January 13, 2013 8:48 pm
A history of hubris and flawed hypotheses
Misunderstanding Financial Crises: Why We Don’t See Them Coming, by Gary B. Gorton, Oxford University Press; RRP£19.99
To what extent was the economics profession to blame for the financial crisis? Many would agree with Paul Volcker, former chairman of the US Federal Reserve, when he pointed in The New York Review of Books in 2011 to “an unjustified faith in rational expectations, market efficiencies and the techniques of modern finance”.
Professor Gary Gorton of the Yale School of Management puts a more technical gloss on it. He highlights the way economists “see” reality by looking through the lenses of models that come to embody the ordinary and the orthodox while failing to recognise structural changes in the financial system. The paradigm is then overwhelmed by reality when a financial crisis strikes.
That is undoubtedly true, as far as it goes, though there remains a big bone to pick with the book’s sweeping starting point. Gorton baldly asserts that “prior to the financial crisis of 2007-08, economists thought that no such financial crisis would ever happen again in the United States”. In perpetuating the myth that no one saw it coming, he traduces many in his discipline, and scarcely mitigates the insult with the subsequent suggestion that “a small number of economists gave vague warnings”. There was nothing vague about the warnings from William White and Claudio Borio at the Bank for International Settlements, to take one obvious example. The point is that there was nothing vague, either, about the rebuffs they received from the heads of leading central banks who determinedly downplayed the problem of financial instability.
There is, of course, substantial economic literature on financial fragility, not much discussed here, that seeks to explain credit bubbles in behavioural terms – exploring how, for example, prudent creditors are driven from the market as others disregard low-probability hazards and fail to charge appropriate risk premiums. The interesting question is why diminishing attention was paid to these disaster myopia hypotheses and why financial stability experts in many central banks saw their status heavily downgraded in recent years.
Part of the answer is hubris. Developed world central bankers tended to believe that the “great moderation” – the period of uninterrupted growth that prevailed in the years before the crisis – was a reflection of their own sagacity in monetary management. An approach to central banking that focused exclusively on monetary policy and inflation targeting also had a certain elegance. It appeared to entail greater accountability because performance could be measured over time against a single benchmark.
Equally important, financial economists who worried about the build-up of risk and debt in the system suffered from the problem that it is impossible to forecast precisely when any bubble will burst. When no action is taken to prick an extended credit bubble, their credibility is easily undermined by accusing them of crying wolf.
The impact of these institutional changes was exacerbated by a lack of historical perspective. Here, Gorton hits an important bull’s eye, quoting approvingly a paper by economic historian Deirdre McCloskey, who noted in 1995 that “40 years of investment in mathematising economics has made it less acceptable among economists to admit to ignorance of mathematics than to admit ignorance of history”.
The book’s strength lies in its examination of financial crises over a long sweep of US history and its recognition of banking systems’ constant vulnerability. It has sensible things to say about the political and practical dynamics of crisis management and the way changes in financial structure, such as the recent development of the shadow banking system, wrong-foot regulators. In this the author was no doubt helped by his experience as consultant to AIG Financial Products, a subsidiary of the US insurer that in 2008 was subject to one of the biggest bailouts of the credit crisis.
Yet one may question whether the right lessons of history are being learnt. Partly based on Canada’s experience, Gorton argues that countries with more concentrated banking systems are less likely to have crises. Well, maybe. But increased concentration in the US financial system in the past 20 years, with added impetus as a result of the recent debacle, means a future crisis will be that much more devastating.
It is hard, though, to disagree with the book’s conclusion that economists must either embrace reality through history, attention to institutional structures and better measurement of risk and liquidity, or sink into irrelevance. A measure of the challenge is that more than five years since the outbreak of the credit crunch, most mainstream economic models still have no financial component.
The writer is an FT columnist
To what extent was the economics profession to blame for the financial crisis? Many would agree with Paul Volcker, former chairman of the US Federal Reserve, when he pointed in The New York Review of Books in 2011 to “an unjustified faith in rational expectations, market efficiencies and the techniques of modern finance”.
Professor Gary Gorton of the Yale School of Management puts a more technical gloss on it. He highlights the way economists “see” reality by looking through the lenses of models that come to embody the ordinary and the orthodox while failing to recognise structural changes in the financial system. The paradigm is then overwhelmed by reality when a financial crisis strikes.
That is undoubtedly true, as far as it goes, though there remains a big bone to pick with the book’s sweeping starting point. Gorton baldly asserts that “prior to the financial crisis of 2007-08, economists thought that no such financial crisis would ever happen again in the United States”. In perpetuating the myth that no one saw it coming, he traduces many in his discipline, and scarcely mitigates the insult with the subsequent suggestion that “a small number of economists gave vague warnings”. There was nothing vague about the warnings from William White and Claudio Borio at the Bank for International Settlements, to take one obvious example. The point is that there was nothing vague, either, about the rebuffs they received from the heads of leading central banks who determinedly downplayed the problem of financial instability.
There is, of course, substantial economic literature on financial fragility, not much discussed here, that seeks to explain credit bubbles in behavioural terms – exploring how, for example, prudent creditors are driven from the market as others disregard low-probability hazards and fail to charge appropriate risk premiums. The interesting question is why diminishing attention was paid to these disaster myopia hypotheses and why financial stability experts in many central banks saw their status heavily downgraded in recent years.
Part of the answer is hubris. Developed world central bankers tended to believe that the “great moderation” – the period of uninterrupted growth that prevailed in the years before the crisis – was a reflection of their own sagacity in monetary management. An approach to central banking that focused exclusively on monetary policy and inflation targeting also had a certain elegance. It appeared to entail greater accountability because performance could be measured over time against a single benchmark.
Equally important, financial economists who worried about the build-up of risk and debt in the system suffered from the problem that it is impossible to forecast precisely when any bubble will burst. When no action is taken to prick an extended credit bubble, their credibility is easily undermined by accusing them of crying wolf.
The impact of these institutional changes was exacerbated by a lack of historical perspective. Here, Gorton hits an important bull’s eye, quoting approvingly a paper by economic historian Deirdre McCloskey, who noted in 1995 that “40 years of investment in mathematising economics has made it less acceptable among economists to admit to ignorance of mathematics than to admit ignorance of history”.
The book’s strength lies in its examination of financial crises over a long sweep of US history and its recognition of banking systems’ constant vulnerability. It has sensible things to say about the political and practical dynamics of crisis management and the way changes in financial structure, such as the recent development of the shadow banking system, wrong-foot regulators. In this the author was no doubt helped by his experience as consultant to AIG Financial Products, a subsidiary of the US insurer that in 2008 was subject to one of the biggest bailouts of the credit crisis.
Yet one may question whether the right lessons of history are being learnt. Partly based on Canada’s experience, Gorton argues that countries with more concentrated banking systems are less likely to have crises. Well, maybe. But increased concentration in the US financial system in the past 20 years, with added impetus as a result of the recent debacle, means a future crisis will be that much more devastating.
It is hard, though, to disagree with the book’s conclusion that economists must either embrace reality through history, attention to institutional structures and better measurement of risk and liquidity, or sink into irrelevance. A measure of the challenge is that more than five years since the outbreak of the credit crunch, most mainstream economic models still have no financial component.
The writer is an FT columnist
Copyright The Financial Times Limited 2013.
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