers definitely contributed to the magnitude of the crisis, but much of the bad lending was for higher priced houses. While the first signs of the crisis showed up in the subprime market, Munchau (2009) is right to argue that it’s a misnomer to refer to this crisis as the subprime crisis. For more on the housing aspects of the crisis see Barth et al (2009), Shiller (2009), and Sowell (2009).

3 The new subfield of behavioral and neuro finance focuses on such possible biases. See, for example, Akerlof and Shiller (2009), Burnham (2005), Peterson (2007), and Zweig (2007).

4 For discussion of these revolutions, see Bernstein (2007), Triana (2009), and Lindsey and Schachter (2009).

5 See, for example, Taleb (2007), Triana (2009), Lindsey and Schachter (2009) and Willett et al (2005).

6 Strong global effects are likely to occur only when major financial centers are heavily impacted as occurred with the Russia-LTCM and the current crisis. See Kaminsky, Reinhart, and Vegh (2003). On contagion moregenerally see the discussion and references in Willett and Liang (2008).

7 On the spread of the crisis see Liang, Willett, and Zhang (2009).Documentation of the limited role of domestic and standard international variables in how hard countries across the globe have been hit by the crisis, see the massive empirical study conducted by Rose and Spiegel (2009). Testing for the effects of some 60 variables on stock market declines, currency depreciation, drops in economic growth and credit evaluations for over 100 countries, they find only large current account deficits, low levels of international reserves and previous stock market run ups as fairly consistently significant.

8 Give refs.


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