Sunday, May 17, 2009

Cognitive Dissonance and the Financial Crisis

. Sunday, May 17, 2009

Good stuff from Niall Ferguson:

For reasons to do with human psychology and the failure of most educational institutions to teach financial history, we are always more amazed when such things happen than we should be. As a result, 9 times out of 10 we overreact. The usual response is to introduce a raft of new laws and regulations designed to prevent the crisis from repeating itself. In the months ahead, the world will reverberate to the sound of stable doors being shut long after the horses have bolted, and history suggests that many of the new measures will do more harm than good. ...

Human beings are as good at devising ex post facto explanations for big disasters as they are bad at anticipating those disasters. It is indeed impressive how rapidly the economists who failed to predict this crisis — or predicted the wrong crisis (a dollar crash) — have been able to produce such a satisfying story about its origins. Yes, it was all the fault of deregulation.

There are just three problems with this story. First, deregulation began quite a while ago (the Depository Institutions Deregulation and Monetary Control Act was passed in 1980). If deregulation is to blame for the recession that began in December 2007, presumably it should also get some of the credit for the intervening growth. Second, the much greater financial regulation of the 1970s failed to prevent the United States from suffering not only double-digit inflation in that decade but also a recession (between 1973 and 1975) every bit as severe and protracted as the one we’re in now. Third, the continental Europeans — who supposedly have much better-regulated financial sectors than the United States — have even worse problems in their banking sector than we do. The German government likes to wag its finger disapprovingly at the “Anglo Saxon” financial model, but last year average bank leverage was four times higher in Germany than in the United States. Schadenfreude will be in order when the German banking crisis strikes.

This reflects one of my greatest fears. Most people know that the stock market indices are down over the past decade. Most people know that we are in a deep and serious recession. Most people (even academics and educated professionals) believe that this is due is "deregulation," although they do not have any knowledge about which specific deregulatory actions are responsible, nor do they have the faintest idea what regulatory changes would have prevented this crisis (or could prevent the next one). Some countries with relatively strict regulatory policies (e.g. India) have done fairly well in this crisis. Others have not. Some pessimistic economists (Roubini and Krugman) famously predicted a recession, but they had the trigger wrong (currency depreciation from mounting debt and trade deficit, rather than banking crisis) and incorrectly predicted recessions for years before this one came (perhaps they deserve credit for continuing to cry wolf until one actually materialized; perhaps not). Some have said that this financial crisis is the fault of the Bush administration and the Republicans, but the same people were not saying the same things during the last financial disruption in the late-1990s... when Clinton was in charge.

Ferguson goes on to say that much of the blame for the crisis can be chalked up to bad regulation (esp. Basel I and II) rather than deregulation. But as Ferguson notes earlier in the piece, "Financial crises will happen," and it's not easy to see in advance what the proximate causes of the next crisis will be. Basel I was a reaction to the exposure of Western banks to the Latin American debt crisis, while Basel II was a reaction to the Asian financial crisis. There is already a strong movement towards international regulatory policy harmonization in response to this crisis. But given recent history, there is little reason to be optimistic that regulators will be capable of preventing the next crisis. If the generals are always busy fighting the last war, how will they succeed in preventing the next one?

So what should be done? In my view, we should accept that financial crises will be a semi-regular feature in our economy, and try to institute regulatory institutions that will minimize the severity and duration of these crises. How to do that? By focusing our regulatory efforts on promoting transparency rather than trying to force banks into behaving well, by making our regulatory efforts counter-cyclical to give flexibility when needed, by limiting moral hazard (esp. the sort that leads to regulatory arbitrage), and by pursuing monetary and macroeconomic policies that lessen boom-and-bust cycles in the financial sector as well as the broader economy.

The last of these may be the most difficult, but also the most critical. The global savings glut and international macroeconomic imbalances had much more to do with the current financial crisis than any regulatory policy. In the future, we should understand that persistent macroeconomic imbalances will eventually correct, one way or the other. A gradual adjustment through the exchange rate mechanism is preferred to financial collapse and crisis. In the future, we should push for more flexible exchange rates, less public debt, and more openness in the financial system. This will not completely eliminate financial crises, but it may make them less severe.


Cognitive Dissonance and the Financial Crisis
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