Arnold Kling  

Another Post on EFC

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I finished reading Engineering the Financial Crisis fairly quickly. In part, it is because it is only 156 pages. In part, it is because I found the analysis so congenial. Actually, if you did not follow the issues closely back in 2008 and 2009, particularly all of the acronyms, you will find EFC a bit difficult to wade through.

From the conclusion (p. 153:)


"deregulated" capitalist finance did not cause the crisis, but rather that regulatory ignorance and ideology, apparently transmitted to the regulators by modern democracy's most trusted academic experts, may have caused it...a potentially fatal flaw: the mistakes that flow from the cognitive limitations of modern democracy's all-too-human decision makers.

The cognitive limitations of capitalist decision makers are, of course, just as likely to lead to mistakes. But capitalists simultaneously put into practice heterogeneous, competing interpretations of the world...At least some of these interpretations, if not all of them, are very likely to be mistaken, but some may be less mistaken than others.

Society might therefore be well advised to diversify its asset portfolio by allowing capitalist competition to proceed unhindered, rather than by predicting that a single interpretation is best in advance and then imposing it on all capitalists' behavior at once.

Another way to put this is that what experts know today is slight relative to what they have yet to learn. A competitive market system will do a better job of learning than a top-down regulated system. The demand for regulation implicitly assumes that our experts know enough to stop learning. That is ultimately a dangerously wrong-headed view.

More thoughts below.

EFC takes the view that the financial crisis caused the recession. That is, when banks had to mark down the value of assets, they curtailed lending in order to avoid having capital ratios fall below the regulatory minimum. This drop in lending caused real activity to decline.

This "credit channel" that EFC takes for granted is not well established, either theoretically or empirically. As you know, Scott Sumner views the recession as a monetary contraction. I think of it as a recalculation problem. Vernon Smith and others stress balance-sheet issues, as households suffered a tremendous loss of wealth due to the drop in house values.

The credit-channel story might seem to do a better job of explaining the sudden, swift decline from the fall of 2008 through the summer of 2009. However, by the same token, it does a poor job of explaining the sluggish recovery since then. The government did succeed in propping up the banks, but that apparently did nothing to fix the economy. Overall, I am not sold on the credit-channel story.

Speaking of the bank bailouts, EFC implicitly makes a case that the government acted wisely as a speculator of last resort during the crisis. The authors say that many of the exotic mortgage securities were under-valued, so that when the government took on the derivatives of AIG and other distressed portfolios, it actually made good bets and earned a profit.

I was initially quite skeptical of those who argued that mortgage assets were artificially under-valued and that the stress that banks felt was more a problem of liquidity than solvency. However, this view looks increasingly persuasive, and it weakens some of my criticisms of the bailouts.

EFC has two outstanding strengths. One is in its careful weighing of various factors that are thought to have caused the crisis. The authors explain why the behavior of Freddie Mac and Fannie Mae should not be given too much weight, why the behavior of the Fed in keeping interest rates low should not be given too much weight, and so on. They seek to increase the weight placed on the implementation of the Basel capital accords, and I think that this view is correct.

The other strength is in making the case for what the authors call radical ignorance. p. 129:


bankers seem to have been as ignorant of what was to come as other investors were, and as ignorant as the regulators...bankers' preference was for safety before yield. This suggests that bankers were not ignoring risks that they knew about. Rather, they were ignorant of the fact that triple-A securities might be much riskier than advertised.

Correct. Those who instead want to focus on moral hazard would be bound to retort that "Well, they would have been less ignorant if they had known that they were going to suffer the consequences of their ignorance instead of expecting to be bailed out." That is not a falsifiable position, but I personally do not find it persuasive. I think that EFC is right to lay stress on inherent ignorance over incentives.


I think that EFC stands out as by far the best economic analysis of the recent financial crisis. Although a number of economists have come out with books since the crisis, for the most part those books merely serve to promote a pre-existing agenda. I would have to say that none of them illuminates the crisis.

For relevance to the financial crisis, the only two other books by economists that I can recommend are This Time is Different and Manias, Panics, and Crashes. Both talk generically about financial crises, and both have something to offer. But neither goes into detail about the 2008-2009 crisis.

Prior to EFC, I would have recommended some of the journalistic accounts. Fools Gold and All the Devils are Here come to mind. But they lack the analytical focus of EFC. So EFC moves to the top of the list.



COMMENTS (6 to date)
Mike Rulle writes:

The book does sounds interesting and will probably purchase. I will pick out two of your points for comment.

1) "I was initially quite skeptical of those who argued that mortgage assets were artificially under-valued and that the stress that banks felt was more a problem of liquidity than solvency. However, this view looks increasingly persuasive, and it weakens some of my criticisms of the bailouts".

I was one of those guys who thought it was a liquidity crisis. I was persuaded by certain essays and my own less rigorous but not immaterial analysis. Yet, it was for that reason I was more against the bailouts (although I probably would have been against it on ideological grounds in any event). Keep in mind that about $600-$800 billion had already been written off by the banks before Tarp, AIG, and Lehman. Respectable economists were forcasting several trillion in losses.That was alot--yet we have seen some of that $600 billion come back into P&L.

