Why I Was Wrong...

Calculated Risk issues an invitation:

Calculated Risk: Hoocoodanode?: Earlier today, I saw Greg "Bush economist" Mankiw was a little touchy about a Krugman blog comment. My reaction was that Mankiw has some explaining to do. A key embarrassment for the economics profession in general, and Bush economists Greg Mankiw and Eddie Lazear in particular, is how they missed the biggest economic story of our times.... This was a typical response from the right (this is from a post by Professor Arnold Kling) in August 2006:

Apparently, the echo chamber of left-wing macro pundits has pronounced a recession to be imminent. For example, Nouriel Roubini writes, "Given the recent flow of dismal economic indicators, I now believe that the odds of a U.S. recession by year end have increased from 50% to 70%." For these pundits, the most dismal indicator is that we have a Republican Administration. They have been gloomy for six years now...

Sure Roubini was early (I thought so at the time), but show me someone who has been more right! And this brings me to Krugman's column: Lest We Forget

... Why did so many observers dismiss the obvious signs of a housing bubble, even though the 1990s dot-com bubble was fresh in our memories? Why did so many people insist that our financial system was “resilient,” as Alan Greenspan put it, when in 1998 the collapse of a single hedge fund, Long-Term Capital Management, temporarily paralyzed credit markets around the world? Why did almost everyone believe in the omnipotence of the Federal Reserve when its counterpart, the Bank of Japan, spent a decade trying and failing to jump-start a stalled economy?

One answer to these questions is that nobody likes a party pooper.... There’s also another reason the economic policy establishment failed to see the current crisis coming. The crises of the 1990s and the early years of this decade should have been seen as dire omens, as intimations of still worse troubles to come. But everyone was too busy celebrating our success in getting through those crises to notice...

[I]n addition to looking forward, I think certain economists need to do some serious soul searching. Instead of leaving it to us to guess why their analysis was so flawed, I believe the time has come for Mankiw, Kling and many other economists to write a post titled "Why I was wrong".

Let me say what things I was "expecting," in the sense of anticipating that it was they were both likely enough and serious enough that public policymakers should be paying significant attention to guarding the risks that it would create:

(1) A collapse of the dollar produced by a panic flight by investors who recognized the long-term consequences of the U.S. trade deficit.

or:

(2) A fall back of housing prices halfway from their peak to pre-2000 normal price-rental ratios.

I was not expecting (2) plus:

(3) the discovery that banks and mortgage companies had made no provision for how the loans they made would be renegotiated or serviced in the event of a housing-price downturn.

(4) the discovery that the rating agencies had failed in their assessment of lower-tail risk to make the standard analytical judgment: that when things get really bad all correlations go to one.

(5) the fact that highly-leveraged banks working on the originate-and-distribute model of mortgage securitization had originated but had not distributed: that they had held on to much too much of the risks that they were supposed to find other people to handle.

(6) the panic flight from all risky assets--not just mortgages--upon the discovery of the problems in the mortgage market.

(7) the engagement in regulatory arbitrage which had left major banks even more highly leveraged than I had thought possible.

(8) the failure of highly-leveraged financial institutions to have backup plans for recapitalization in place in the case of a major financial crisis.

(9) the Bush administration's sticking to a private-sector solution for the crisis for months after it had become clear that such a solution was no longer viable.

We could have interrupted this chain that has gotten us here at any of a number of places. And I still am trying to figure out why we did not.

Comments

[albrt]

It is notable that 3-5 and 7-9 are (or should have been) within the purview of banking regulators. Same with the failure to regulate swaps, "synthetic" securities and other fundamentally Ponzi-like assets. The process was really pretty simple, and all the important parts of it are captured in the infamous "chainsaw" photo-op.

With regard to 6, I don't think it is clear that investors were wrong to flee from other financial asset classes once it became clear how crooked or incomptetent the financial institutions actually were in every aspect of the security creation process.

[david]

I think the question from CR could be put as: was there something about the tools you use or the views to which you subscribe as an economist that led you to miss 3-9? Or, how much does the meltdown challenge what you thought you knew about the relationship between finance and the economy?

Maybe lots, maybe none, I have no idea, and you say at the bottom implicitly that you are working out the why.So far the blogs are full of: mathematicization ignoring systemic risk, corruption left out of models, tendency to reinforce those things that reward people with power, punch bowl can't stop dancing yadda yadda.

