Monday Smackdown: What Tobin Harshaw of the New York Times Wants to Be Remembered For: "I Am Not Authorized to Explain Why I Am Not Authorized..."

Self-Fulfilling Financial Crises: No Longer Fresh at Project Syndicate

As Published: Self-Fulfilling Financial Crises: Many mistaken assumptions about the 2008 financial crisis remain in circulation. As long as policymakers believe the crisis was rooted in the housing bubble rather than human psychology, another crisis will be inevitable. | My Earlier Draft: The 2008 financial crisis and subsequent recession left the Global North 10% poorer than it otherwise would have been, based on 2005 forecasts. For those hoping to understand this episode better, for a while now I have been recommending four very good books on and about the financial crisis of 2008 and what has followed—the catastrophes that have left the Global North 10% poorer now than we confidently forecasted back in 2005 that we would be today. They are:

  1. Kindleberger's Manias, Panics, and Crashes,
  2. Reinhart and Rogoff's This Time It's Different,
  3. Martin Wolf's The Shifts and the Shocks, and
  4. Barry Eichengreen's Hall of Mirrors

Now I want to add on a fifth book: Nicola Gennaioli and Andrei Shleifer's A Crisis of Beliefs: Investor Psychology and Financial Fragility (Full disclosure: Shleifer was my roommate in college and graduate school; to this day, I credit him more than anybody else with whatever positive skills or reputation as an economist I may have.)

A Crisis of Beliefs is important for three reasons. First, it offers a welcome rejoinder to those who argue that the past decade was an unavoidable result of the housing bubble in the United States. Many experts still claim that the bubble’s deflation triggered the financial crisis. Only last month former Federal Reserve chair Ben Bernanke pointed to the deflation of the housing bubble as what had “triggered the financial crisis” of 2008. But the deflation of the housing bubble did not do so. The housing bubble had already deflated substantially before the financial crisis.But the fact is that the bubble had already deflated substantially before the crisis erupted.

Recall that by mid-2008, home prices had returned to, or even fallen below, levels supported by their underlying fundamentals, and employment and production in the residential construction industry had declined to levels far ar below trend. The work of rebalancing asset valuations and reallocating economic resources across sectors had already been accomplished.

To be sure, there were still about 750 billion dollars worth of financial-asset losses to be assigned to somebody–that is the likely level of access subprime and home equity defaults that would have occurred in the absence of a big recession. But 750 billion dollars of total losses is one-quarter of what global equity markets saw on the single day of October 20, 2018—not something that should take down a global financial system with sophisticated risk-bearing institutions.

Ben Bernanke himself and his Federal Reserve appeared highly confident in the summer of 2008 that the deflation of the housing bubble had not triggered any unmanageable financial crisis: he and his were focused more on the dangers of rising inflation.

It is true that some welcomed financial stress and the prospect of a recession because they thought it would assist in needed rebalancing. In November 2008 there were people like John Cochrane of Stanford’s Hoover Institution claiming that the economy “needed“ a recession “because people pounding nails in Nevada need to find something else to do“. But people of that ilk were simply not reality based: clueless about what the numbers were.

And yet the bottom fell out, even though the structural work of expenditure- and resource-switching had been accomplished, even though there was no air left between risky asset prices and fundamentals in a bubble to be popped, even though the magnitude of unallocated losses was small relative to the risk-bearing capacity of the global economy.

This is why Gennaioli and Shleifer are most worth reading. They understand why: the bottom fell out because beliefs changed in a way correlated with but not rationally motivated by changing fundamentals. The freezing-up of the interbank market, the housing finance failures, the collapse of Bear Stearns, the Treasury's move to take advantage of the embarrassment of FHLMC and FNMA to bring them under its control and curb their exorbitant privileges, and most of all the unmanaged failure of Lehman led investors to diagnose that financial markets were suffering from greatly elevated risk. Hence the sudden run on the shadow and then the non-shadow banking system, as a desperate scramble to buy assets that would still be perceived as safe no matter what and to dump others caused the increase in risk that they had diagnosed. Think of investors as triage nurses in an emergency room, taking a hasty look at the most salient features of the case presented and then running with their immediate diagnosis as if it were the only way things could be.

And yet nothing about the fallout from the crisis was inevitable. All this was contingent: Had the Federal Reserve had possessed contingency plans for putting all too-big-to-fail institutions into receivership and becoming the risk-bearer of last resort, whether or not such plans were ultra vires the technicalities of the Federal Reserve Bank of New York's corporate charter, we would with high likelihood live in a very different world today. Gennaioli and Shleifer recognize this contingency in a way that many who now construct retrospective narratives of inevitability stemming from the existence of the housing bubble did not. This is why they are most worth reading.

The second reason that I see Gennaioli and Shleifer's book as important is that they see such "crises of beliefs" like 2008-9 as so deeply rooted in human psychology that we will not be able to institutionally outgrow or route ourselves around them. Prudential policy before and crisis-management policy during such episodes cannot regard them as one-off exceptions, but rather as chronic conditions that must be managed.

This means, most particularly, that central banks and fiscal authorities cannot take the end of a crisis as an excuse to stand back. Beliefs have been permanently shifted, and so the configuration of policies that supported full employment, low inflation, and balanced growth before the crisis can no longer do so. Moreover, the seeds of the next Kindlebergian episode of displacement-optimism-feedback-enthusiasm-crash-panic-revulsion-descredit are already being sown by the policies needed in the aftermath of a depression to rebalance the fundamentals of the real economy and employ resources.

And there is a third reason—a more technical reason for economists to pay attention to Gennaioli and Shleifer's diagnostic expectations. Economists have long recognized that requiring one's representative agents to hold rational expectations of the future leasd to models that are in many ways profoundly unapplicable to the real world. But no alternative has yet gained traction. Their modeling strategy of seeing investors as triage nurses overfocusing on the most immediately salient features of the patient right now has great promise as an alternative horse to bring on to the model-building track.

For a decade now, people have been looking for a silver lining to the disasters of 2008-2018, hoping that this period will bring about a more productive integration of finance, behavioral economics, and macroeconomic orthodoxy. So far, they have been searching in vain. But with the publication of A Crisis of Beliefs, there is hope yet.