Category Archives: Financial Crisis of 2008

The paradox of accountability

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Accountability means having our ideas and actions evaluated by others, with those evaluations having consequences. The paradox of accountability is that everybody needs it but nobody wants it.

Everybody needs accountability in order to stay on track. Without effective accountability, individuals and organizations become weak and corrupt.

Nobody wants accountability, because it limits our autonomy. Whether our intentions are good or not, our autonomy is constrained by those who hold us accountable.

Because nobody wants accountability, we try to counteract mechanisms that are designed to create accountability. A CEO is supposed to be accountable to shareholders via the board, but the CEO tries to get around this by “stacking the board.”

Some remarks:

1. With any organization, you can study its accountability mechanisms. Who set them up? What concerns were they trying to address? How well do the mechanisms work? What are their weaknesses?

2. One can interpret institutional history as an evolutionary struggle to establish and evade accountability mechanisms. Organizations respond to corruption by trying to adopt more robust accountability mechanisms. Individuals try to increase their autonomy by finding ways around those mechanisms.

3. The 2008 financial crisis exposed a weak link in the accountability system in an unexpected place: the credit reporting organizations, like Moody’s and Standard and Poor’s. The buyers of mortgage securities were looking for AAA ratings for regulatory purpose only, not because they truly wanted to be certain that the securities were highest quality. The regulators treated the AAA-rated securities very leniently in terms of bank capital requirements, thinking that the credit reporting organizations were more accountable than was actually the case.

4. It seems to me that our society is collapsing because accountability mechanisms are falling apart.

Professors don’t give students bad grades, and students wish to abolish grading entirely. When they graduate, they long to work in the non-profit sector, where for the most part you are accountable for intentions and not results.

The professors themselves are not accountable for doing rigorous work. They just have to worship the diversity religion.

We are losing the small-business sector, which is most accountable to customers. We are replacing it with large corporations that are accountable to government for bailouts and to the social justice mob for approval.

Five books on the financial crisis

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My list is here. For example,

Of the journalistic accounts of the crisis, my favorite is Bethany McLean and Joe Nocera, All the Devils are Here. I think that it helps to bring out two important aspects of the crisis. One aspect is the lack of awareness that many senior executives at financial firms had about the complex risks embedded in their firms’ portfolios. Another aspect is the role played by lobbying by Wall Street firms and Fannie Mae in shaping the mortgage finance system as it evolved in the decades leading up to the crisis.

The bank run of 1930?

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Gary Gorton, Toomas Laarits, and Tyler Muir write,

At the start of the Great Depression there were no nationwide bank runs and banks did not avail themselves of the discount window. Yet, output dropped substantially: industrial production fell over 20%. As a consequence, 1930 is viewed as a puzzle. For example, Romer (1988) writes: ”The primary mystery surrounding the Great Depression is why output fell so drastically in late 1929 and all of 1930” (p. 5).2 And Bernanke (1983) does not include 1930 in his study of the effects of bank failures on output: ”it should be stated at the outset that my theory does not offer a complete explanation of the Great Depression (for example, nothing is said about 1929-1930)” (p. 258).

In this paper show that a large part of the output drop in 1930 can be explained by bank actions: the reduction in loans and purchase of safe assets. We argue that banks realized the severity of economic conditions and, in effect, ran on themselves.

I want to note this paper for future reference. But I’m not saying I buy it. I mean, the reason that output dropped so sharply is that the banks ran on themselves, and the reason that the banks ran on themselves is that they realized that output was dropping so sharply?

Kling on the financial crisis of 2008

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For the Concise Encylopedia of Economics. An excerpt:

There can be no single, definitive narrative of the crisis. This entry can cover only a small subset of the issues raised by the episode.

Metaphorically, we may think of the crisis as a fire. It started in the housing market, spread to the sub-prime mortgage market, then engulfed the entire mortgage securities market and, finally, swept through the inter-bank lending market and the market for asset-backed commercial paper.

It is now a decade since I wrote Not What They Had in Mind, which in my opinion still holds up.

In the encyclopedia entry, space was limited, and I had to limit my coverage. I decided that I had essentially no room to cover the many narratives of the crisis that differ from my own.

Kotlikoff on PSST

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Laurence J. Kotlikoff writes,

Economics has many theories of economies rapidly flipping from good to bad. They go under the headings multiple equilibrium, contagion, self-fulfilling prophecy, panics, coordination failures, strategic complementarities, sun spot equilibria, collective action, social learning, and herding.

Pointer from John Cochrane, who offers extensive comments. Read his whole post.

Kotlikoff argues that the mere perception that the economy was in trouble was enough to cause trouble.