[King Rat]

So this begs questions if you expected housing prices to fall to a pre-2000 level price to rental ratio-wise and the banks to notbe holding the MBS: a) who did you expect to take those losses? b) how would that allocation of the losses not led to a recession of ginormous proportions?

[Wolf]

I worked in the mortgage securitization field and it was clear to me in 2002 that mortgage banks were going to go bankrupt in droves. The volume never made any sense, and anyone could have known this.
DeLong even relatively recently opined that in the Bay Area home prices would not retreat at the rate other areas are. The reason for such an assessment appears to be this: One has no sense of affordability. Perhaps I underestimate how many highly educated people make high incomes in the Bay Area (in certain places one really gets the feeling everyone has a Ph.D.:-)). But I doubt that.
Given measures of affordability and the trend from 2002 onward clearly pointed to a Japan-style collapse. Forget loan-loss provisions, and ratings assigned to securities. The credit expansion was never sustainable and had reached such absurd levels that the only logical conclusion was the collapse of the financial system. No matter what Moody's says about individual securities, in sum none of it made sense.

Now, the only thing that wasn't quite a public was the market for CDSs. My sense is that without those, the extraordinary measures taken by central banks would be sufficient (although they could never have prevented a nasty recession given the overstretched consumer).

Brad Delong has been one of my favorite sources for economic information, but I have felt quite disappointed over the last 2-3 years.

[Jim Harrison]

The fundamental problem of the political economy of the U.S. and, to a lesser extent, other industrialize countries is excessive inequality. If the haves get too big a share, they won't be able to find an adequate return on their wealth by putting their money in productive investments because the market for new goods and services won't be big enough. Hence there will be an endless succession of speculative bubbles as all that money drives up the price of one class of assets after another. Under these circumstances, economists, like technocrats everywhere, will attempt to find specific technical explanations for each crisis because the underlying issue involves unpleasant politics. The blindness of the geeks is not irrational. After all, there has been no real prospect of doing what needed to be done, i.e. changing the tax and labor policies that promote inequality. Recall that Clinton took a huge political hit for slightly increasing the tax rate on the highest brackets, even though the official justification of the increase was controlling the deficit, not increasing income redistribution.

The prospect of a new depression has changed the politics of income distribution so that it may be possible to understand what's happened and even do something about it, at least until things calm down. O well, what's left to say except "sweet are the uses of adversity," or, if you prefer Heraclitus to Shakespeare, "every cow is driven to pasture by a blow."

[PeteE]

Here is a variant on albrt's comment: Most bankers and traders weren't crooked or incompetent; they were deluded. They believed that they had commoditized risk thanks to financial theory, and that either the buyers or sellers of risk would value risk accurately. They realized that costly tail events were possible, but thought that they'd pass quickly because the financial world now has the right theories and tools to manage the risks. A couple of years ago I attended a talk on the shocks of the 80s and 90s by one of the leading financial engineers who argued that market shocks are growing more severe (rises and falls in markets) but shorter in duration thanks to financial engineering.

[EL]

"And I still am trying to figure out why we did not." Short answer: Koolaide.

[wcw]

Like others, I saw a good number of things coming (I was short homebuilders by spring/summer 2006; I was short FRE by winter), but I did not predict the full denouement. My first surprise was not the failure of all concerned to consider a housing-price downturn (just looking at the model results told you that), not the abject failure of the NSROs (who have always superciliously minted money by telling investors soothing lies couched in grade-school math), nor that banks had not distributed enough housing exposure (they were buying in in 2003-2006, not selling out), and certainly not panic when it all became clear.

However, the surprise point for me (and, alas, the reason I left so freaking much money on the table when I covered my shorts much, much too early) was the response to a broken buck in the money markets and WaMu's seizure in the loan markets. I assumed that money-market investors would simply and accurately have reevaluated those funds with an eye towards risk instead of yield first (Reserve had amazing yields and had siphoned up vast assets with them; you knew they were taking risks), but they put runs on funds instead. I assumed the bond market would simply mark up spreads to compensate for the real chance of being wiped out by a bad loan book, but it simply stopped lending to banks instead.

Those were mistakes I could have avoided going in. I was wrong, and had every chance not to be. The lesson I draw for my little trading accounts is not to assume I know what other market participants will do in a novel environment.

