The Simplest Narrative

Most "once-in-a-century mistakes" are not a single mistake, though, but a series of them. That makes it even harder to explain by a narrative, because there may be many contributing factors, but none of them really sufficient as an explanation alone.

How about
Claptrap is falling.

(Claptrap is the City built by Techne in Pilgrim's Regress of CS Lewis)

The simplest narrative is this: it was Keynesianism pure and simple. The view that we have to keep the economy in a quasi-boom by eliminating slumbs. We did that until disaster struck in the 1970's. Keynesianism led to stagflation. So we said farewell to Keynesianism for a while, because we had to conquer inflation first. Volker did just that, after which Keynesianism came back with full force (budget deficits in the 1980's, and loose monetary policy after that). And again disaster struck, just as Hayek and Mises would have told you.

The once in a century mistake? Fits Sumner's hypothesis. He sees it as a fed mistake that caused the downturn.

It is interesting that the downturn coincided with some rather large structural changes in US institutions. The FASB changed its accounting standards, and the central bank began paying interest on reserves.

Agreed, except I think it is probably more common than once a century. Despite bad incentives and market distortions, people like Jimmy Cayne, Dick Fuld, Chuck Prince, Stan O'Neal etc. etc. and all their shareholders and the people who worked for them had fundamentally the right incentives, and they all made the same mistake.

I think that the basic mistake was thinking that the housing market would have a soft landing. I doubt they thought that prices would just keep rising, but it was a very common view in 2005-2006 that they would just sort of level out, maybe drop a little, and just not rise for several years. After all, housing prices hadn't dropped in a generation or more. If that had happened things would have looked very different, but in hindsight it probably couldn't have happened due to the extent of the bubble.

It's not a once-a-century catastrophe if it wasn't even a catastrophe. There's a persistent narrative that we could have been much less vigorous in response and it wouldn't have been such a big deal after all. It would be nice to know whether we really did need to cede all kinds of resources to the U.S. federal government and then follow it up by shifting part of the financial industry into the public sphere. It would be nice to know if our reactions weren't making it worse.

Politicians love to declare emergencies, grab lots of power, do lots of random things, and then pat themselves on the back for how great it was they were there. The only way to prevent this is if outside experts look into the matter and discern the truth.

I think you are unsatisfied with your narrative because it provides no basis for policy. Lefties would say "we must protect against 100-year events" and righties would say "hands off and let events take their course".

I'll buy this narrative, provided you caveat it with "Once-in-a-century may happen fairly often." Consider that in the weather arena, we seem to get a "storm of the century" about once a decade or so.

Remember, the financial debacles of 1979, 1986, and 2000 were all unique, unpredicted, and unprecedented at the time... at least, that's what I remember having lived through them.

Putting aside the matter of whether these events really are the "once-in-a-century" kind, observing a statistical regularity is not an explanation. Once every now and then a new star system forms, but a physicist who accepted that as "the best narrative" of the birth of new star systems wouldn't be advacing physics any.

But then, you're a Bayesian--the philosophy, not the mathematics.

"I don't doubt that lots of people in finance and government had perverse incentives and acted on them. But without a once-in-a-century mistake, this perversity would have been gradually built into asset prices as it developed, not ignored, then suddenly noticed over the span of a few days in 2008."

One other possibility is that the advent of computers makes this sort of snafu more likely.

My take on the situation is that most people involved in selling and buying securities didn't really know what was going on. They relied on the quants to tell them what it all meant.

But I wonder if many/most of the quants weren't probably were just plugging numbers into a computer? If the computer spat out what the quants wanted to hear ("fantastically large sums of money can be made at little risk!") then the quants didn't want to question the computer.

This is my theory. Not backed by evidence or even knowledge. (The beauty of the Internet is that theories unsupported by evidence or knowledge can be widely disseminated.)

So here's the state of modern macro, courtesy Bryan Caplan.

If everything is predictable, by fitting regression equations up the kazoo, and extrapolating expectations on the basis of past parameters, many of which we have to assume because we can't estimate everything, then only predictable things will happen and we can then predictably deal with it in traditional and predictable ways. Of course, if it's not in the data, we can't predict it, and then unpredictable things may regrettably happen. But since we can't reestimate all our equations on the basis of a once in a lifetime unpredictable event, we'll revert back to dealing with the predictable. Just keep on modeling! Maybe another dummy or two, what do you think? In that equation there? No, maybe here, it looks a little better there. Thank you for your patience and understanding while we splat some more paint on this Rorschach test.

Or, in my words. Sh*t happens. If sh*t don't happen, we're clean. But, if it should happen, things may get really sh*tty. So, just hope for the best. Remember, we don't do clean-ups, and thank you for your interest in macroeconomics.

On that analysis, I agree with Bryan.

What Bob Knaus said. Seems like there have been several once-per-century mistakes during the last 97 years.

Millions of people figured it out and made money.

That narrative doesn't explain why these types of catastrophes happened far more than once a century before the New Deal.

I think you have to say it is inherent in the system. The more risk is successfully encountered, the more risk will be entertained until an "accident" happens, a la Minsky. Capitalism at work. People in nature.

I agree it was a perfect storm. Just like the current Oil spill, things like that will happen ever 50 to 100 years despite (or because) of regulations. Although I still say if Freddie and Fannie had not existed thus Sub-prime market being a lot smaller, the impact would of been significantly less . They were the largest single multipler out of all the major factors. It was collective stupidity and short term greed that caused the crises. Free markets will have this every two or three generations. It is the nature of humans. No one party, if they had know this would happen how it did could of prevented it.

So then criticism of stimulus spending can now finally be ditched? So what if it adds about 20% of GDP to our debt level? If it's only going to happen once per century it's no big deal.

I would say, it could have been prevented, had been prevented several times, but each successful prevention just leads to reduced vigilance and larger wagers, so eventually prevention fails.

"Hardly anyone figured this out until disaster struck."
Plenty of us figured it out, and were only surprised that it took so long. Try this:
"The people in power had incentives to lie about it until disaster struck, and those incentives remain in place."
Hint: the downturn began at least several years ago, and stemmed from eliminating laws that governed the financial industry, and passing laws that gave large financial institutions more power.