Arnold Kling  

Jeffrey Friedman on the Financial Crisis

Great Questions, Matt... Further Reply to Matt: Who is ...

Critical Review is publishing a special issue on the financial crisis. I have uploaded Jeffrey Friedman's introduction. I strongly recommend the entire issue. The paper by Acharya and Richardson is the one that most closely reflects my own views.

Friedman's introduction is much more than a summary. He writes,

if we take seriously the possibility that market participants are making cognitive rather than incentives-based errors, the case for regulation loses considerable force.

His point is that regulators made the same cognitive mistakes as financial executives--trusting the rating agencies, for example.

He says,

Indeed, what may have saved the world from complete economic chaos in 2008 was the fact that the regulations were loose enough that many investors and many bankers had resisted buying the "safe" securities that most banks seem to have bought. Heterogeneous behavior like that, however, is allowed for, encouraged, and rewarded by capitalism; and is either discouraged or prohibited by regulation, depending on
how tight the regulations are.

Which is more vulnerable to catastrophic failure: a relatively unregulated system, in which participants pursue diverse strategies; or a strongly regulated system? For Friedman, the latter is more vulnerable, because of the risk of promoting homogeneous behavior, so that one mistake affects everyone.

All of us have our intellectual hobby horses. Friedman's hobby horse seems to be the existence of cognitive weakness or ignorance. He is constantly asking what happens if leaders have cognitive biases or information gaps. In general, I think when you take that problem seriously, you fear strong government.

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COMMENTS (10 to date)
Vichy writes:

The homogenization of 'parts' has been treated by general systems theory, and been considered dangerous precisely because it creates adaptability problems.

Critical Review is one of the best journals I'm acquainted with.

BIll N writes:

My own hobby horse is that regulation reduces the diversity of ideas and approaches. While regulation might be a good idea, be careful what you ask for. Ask anyone who thinks government could have averted the financial crisis with regulation "How well did Iraq work out". The market allows bubbles, but only government brings force of law.

spark writes:

"Which is more vulnerable to catastrophic failure: a relatively unregulated system, in which participants pursue diverse strategies; or a strongly regulated system? For Friedman, the latter is more vulnerable, because of the risk of promoting homogeneous behavior, so that one mistake affects everyone."

A related perspective has been expressed by Anthony de Jasay:

The Bell Curve of Individual Choice

Economist writes:

By William K. Black

"As a white-collar criminologist and former financial regulator much of my research studies what causes financial markets to become profoundly dysfunctional. The FBI has been warning of an "epidemic" of mortgage fraud since September 2004. It also reports that lenders initiated 80% of these frauds.1 When the person that controls a seemingly legitimate business or government agency uses it as a "weapon" to defraud we categorize it as a "control fraud" ("The Organization as 'Weapon' in White Collar Crime." Wheeler & Rothman 1982; The Best Way to Rob a Bank is to Own One. Black 2005). Financial control frauds' "weapon of choice" is accounting. Control frauds cause greater financial losses than all other forms of property crime -- combined. Control fraud epidemics can arise when financial deregulation and desupervision and perverse compensation systems create a "criminogenic environment" (Big Money Crime. Calavita, Pontell & Tillman 1997.)"

Read more here:

Floccina writes:

I have said that it might be that the USA economy is too big and (barring free banking) that we should have 3-5 USA currencies, regulatory schemes and central banks.

fundamentalist writes:

An amazing intro to the series! I loved it! If you haven’t decided to read it yet, here are a couple of gems:

“Perhaps a truly comprehensive set of regulations would cover the central bank, too. But the more types of policy have to be coordinated in a single comprehensive framework, the greater the
cognitive burden placed on the super-regulator charged with designing the whole system—which brings us back to the overriding problem: the regulators’ all-too-human ignorance.”

“The problem of the regulator and the scholar—and of the citizen of a social democracy—is essentially the same: There is too much information. This is why modern societies seem “complex.” And it creates the special kind of ignorance with which modern political actors are plagued:
Not the costliness of information but its overabundance. This is a curse because, as a practical matter, it becomes impossible to learn, from the blooming, buzzing profusion of data about previous political actions and their effects, precisely the things we would need to know if we are to arrive at the correct theory, such that we avoid mistakes that contribute to systemic catastrophes. While from an optimistic perspective, therefore, the financial crisis might be seen as a “perfect storm” of unanticipated regulatory interactions, and thus as unlikely to be repeated, a more realistic view would treat the crisis, and the current intellectual response to it, as warning signs of more, and possibly worse, to come.”