[macheath]

Some people saw pieces of it, but were largely ignored or marginalized. Dean Baker was hammering on the house price bubble for years, and several people (including Gary Gensler at Treasury) called for stronger capitalization of Fannie and Freddie, saying their business model was not sustainable, and they were beaten up by Congress, Democrats and Republicans alike. Brooksley Born at the CFTC wanted to start investigating derivatives in the mid-1990s, and was slapped down by Greenspan, Rubin, and Summers, leading to legislation (backed by Summers) to prohibit the CFTC from regulating derivatives. Etc. Hindsight is cheap, but I have to agree somewhat with the "Kool Aid" poster--maybe the profession didn't drink it all the way, but there was a lot of sipping.

[macheath]

Oh--and say a good word for poor, ignored Hyman Minsky. Banks and finance institutions in modern capitalism are two contradictory things: profit making institutions who take risks and maximize their returns, and collectively the financial system of the economy, where we don't want systemic risk. The periodic financial crises (Third World debt, S and Ls, Long-Term Capital, now this) come when everybody starts to copy the "innovation" and everybody (including various Nobel economists) say that it is different this time, and the risks are under control due to clever market adaptations. Then the collapse, and the taking on of the bad assets by taxpayers. Krugman's main recent point is that everyone gets so excited by the rescue that they ignore how we got into each problem in the first place. Risk taking banks and financial institutions overshoot, and as they make money, everyone else copies them, hence the systemic quality. Regulators have to anticipate that and work accordingly, and be supported politically. Career regulators, especially in the U.S., cannot by themselves fight off the massive lobbying and political expenditure by these firms and industries. Otherwise, we'll just keep getting a series of these down the road, and then everyone can say "Oh gosh, how did this happen?"

[Neil B]

As per Bushie types, the simple explanation is their silly and unlimited trust in "the free market" to just sort things out. Many of them still think the government is most responsible for TGD, instead of investment bubbling (well, the latter is most responsible, isn't it? ....)

[bigTom]

Isn't this a case of experts being confused because they are lost in the arcane details. From a relatively uninformed macro point of view, it was clear that an unsustainable debt buildup was occurring. It should have also been obvious that a lot of the debt was backed up by an unsustainable increase in asset prices. Yet it was assumed that the overall system could absorb the unwinding of these unsustainables without major damage. I have to admit that, like wcw I was somewhat taken in by the expert opinion. Because I gave it some weight, my flight from the equity & debt markets was far too timid -really just a minor readjustment of asset allocation, when a wholesale retreat would have been in order.

[albrt]

"Most bankers and traders weren't crooked or incompetent; they were deluded. They believed that they had commoditized risk thanks to financial theory..."

You are right in a sense. But bankers and regulators who uniformly believe that it's different this time are systemically incompetent.

And bankers are systemically corrupt if they believe that it's OK to pocket the proceeds of a synthetic debt product that has no underlying collateral and represents no productive investment other than maintaining the lifestyle of the banker who will then create more synthetic debt products. Whether the banker subjectively recognized that it was a Ponzi scheme is just a matter of semantics.

[Cranky Observer]

The problems with the ratings agencies were pretty clear to all by 2002 (and I believe were discussed extensively in the comments section of this blog), but "when a mans income depends on his not understanding something" came into play and the finance and politco-economic worlds closed ranks to shut up anyone who tried to point out the leaks in the dike.

All of Wall Street since 1995 has essentially been one big ball of conflict of interest at a level that would get any $30k/year junior purchasing agent fired in a heartbeat, but anyone who tried to point that out was brutalized (and I suspect if they had any connections to the Street or the Treasury they and/or their institutions were threatened). Read the comments from the "professional finance people" here, on Crooked Timber, and in Drum's comments section: they are still in vicious counterattacking denial mode. Our job as taxpayers is to shut up and send our paychecks to Uncle Sam so that Wall Street salaries can continue uninterrupted.

Cranky

[Massimo GIANNINI]

OK we got 2 to 9, but there is still room to get 1 that is " A collapse of the dollar produced by a panic flight by investors who recognized the long-term consequences of the U.S. trade deficit" and just add its public and private debts. Better talk to Chinese and others holding US$ reserves

[RW]

Akin to bigTom (and WCW) I'm just an investor who became overall defensive too early while shorting specific asset classes such as real estate and mortgage lenders (some of that worked out just fine later). It was clear we were in a bubble but, in the end, the magnitude of its consequences was simply shocking and I was not nearly defensive enough; in 20-20 hindsight 90% in T-bills with 10% in double short market ETF's like SDS would have been about right WRT risk-adjusted return.