It was clear that Paulson and whoever was pushing the "bailouts" along never believed their own "potential end of the world" argument, or at least changed their belief very fast. When TARP changed to a forced injection of preferred within 10 days from the intial plan of buying "undervalued assets", they used that whole saw horse of a quote from Keynes to justify it. But nothing had changed. I admit to not having a coherent view as to what the Fed should have done (as opposed to the Treasury), but being the "lender of last resort" seemed okay to me, which it almost was but not really as it favored certain assets.

But in the mean time, with a calmer and less panic driven administration egged on by WS firms fearing more mark to market losses, I think the banks themselves with proper leadership (I always reference 1907 and 1998 when discussing this) would have lead to a more normal crisis without the panic that ensued. It is still shocking to me that the top 30 Banks received only 200 Billion of Tarp Funds and paid back soon. This was all but an admission that this was never necessary. But what came with that were precedents which led to Car bailouts and other remarkable rationalized government micromanagement proposals (think Volcker Rule).I could blab on but will go to second point.

2)"Those who instead want to focus on moral hazard would be bound to retort that "Well, they would have been less ignorant if they had known that they were going to suffer the consequences of their ignorance instead of expecting to be bailed out." That is not a falsifiable position, but I personally do not find it persuasive. I think that EFC is right to lay stress on inherent ignorance over incentives."

I believe moral hazard feels like a hypothetical to most particpants in the market most of the time. But Dick Fuld thought he would be bailed out. If he knew that was highly unlikely would he have sold earlier on when he could have? I obviously do not know, but the odds would seem to be higher. Or, if the purchasers of credit insurance from MBIA, AIG and the like required reasonable collateral from these entities (as all banks did with each other in the CDS and the REPO markets), the cash constraints imposed on the insurers would have limited the amount which could have been been sold in the first place. But isn't this a really convenient blind spot? I believe in ignorance, but its correlation with subsequent bailouts makes one at least pause.

Is this a moral hazard issue? It may not be literally so, but having another party getting a bailout, technically outside the banking system (i.e., AIG), may very well have altered the thought process by the purchasers of CDS (like GS and the rest) in the first place. Not a one would have created that much exposure to other banks yet they did to AIG. We then suddenly found out that AIG was the supposed equivalent of the literal lynch pin of the financial markets. That is now a demonstrable "inaccuracy". This may not be exactly playing the "moral hazard" game, but it is a close kissing cousin.

Back in 1998, many firms would not do business with LTCM because they played the same collateral game as AIG---i.e., refusing to post any to do business. But there was so much business to be done in the Mortgage Market, we conveniently let AIG hold too much (even as their realized lossed ended up being much lower than expected).

One thing I can guarantee, is that in the same way Fannie/Freddie were blatant "in your face" moral hazard entities, the banks "off balance sheet SPVs" were equally so. Everyone knew, in the same way that everyone knew the F and F Bros. were Government guaranteed, these SPVs were in reality bank guaranteed.

While this does not directly tie moral hazard to the mortgages crisis per se, the moral hazard way of thinking seems to always arise "when it needs to".

I do believe moral hazard was a major contributor to the crisis, as well as legitimate ignorance.

Urstoff writes:

What about Gorton's Slapped by the Invisible Hand? David Warsh called it the best economic analysis of the crisis.

Becky Hargrove writes:

This Time is Different was the first book I read about the crisis. Prior to that, I checked out the selection at B&N one day when every book seemed to be screaming about it all. I told my cousin afterwards that I went home with Why Popcorn Costs So Much At The Movies.

From the first EFC paragraph (regulation, not deregulation): in my first years of economic study I used to bang my head against the wall about that problem. It's too easy for local business to complain to Washington about their heavy regulation load when at home the average guy is regulated out the wazoo from starting anything by the big guys. Many lower income individuals don't want money from the higher income individuals, they just don't want the rich to define the economic environments and perimeters of the world they live in.

Thucydides writes:

The "credit channel" story is consistent with the sluggish recovery: banks still have large amounts of questionable assets not marked to market, and so they would continue to be very careful about expanding lending, knowing that their capital is impaired under a realistic accounting. However, unwillingness of borrowers to borrow may be as strong an impediment.

MattW writes:

Mostly off topic, but I think the most impressive part of the post is where you said, "I was initially quite skeptical of those who argued that mortgage assets were artificially under-valued and that the stress that banks felt was more a problem of liquidity than solvency. However, this view looks increasingly persuasive, and it weakens some of my criticisms of the bailouts."

It's a rare case where someone takes new information and admits maybe their beliefs aren't as strong as they previously though. Extremely rare and worth noting.

jd writes:

Mr. Kling:

What do you think of Reckless Endangerment's thesis? ie. that the banks, whether ignorant or not, were compelled by law to make bad loans. Moral hazard was certainly a factor, but if the feds tell you to do it, you'll do it, moral hazard or not.

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