Arnold Kling  

Paul Seabright on Free-Market Ideology

Reconfigurations... Thoughts on Immigration...

He writes,

The reason why it was so easy to sell securities rated triple-A -- like the higher tranches of the now notorious collateralized debt obligations -- was not that every potential buyer was a true believer in the theory of efficient markets. It was because financial regulators insisted a triple-A rating was necessary for many of the investments made by pension and mutual funds, which the regulators would never have done had they been convinced that the market would take care of these investment decisions by itself. If the market is always right, why insist that investors choose highly rated assets? So the problem was not that market failure was thought to be impossible, but the much more sinister belief that someone else was going to take care of it when it happened.

Read the whole thing. It is an important essay, because I believe it reasonably captures the thinking at the time of the housing boom, as opposed to the perspective of 20-20 hindsight.

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COMMENTS (7 to date)
Shangwen writes:

The article concludes with this advice with respect to responding to the crisis: "we must avoid comforting ourselves with the judgment that the system's architects were naive and that therefore we might hope to do much better". I guess he isn't working in the White House.

fundamentalist writes:

Great summary of the failures, but what about answers? After highlighting the "asymmetry" of Greenspan's responses to crises vs bubbles, the author doesn't fault Greenspan at all. Very strange.

The one thing that few people are considering is the monetary theory of crises. Why is that theory so obnoxious to mainstream econ that they won't even give it a hearing?

steve writes:

"So the problem was not that market failure was thought to be impossible, but the much more sinister belief that someone else was going to take care of it when it happened. "

Big jump in logic. Believing that markets can fail is not the same as believing that "someone" will take care of it.


Thomas Esmond Knox writes:

"In fact, the Belgian fortifications were impressive, and the Germans broke through at their strongest point, Fort Eben-Emael, which was where the attack was least expected."

I wasn't there, but General Heinz Guderian certainly was. I have re-read his account up to the capture of the Channel ports & he has not mentioned Fort-Eben-Emael (as I suspected).

Also, the chestnut that if Lehman Brothers were saved than everything would have been hunky-dory. You may as well have saved Bernie Madoff.

Lehman were rotten.

NormD writes:

Well, he gets his history wrong...

The breakthrough in 1940 was in the Ardennes. This region is heavily forested and was thought impassable to tanks and thus was lightly defended. The attack at Fort-Eben-Emael (which was done by glider borne troops) was part of a feint meant to draw the British and French into Belgium and thus allow them to be cut off when the Panzers swept through the Ardennes to the coast.

Jeremy, Alabama writes:

Very well written and worth reading, but the article treats moral hazard as a depositor's problem, not a corporate or systemic problem.

Re-read the article, but replace every occurrence of "absolute faith in markets" with "absolute faith in government guarantee", and you get a much better explanation of the crisis.

This does not even have to be an explicit guarantee. It can be quite subtle. For instance, a belief (based on previous crises) that government has the tools, the ability and the desire to backstop the financial system during every correction.

Colin K writes:

I wonder what percentage of senior banking/financial professionals lost their shirts in the past two years, and how that compares to the Great Depression?

As an entrepreneur, I live daily with the very real possibility that I could lose everything if I screw up sufficiently badly. Many if not most small-business owners are in a similar boat. The knowledge that I could go very literally broke functions as a very acute check on some of my more wild-eyed bouts of irrational exuberance.

My sense, anecdotally, is that the consequences of total failure (e.g. Lehman or Bear) fell somewhat hard on the low- and mid-level staff whose wealth, if any, was in stock options, and whose compensation, while good, was solidly upper-middle class. Meanwhile, the senior folks had pocketed sufficient cash over the years that even the total loss of their company stock left them with plenty of assets.

Likewise, in the technology startup world, even the more privileged neighborhoods of VC-backed companies, it's considered normal for the senior folks to draw lower 6-figure salaries until the first liquidity event and often beyond that.

Every time I read about the Depression, I read about guys who were wealthy and became broke--of course, those might just be the stories that got written. But it does seem that there was an entire generation of people every bit as human as the current Masters of the Universe, who went through the collective experience of getting wiped out and having to drive trucks or otherwise crawl their way back out of the hole. That would seem to provoke a major lifestyle change, even in the absence of regulation.

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