Excluding movement conservatives incapable of appropriately assessing the dangers for ideological reasons and those deepest in sell-side servitude who wouldn't tell the truth even if they knew it, I'm guessing the only economists making reasonably accurate predictions were heterodoxic (students of Minsky or those grounded in complexity and systems theory perhaps) with strong proponents of neoclassical framework(s) missing the boat by the widest margins and everyone else winding up more or less in between.

I believe it was Nikki Giovanni who said, mistakes are a fact of life, it is the response to error that counts: It will be interesting to see how the field of economics responds to the empirical challenge this 'mistake' represents to say nothing of the continuing monetary and fiscal policy responses by government since that has vitally important consequences for all of us: I would certainly feel better though if some of those who predicted this debacle were on that new advisory council along with Paul Volcker; don't think any of Obama's economic transition team were among those who 'saw this coming' were they?

[Paul Yarbles]

Don't feel so bad, Delong. Few can overcome the indoctrination that is required for an advanced economics degree and the never-ending reindoctrination that is required of the professional economist. This indoctrination requires one to ignore the real world and focus instead on very pretty, if fictional, models. This tunnel-vision allows one to suspend common-sense and write elegant papers set in fairytale lands in service to existing wealth and power.

The fully indoctrinated economist sees bubbles as the this time it's different/forever happy times of new paradigms, increasing inequality as a rising tide lifting all boats and financial swindles as desired innovation.

Look at Robert Rubin and his economist offspring Larry Summers. Two people who really really eff'd up and yet they are held in high regard. Why? Because the profession can not allow those orthodox to doctrine to be shown to be really really wrong. Once the foundations are shown to be made of sh*t, the whole rotten edifice could fall in a heartbeat.

Ask yourselves, if the majority economics profession not only didn't see this train wreck coming but instead justified the train's direction, then aren't they part of the problem?

[J. Michael Neal]

Here is a variant on albrt's comment: Most bankers and traders weren't crooked or incompetent; they were deluded. They believed that they had commoditized risk thanks to financial theory, and that either the buyers or sellers of risk would value risk accurately. They realized that costly tail events were possible, but thought that they'd pass quickly because the financial world now has the right theories and tools to manage the risks. A couple of years ago I attended a talk on the shocks of the 80s and 90s by one of the leading financial engineers who argued that market shocks are growing more severe (rises and falls in markets) but shorter in duration thanks to financial engineering.

Shorter version: Finance attracts the sort of geniuses who are idiots.

[Barkley Rosser]

I'm being hard on Brad these days, and I am feeling sorry about it, because I think he is a genuinely insightful and knowledgeable economist with a progressive orientation. I have poked at him and Larry Summers elsewhere (and I think here as well) for missing the importance of the housing bubble. This is especially ironic given that I think Brad's most cited paper ever was with Summers, Shleifer, and Waldmann on noise trader risk. They, of all people, should have been more on top of this than anybody living, given that Kindleberger and Minsky are no longer among the living.

Which leads me to the fact that there seems to be a missing item in the list, the high degree of leverage and entanglement among the various higher order derivatives, which is why we had the financial collapse that needed the recapitalizaton. Ever since Geithner's Hong Kong speech of Sept. 2006, which I have mentioned here previously more than once, this should have been high on any financial market watcher's list of things to worry about.

BTW, I think the people at the Fed were worrying about it. Most fail to remember how quickly the Fed responded in August, 2007 with their innovative response. They were not as taken by surprise as Brad and so many others.

[William Shakespeare]

"The fires of Hell are fed by the souls of ambitious men"

[bakho]

How are 3, 5, 7 and 8 not incompetence?

[andres]

Brad, congratulations for issuing a clear mea culpa in this regard, and I hope enough economists agree with you to turn it into a nostra culpa.

It is important because it is the first step in acknowledging that between the 1970's and the 1990's, a substantial portion of accepted economic doctrine turned into horseshit and with it many economists turned into purveyors of nonsense.

Some of this nonsense--that the Fed caused the Great Depression and that the economy is naturally self-correcting in the absence of Fed bungling--was accepted by those economists self-labeled as monetarist or new classical but thankfully not by the majority of the economics profession.