Employers laid off their workers in droves to lower their payrolls before their customers stopped arriving. This was the worst of the many types of multiple equilibria associated with the GR.

…The slow recovery is hard to explain except as the result of everyone expecting a slow recovery.

I see this as a PSST story. Patterns of specialization and trade depend on business managers’ confidence that those patterns will continue.

I, too, have been thinking a lot about the contingent nature of economic outcomes. I am mulling an essay that will strongly criticize the view that the market acts like a set of equations providing a deterministic solution for given tastes, technology, and resource endowments. Instead, there are multiple equilibria that depend on people’s perceptions and beliefs.

Part of my argument is that hardly anyone in the economy has a measurable marginal product. Most of us are producing intangible output, even if we work in goods industries. For example, relatively few of the employees at a pharmaceutical company are actually bottling pills.

Businessmen operate in a world of high fixed costs, with mostly overhead labor. If they doubt that revenue is going to remain at current levels, one response is to cut costs by reducing overhead labor. If enough firms do this at once, their fears of recession becomes self-fulfilling. This sort of self-fulfilling recession is particularly easy to fall into when there is a financial crisis.

Kotlikoff’s main point, which Cochrane emphasizes and expresses support for, is that a financial crisis of 2008 was itself a sudden shift in perceptions that took place in the context of an inherently fragile financial system.

Kevin Erdmann responds to Dean Baker

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Erdmann writes,

we imposed the “inevitable” bust on the owner-occupier housing market. Instead of looking for ways to stabilize mortgage markets, lending was largely cut off to the bottom half of the market from 2008 on, and we can see the devastating effect if we look within cities, most of which look like Atlanta, where low tier prices took a post-crisis hit to valuations, frequently of 30% or more. This has caused the market price of low tier homes to drop below the cost of construction, causing new building to dry up in low tier housing markets.

Read the whole post. Note especially the first chart. My thoughts:

1. That first chart depicts construction spending as a percent of GDP. Baker did the same thing. This makes 1986-1990 appear similar to 2006-2010. But the denominator, GDP, was rising in the early period and falling in the latter episode. So the slump in the numerator, construction spending, was probably much more pronounced in the latter period.

2. Some of the credit tightening in the mortgage market was inevitable. You could not keep lending on generous terms to non-owner occupants. At some point, the speculators had to get squeezed out.

3. But the political crackdown on mortgage lending was severe. I remember that it seemed as though in 2009 the only people who could get mortgages were those who did not need them.

4. Some day, people may look back at “quantitative easing” as a credit crunch. It steered banks toward holding interest-bearing reserves rather than lending to the private sector. I think of it as a credit-allocation scheme, in which government debt was favored (by the Fed, which n-tupled the size of its balance sheet) and private investment was dis-favored.

5. Instead of looking at aggregate demand, try to think of 2007 to the present from a PSST perspective. Perhaps patterns of specialization and trade related to the construction boom became unsustainable around 2007. Other patterns became unsustainable when the government took over the credit markets in 2008 and 2009. Other patterns became unsustainable when the Obama-era zeal for regulation had an impact. Only recently have new patterns of trade been emerging significantly faster than old patterns disappeared.

Dean Baker on the Great Recession

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He writes,

Prices of non-residential structures increased by roughly 50 percent between 2004 and 2008 (see Figure 5 here). This run-up in prices was associated with an increase in investment in non-residential structures from 2.5 percent of GDP in 2004 to 4.0 percent of GDP in 2008 (see Figure 4).

This bubble burst following the collapse of Lehman, with prices falling back to their pre-bubble level. Investment in non-residential structures fell back to 2.5 percent in GDP. This drop explains the overwhelming majority of the fall in non-residential investment in 2009. There was only a modest decline in the other categories of non-residential investment.

Again, the collapse of Lehman hastened this decline, but the end of this bubble was inevitable. In this respect, it is worth noting investment in non-residential structures is pretty much the same share of GDP today as it was at the trough of the Great Recession, supporting the view that the issue was levels were extraordinarily high before the downturn, rather than being extraordinarily low in the downturn itself.

Pointer from Mark Thoma.

I pass this along not because I am inclined to agree with it or any other aggregate-demand story, but because:

1. Explaining the depth of the recession is hard. It is easy to point to the financial crisis and do hand-waving, but as Baker points out, the actual chain of causation is not so clear.

2. Baker is someone who does not succumb to mood affiliation. His views, correct or not, are arrived at independently.

3. I had forgotten about the bubble in commercial real estate.

4. I expect to see an insightful response from Kevin Erdmann.

Cognitive failure and the financial crisis

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My review of A Crisis of Beliefs, by Nicola Gennaioli and Andrei Shleifer.

