Arnold Kling  

Delusions on Both Sides

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Many people, including Mark Thoma (also here) are interested in the question of whether it was private markets or government regulators who got us into this mess.

My answer is, "yes." There were delusions on both sides.

In the private sector, many lenders and investors became deluded about the virtues of credit scoring. Credit scoring is a good technique for assessing risk, but people forgot that rising home prices cover up all sins. What they thought was brilliant mortgage underwriting was in fact just luck with rising house prices. When the luck ran out, it turned out that credit scoring is only a tool, not a magic potion.

The other private-sector delusion concerned derivatives. See my post on systemic risk. Financial institutions thought that they were getting rid of risk, but instead they were just passing it around, as in the card game Old Maid. The contingency plans that companies formed to deal with risk have proved impossible to execute collectively in practice.

Government regulators can be faulted for two things. First, they enabled the private sector delusions. Regulators did not sound warnings about credit scoring, and they issued only minor scolding on derivatives.

Second, government operated under the delusion that low-down-payment mortgages are a good thing. I have coined the expression "home borrower" to describe someone who puts little or nothing down to buy a home. Government encouraged home borrowing, and that made the bubble inflate higher on the way up and crash harder on the way down.


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Both Cato @ Liberty and Paul Krugman blame the housing bubble on land-use regulation. The correlation is highly suggestive, although I'm not sure why such regulation should encourage bubbles in addition to raising prices generally. Unfortunately, neither piece provides a causative model which would predict bubbling. Any thoughts on this?

Arnold Kling writes:

I share your skepticism, and Bob Shiller shares it as well. A bubble is temporary, while land-use regulation ought to permanently raise the cost of housing in some areas. A permanent increase in price is not a bubble.

Alex J. writes:

It has been claimed that government funding and direction of scientific research might be a net negative for science, once you take in to account the displacement of our best researchers into government directed programs.

A description of the conditions of research at the JPL.

I wonder if there is also a displacement effect at work with regulation. How much of the time and energy that businesses spend complying with sarbox and the rest is not just a waste, but also detracting from more reliable accounting and reporting?

Surely the private sector had its delusions, but at least in credit ratings for individuals and auto-insurance regulation for individuals, the government's actions tend to reduce accountability by requiring that rating agencies ignore old events.

Fazal Majid writes:

One could argue the market for securitized debt shows the same information asymmetry effects as Akerlof's used cars and lemons.

J. writes:

More to the point on the how it is the government's fault. The credit scores and credit ratings were used as regulatory tools that made markets very nontransparent.

Lord writes:

Low downs don't trigger bubbles though, only making loans borrowers have no capacity to repay does that.

David LaDow writes:

The other delusion in the derivatives market is the use of flawed pricing models that do not properly evaluate risk, as Nassim Taleb and others have pointed out. See e.g. "http://www.edge.org/discourse/fourth_quadrant.html"

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