But a more important load of nonsense was accepted by the majority of the economics profession--that thanks to wise management by the Fed, financial catastrophes on the scale of the early 1930's and their potential economic consequences were a thing of the past. Macroeconomic textbooks shoved the study of financial crises off to the less popular money and banking courses and instead concentrated on growth accounting for rich nations, balance of payments accounting for emerging market nations, and wise long-term policies to improve the numbers on both accounts.

Short-term macroeconomics became childishly easy in this narrative--a few interest rate cuts were all that was needed to ameliorate a recession, while fiscal policy was too slow and ungainly to be relied on, and the real danger was that the central bank would be too profligate and would spark off inflation.

The above is what I read from the economics textbooks I studied--Lipsey and Steiner on principles and Branson at the intermediate and advanced levels--those I taught with such as Baumol/Blinder and Dornbusch/Fischer, and those I have read through, such as Mankiw.

If one wanted to study in detail the mechanisms of unsound lending, securitization of loans, counterparty exposure, cascading writeoffs, the freezing of credit, and the whole process of collective amnesia that made such a sequence possible, one had to study the writings of J.K. Galbraith or the U.S. post-Keynesians, both outside the economics profession mainstream.

As to Obama's economic team, maybe I'm being too pessimistic and Larry Summers, Tim Geithner and Paul Volcker(!) have learned from the current crisis and will help create a financial system that tightly restricts unsound lending and encourages greater transparency. But I am not betting on it, and while I sympathize with Obama's argument that he needs people with Washington-experience, I don't agree with it. All the inside knowledge of Wall Street and the Treasury in the world will not make a difference if one has learned no lessons or the wrong lessons from the current financial mess, and the true faith of the economics profession encourages its practitioners to do exactly that.

[The Raven]

Thank you, Prof. Delong. It takes courage to admit to error, especially on the part of a genuinely knowledgeable person, and I for one appreciate that you have done so.

"We could have interrupted this chain that has gotten us here at any of a number of places. And I still am trying to figure out why we did not."

Surely, widespread corruption and a lack of the old conservative virtues? It is enough to make one believe in demonic tempters! I don't believe that, but I do believe that we'd spent decades persuading ourselves of a number of things that were plainly false: most significantly that unregulated markets somehow can discipline themselves. It seems to me that in the second half of the 20th century, the USA mass culture went from a belief, at both the individual and social levels, in intense harsh self-discipline, to license, without every passing through moderate, sensible self-discipline in the middle. I hope we will see more of that in the future, but I am not hoping too hard; moderation is one of the great philosophical teachings, and one of the ones that seems to most need repeating.

Caw!

[Jrossi]

I have gotten used to economists having only a very rudimentary understanding of the economy. The system is complicated. I have gotten used to economists being vastly overconfident about their understanding of the economy. Wannabe physicists and all that. The real problem for the rest of us is when to believe economists and when not to. Because economists' insight and foolishness and ideology and full-on bullshit come mixed up in an alloy that is very difficult for us to separate. And I don't see that particular problem going away.

[Bram Cohen]

To be fair, there are a few things which masked the extent of the problems:

First, the out of control housing bubble's effect on the market was largely counterbalanced by the continuing out of control dot com bust, and the two put together looked like the dot com bust had simply ended and we were entering into a normal recovery.

Second, there really is a lot of demand to live in major urban centers, particularly in New York and California, and while the rent/own disparity is very real, it could just as easily have equalized (and still might) in the direction of rents going up rather than prices going down, especially with income disparity having gotten as out of line as it has, what are rich people going to spend money on besides driving up the price of housing in the very most desirable locations to insane levels? Of course, that last argument might now have fallen through, because one of the effects of this bust might be that income levels equalize a lot, especially in NYC as we go into a semi-permanent oversupply of finance industry labor, pretty much all of it located where the most ludicrous pricing was happening...

[Peter Principle]

We could have interrupted this chain that has gotten us here at any of a number of places. And I still am trying to figure out why we did not.

Go back and re-read your points (8) and (9).

Also, just because you expected (1) and instead got (2) doesn't mean that (1) won't show up one of the days.

[Quiddity]

Did you see the Greenspan low-interest-rates-policy - especially after 2002 - as a contributing factor? I sure did.