GS directly attack the hypothesis of “rational expectations,” which has dominated the economics profession for forty years. The rational-expectations doctrine holds that when economic actors make decisions that require forecasts, they make optimal use of the available information. They are not guilty of predictable irrationality.

. . .Think of a forecast as employing two types of information about a variable being forecast. One is a “base rate,” which is a very generic property of the variable. The other is “recent information” about that variable or about factors that could affect that variable. Recency-biased forecasting over-weights the recent information and under-weights the base rate.

What I’m reading

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I was sent a review copy of A Crisis of Beliefs, by Nicola Gennaioli and Andrei Shleifer (henceforth GS). They say that the financial crisis of 2008 illustrates a theory of expectations formation in which market participants both place too much weight on recent news and in some circumstances ignore tail risk.

We know from Tetlock, whose name does not appear in the index, that a good forecaster puts a lot of weight on baseline information–characteristics that are more universal and permanent. Inefficient forecasters instead tend to focus on information that is more recent and local. GS argue that financial market participants are inefficient forecasters.

So far, what I like about the book:

1. The writing is clear.

2. Years ago, I contrasted two classes of theories of the 2008 financial crisis. One I called “moral failure” and the other I called “cognitive failure.” The theory that GS builds falls within that latter class, which is the one on which I would place more weight.

3. GS take seriously data that comes from surveys of the expectations of market participants. They are not afraid to find fault with the rational expectations hypothesis.

What I don’t like:

GS use standard economic modeling methodology, as opposed to Bookstaber’s agent-based modeling. See my review of The End of Theory. In particular, I think that institutional details are important, and Bookstaber’s rich depiction of different classes of market participants is better than a standard mathematical model. Also, I don’t like the idea of collapsing divergent expectations into a single representative agent. Getting away from the representative-agent model is a point in favor of Frydman and Goldberg. Note that Bookstaber, Frydman, and Goldberg do not appear in the index, either.

Nobel Symposium on Banking

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John Cochrane writes,

I attended the Nobel Symposium on Money and Banking in May

Diamond and Rajan say that debt is necessary, because it disciplines managers. Debt holders are constantly monitoring management, and running at the first sign of trouble. In direct contrast, Gorton’s debt holders are paying no attention at all most of the time, and then dump debt out of blind fear.

One weak spot of the conference was that everyone was being too polite. Well, everyone but me. Here we have a glaring difference in views. Which is right? I asked the question.

Rajan’s response was very informative: Yes, most retail debt customers are “information insensitive,” and likely even most corporate treasuries using repo as a cash substitute. But among the New York banks who are funding each other very short term, yes indeed they are paying a lot of attention and will run when they see trouble. So the “discipline” story is narrow, for this class of lender and borrower. That seemed to me a nice reconciliation of dramatically opposing views that has troubled me for some time.

I have watched several videos from the event, including the one where the exchange between Cochrane and Rajan occurs.

Cochrane asked another question, which I don’t think anyone answered. In some sense, I think he was asking how there can be a shortage of liquid assets, given how easy it is to trade assets, including stock mutual funds. My thought is that if this phenomenon of a shortage of liquid assets is real (or was during the financial crisis of 2008), it is because of the enormous balance sheets that some of the financial institutions had assembled on very little equity, leaving them with tiny margins of error.

On the general topic of how financial intermediation operates in the economy, I keep saying that we need to appreciate the layering that takes place. Finance is a complex ecosystem, with many niches. Beware of models that simplify it. I would wager that many of the conference participants could not have been able, as of 2005, to explain the nature and significance of repo haircuts, super-senior CDO tranches, or credit default swaps on mortgage securities.

I think that Doug Diamond and Gary Gorton are a bit too much invested in the issue of runs on short-term debt. And from Cochrane’s second post on the conference, I gather that Ben Bernanke is the most invested of all.

Instead, I preferred the speakers, like Alan Taylor, who emphasized dramatic changes in asset values, rather than liquidity. Yes, a sort of run took place in 2008 in the inter-bank lending market, and that run really got the attention of Wall Street and policy makers. But the big build-up in mortgage debt and house prices, followed by a crash, was not a liquidity crisis.

Do you remember my post on the Eric Weinstein interview? One of his glib, provocative comments was

The so-called great moderation that was pushed by Alan Greenspan, Timothy Geithner, and others was in fact a kind of madness, and the 2008 crisis represented a rare break in the insanity, where the market suddenly woke up to see what was actually going on.

I would like to have seen some of the conferees respond to that remark.