I sense the ghost of Hayek being channeled.

Just one observation. Friedman allots a good amount of space to Federal Reserve policy, but I can’t help thinking that had the Fed not reduced interest rates to 1% and kept them there for five years, the housing bubble would never have happened. Interest rates would have been too high for houses to sell at the rate they did. Without the bursting of the bubble, the ratings agencies would have been right and none of the mortgage derivatives would have become toxic. All of the financial models would have proven to be works of genius.

Jim Glass writes:

Friedman's hobby horse seems to be the existence of cognitive weakness or ignorance. He is constantly asking what happens if leaders have cognitive biases or information gaps.

Overstating what was knowable and predictible about the crisis can lead to big mistakes in "reform" -- and everybody on all sides has a huge incentive to overstate what they knew and say "I saw it coming." Nobody gets invited onto a pudit show by saying "Duh, I'd no idea!" -- and nobody gets political control of the reform movement that way either.

But who knew? The Fed, ECB, Bank of England, Russians, big commerical and investment banks, etc., all had huge amounts of skin in the game and none saw how things were going to play out. Anybody who did foresee it could have made a fortune: but who did? Buffett? Soros? (Schiff ???)

Consider this. In the NFL 50% of games are determined by chance. This is why even the smartest sports mavens and most sophisticatec game models running on supercomputers can't pick much more than 70% winners -- half the time the best team wins, the other half the best team splits ~~ 75% prediction limit.

This is not an idea that goes down well with football fans -- they tend to react to it on a scale ranging from incredulousness to outright anger.

And when was the last time you saw sports columnists or high-priced post-game TV analysts say, "Well, another important game decided by chance."?

Instead games are parsed with causation read into them backwards to the Nth degree -- especially in close games, the ones most determined by chance. The obvious random chance element is buried by denial. "Great teams win close games! Another example! Look at this one played out ..." (Vince Lombardi's record with the Packers in one-score games was 50%. Bill Walsh's with the 49ers was 43%.)

OK now, where are the unknowns, unknowables, and forces of chance greater, in a staightforward football game or in the constantly evolving world ecomomy and financial system?

And where are the incentives for denying the unkowns greater, among sportswriteres and game analysts, or among political punits, politicians and interest groups trying to lever up their control over as much of the economy and poltiical system as possible?

fundamentalist writes:

I didn't get from Friedman's intro that he rides a hobby horse about cognitive weakness. He merely contrasted the evidence for moral weakness with that of cognitive weakness. The popular thing to do is to blame bankers and regulators for greed and laziness. Friedman merely showed that the evidence is more in favor of ignorance.

kievite writes:

The real problem is quite different the ignorance or cognitive weakness: it is the capture of regulators by market actors. See Atlantic article "The Quiet Coup"

shayne writes:

To Arnold - thank you so much for this reference (I've purchased the full issue of Critical Review).

To Fundamentalist - I may be mistaken, but I sense you are one of the many who 'blame' Greenspan (and the Fed, at large) for the financial crisis. I would recommend the following video of Faber's interview of Greenspan. The low interest rate Fed policies you refer to may well have been an enabling factor (although I doubt it), but they certainly were not causal. Additionally, those policies should be considered in context with the times and circumstances prevailing, which the interview video reiterates. In short, had the Fed NOT had the low short term rate policies, the only evidence that a housing bubble would not have occurred would be due to the highly probably eventuality that the U.S. economy (at least) would have been engaged in severe recession/depression in 2001-2005, precipitated by the ' bubble' bursting, the 9/11/2001 attack and the 2003 war in Iraq. The Fed policies of the time were put in place to deal with the situation of the time. I'll confess my bias - I am a Greenspan fan. Not because I consider him universally infallible, or even universally correct in all his past policy actions, but I am a fan because he has an incomparable sense of his and his system's limitations and is willing to confess and analyze his own mistakes.

Friedman's introduction emphasizes the mistakes made by a variety of components of financial system and heaps blame on ignorance rather than greed. It's about time. Both greed and ignorance are human failings, and neither can be effectively legislated against, as both Friedman and Greenspan note. But there is a third human failing that is just now coming into play to have its way with us - arrogance. Friedman strongly hints at it as does Greenspan, but neither mentions it specifically. I will. The notion that any future transaction, or even class of transactions, can be rendered absolutely or nominally safe by virtue of new 'super risk regulatory regime' is the ultimate in human arrogance. Greed and ignorance are both costly and they are just now commanding their full price. Arrogance is equally, if not more costly, and has yet to fully tally let alone invoice it's price.

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