Re (3): the discovery that banks and mortgage companies had made no provision for how the loans they made would be renegotiated or serviced in the event of a housing-price downturn

Given that the loans being issued were ridiculous (NINJA, liar loans, etc), and that you anticipated a fall back of housing prices, what provisions could have possibly been in place to prevent trouble? Please provide examples.

[marcus medler]

Economist must be pleased that a 19th century description of their discipline;"the dismal science", can morph in this century to "the dismal swamp"! Commission driven goods or service exchange is by its very nature fraught with non quantifiable factors. Any exchange where both parties involved have nothing to lose except a commission begs to be regulated. We have learned that denial is not a river in Egypt.

[Don Majdanik]

[Most bankers and traders weren't crooked or incompetent; they were deluded.]

Deluded? How about "defrauded". Whether false or phantom incomes, overstated cash assets, bankable leases, accounts receivable, historical business success, and other wonderful facts; much is bogus ... overstated only 25% high ... just under the bar to get the money. Not simply residential and individual requests for loans. The next shoe to drop will surely be commercial/industrial projects.

Further problems exist with Municipalities and States which have levered themselves with Port Authorities, convention centers, several layers of colleges and libraries all with borrowed funds supporting employees with entitlements for salaries, office buildings, stadiums and the necessary utility services to enhance the quality of life of the citizens with debt up to their eyeballs (cities and citizens). Somewhere the asset values came to be examined and the march to "mark to market" seemed to expose the scheming asset inflation.

Recent blogs by Bill Gross of Pimco speaks to formal education enhanced by the CS (Common Sense) quotient. Robt. Shiller says that economic education needs to understand the herd mentality in society including the recognized "experts". Gross and Shiller have insights into why we act as we do.

Finally, this rant posits that mere education needs to be supplemented with real money (Preferably ones own) and experience with market rents, rent collection, slow paying customers, and other small but growing problems that affect individuals and the economy. I sometimes wonder how we ever intended to have Iraq repay the costs of the war in their country. The propoganda line was that the repair of Iraq's oil production would open the dollar valve to pay for the war.

This leads me to wonder about a rumor about the first Gulf War. Saudi Arabia was a creditor nation prior to that war. Many Saudi students were attending USA schools in the USA and they received a stipend for study. After that war Saudi Arabia paid for many of the USA invoices for their defense. Saudi Arabia paid and suddenly became a net debtor nation. The students lost their stipends. The 9/11 attackers in the Twin Towers were Saudi nationals. Could there be some relationship between our fiscal and military policies that involves more than our defense of Israel and altruistic overthrow of despots?

We need some smart people in government connecting a lot of dots.

[Bill Stepp]

"the discovery that the rating agencies had failed in their assessment of lower-tail risk to make the standard analytical judgment: that when things get really bad all correlations go to one."

This isn't what rating agencies do. Aside from the fact that correlation is not causation, their models were simply designed to assess the probablility of default of bonds, mortgage-backed securities, etc. Their models did err in assuming that home prices would never decline, as a friend at one of the rating agencies pointed out to me. They were not used to predict bond prices, however, the way a brokerage firm's bond (or stock) model might work.
More importantly, the SEC granted the Big Three rating agencies a cozy little triopoly in 1975, which warded off the competition of johnny-come-latelys such as Egan-Jones and Weiss Research. Those two firms have been more critical of some of the stuff the Big Three rated, but they have been on the periphery of the industry, although that might change.
I don't recall you or Krugman criticizing the lack of competition among the rating agencies. Presumably, a more competitive rating industry might have warned about the growing risk of default.

[Admiral Turpitz]

>> "We could have interrupted this chain that has gotten us here at any of a number of places. And I still am trying to figure out why we did not."

How does one interrupt a solvency crisis? It is interesting to see so much pulic commentary trying to label this a crisis of trust: how better to justify policies that socialize such enormous lessons. I do not know if there is a better way to hold off the beast at the door.

How exactly is the global economy supposed to de-leverage without triggering #1?

[John Emerson]

We didn't know important things because no one had an incentive to tell us the truth, and many had an incentives to conceal it, and if there were any truth tellers, their voiced were drowned out by more eminent liars.

If truth is a commodity, it will be expensive and hard to find.

Suppose you generalize and ask, "What would happen if truth were entirely commodified?"

In that case, no one would ever have any more truth than they could pay for, but everyone would have as many free lies as they wanted. People who had truth to give would dole it out on a cash basis. Anyone who gave out truth for free would be a sucker or an irrational altruist.

Not terribly different than the present case, of course. Most of us depend on free or heavily-subsidized media. The dishonesty of the Times and the Post is no mystery. The truth market works for some people, but not for us.

[AllenM]

That would be a big told you so...

But seriously, what is the point?

As long as people take the Cato folks seriously, there is no point.

Good luck in the next administration- your gonna need it.

[peter jones]

Hi great blog and resource.

I've added you to the economics resource listing at:

http://www.p-jones.demon.co.uk/linksIV.htm

The associated conceptual framework helps to maintain a four-handed perspective on things...

Best regards

Peter Jones
RMN, RGN, CPN(Cert), PGCE, PG(Dip) COPE, BA (Hons.).
Community Mental Health Nurse Older Adults,
Independent Scholar & Informatics Specialist
Wigan
Lancashire
UK
http://www.p-jones.demon.co.uk/
Hodges' Health Career - Care Domains - Model
http://hodges-model.blogspot.com/
h2cm: help 2C more - help 2 listen - help 2 care

[PJ formerly of WI]

I agreed with this post the first time I read it, but went away feeling dissatisfied but not sure why. After some reflection, I think I know now what seems to be missing. There is no mention of *how* the bubble in (2) came into being. Anybody who, in say 2004, was willing to acknowledge the existence of the housing bubble and asked, "How is this happening?" would have probably been led to evidence of some, and maybe most, of (3) through (8). And as for (9), I would never have expected otherwise.

I also would echo a previous commenter's thought that this isn't over and (1) could still happen.

[Yancey Ward]

I don't often find myself in agreement with Krugman, but he tells you why no intervention was taken until it was too late- no one likes a party pooper.

It never ceases to amaze me how people miss the most fundamental thing- strict lending standards are at odds with inflationary policies. You don't loosen up credit only to restrict lending to those who are credit-worthy and with solid business/personal plans. You loosen credit so that you can lend to as many entitities as possible.

Also, I would second King Rat's first comment. Someone was always going to have to step up and take the losses on inflated assets. Everything we have done so far is pass the hot potato, but the losses are there, and they aren't going to disappear.

[Slocum]

"We could have interrupted this chain that has gotten us here at any of a number of places."

Was there really a good way to insulate the financial system against a collapse of housing prices of the magnitude we're seeing? I'm skeptical. And are the kind of draconian economic policies necessary to arrest the development of a bubble ever going to be politically feasible? Probably they would be *now*, but we don't have a new bubble to pop now. And by the time the next one starts inflating, the political will will probably have dissipated. We also had the problem that the collapse of the dot-com bubble did not have enough of an effect to really put the fear of god into everybody.

That's not to say that there's nothing that we could have done, but I really don't believe that the problem could have been averted by breaking any one of nine links on a chain. That would imply that there were many different possible solutions and many opportunities to solve the problem at low cost -- so it should have been really easy -- but we missed all the opportunities.

[bigTom]

"We could have interrupted this chain that has gotten us here at any of a number of places." Isn't this just the painfully breaking wave of the Kondratieff cycle? If so is there any evidence that we have any real control over the long cycle (roughly a human lifetime) whereby the old lessons of prudence are gradually forgotten, and excesses accumulate at an increasing rate until their collapse can no longer be put off? I'm pretty skeptical that we could do much about this sort of cycle, whose genesis is in human psychology. Esoteric financial instruments are just the symptom, and the means, but not the root cause of the long cycle. Or has this been discredited to the point that economists no longer have to consider it as a serious thesis?

[MattYoung]

I was wrong about how addicted the trading world was to American dollars, leading to the same wrong conclusion - the dollar would drop in value.

[Barkley Rosser]

Bram Cohen,

No, it was not equally likely that rents would go up. Shiller has shown that over more than a century rents and incomes tend to stay remarkably correlated. You would not have seen some rise in the rent to income ratio to offset the historically high price to rent and price to income ratios. Prices were going to come down. The only question was, how bad would the collateral damage be on the financial system and thus the real economy, which was harder to call.

[albrt]

Great comments, as usual.

It has suddenly occurred to me to ask - insurance companies and similar financial institutions are paid to manage risk; why did anybody ever think it was a good idea to encourage them to "spread the risk" back to us?

My guess is that we simply assumed our financial institutions were spreading the risk to anonymous Saudi princes and other semi-mythical greater fools who would quietly take the losses. Instead they spread the risk to our pension funds and other similar places. Oops.

[Cranky Observer]

> I'm pretty skeptical that we could do much about this sort of
> cycle, whose genesis is in human psychology. Esoteric financial
> instruments are just the symptom, and the means, but not the root
> cause of the long cycle.

Controlling the per-person rake-off to a reasonable level - say, $2-3 million/year maximum - seemed to do wonders for Wall Street prudence. When the restrictions and taxes were removed, such that the sky was literally the limit, suddenly we saw trees being sold (and options on trees, and derivatives on rate of tree growth, and insurance on derivatives on rate of tree growth, and ...) under the premise that they would grow to the sky.

Cranky

[Bram Cohen]

Barklay, that is true, but my point is that with the recent income disparities which have been created, the income to rent rate in the very most expensive parts of SF, LA and NYC might be out of whack the other way, due to the very high incomes some people have (or had - NYC might be going down the tubes in a big way). Housing price bubbles in other places were simply inexplicable.

[Barry]

1) The basic situation was that the system was deregulated until it broke; strong conflicts of interest (e.g., the rating agencies) were deliberately ignored by econommics professors, who invoked 'the market' to explain concrete facts away.

2) A lot of people made fat cash off of this; they had strong incentives to keep it going.

3) There is no accountability whatsoever - if the world were a bit more just, there'd be a gallows in Harvard Square, with the Econ dept and B-school faculty decorating it. It wouldn't compare to the mega-gallows running up and down both sides of Wall St, but it'd be impressive.

There isn't, and the elites of economics know that. They lied and BS-ed, and some of them (like Summers) are going to be hired to fix the problems they created (actually, to throw money at their cronies).

And when the various very, very, very wrong economics professors go to AEA meetings, they won't be shunned. In the end, academic economics is no less corrupt than any Wall St firm.

[krishna]

Barry,
Add Robert Rubin to the list of economic elites who have and are lying:

http://www.nakedcapitalism.com/2008/11/mirabile-dictu-rubin-takedown-by-wall.html

I also agree with you about the economics profession. It has an excessive number
of hacks in its upper rungs, and it seems to me that this sort of corruption is
incentivized because it enables better access to people with power and influence.

[John Emerson]

Yay Barry!

[Jake]

We didn't know important things because no one had an incentive to tell us the truth, and many had an incentives to conceal it, and if there were any truth tellers, their voiced were drowned out by more eminent liars.

Bingo. Although in addition to the liars there were a huge number of self-deluded folks. Most everyone wants to believe that it's possible to make a lot of money without working, and they found people willing to tell them this was the case.

Also, the Bush administration really wanted to delay the recession until it was out of office, no matter how much delaying it made things worse. They didn't quite make it.

[nathan]

The variety and creativity in responses has been interesting - bailout, no bailout, low interest rate loans or preferred, high interest rate loans, participation in upside, participation in downside, shotgun mergers ... This will keep people busy for years. Some sort of a recap might be nice.

[Sam Taylor]

From the perspective of a retired non-economist with some understanding of and experience with but little current daily interest in financial markets until quite recently, it is clear that no one has been minding the store. Even those who didn't drink deeply of the Ryandian cool aide sipped enough to stay tipsy.

Brad list sounded a lot like Robert Rubin's. He did a slightly better job with his position on the invasion of Iraq,

[Doctor Science]

I basically agree with Barry. The people who caused this mess appear to have been *flawlessly* rational actors: they have been personally enriched to a truly astounding (one might say "obscene") degree without taking any personal risk or suffering any personal consequences.

When Brad says, for instance, that he didn't expect:

"(3) the discovery that banks and mortgage companies had made no provision for how the loans they made would be renegotiated or serviced in the event of a housing-price downturn."

and

"(8) the failure of highly-leveraged financial institutions to have backup plans for recapitalization in place in the case of a major financial crisis"

I submit that he was wrong because he was expecting those organizations to act like single entities, for the people within them to work (generally speaking) for the good of the institution. Instead, to Barry and me it looks as though the most powerful people in those organizations were acting as libertarian individuals, concerned only with their own ends -- which is exactly the philosophy they claimed to admire. And it certainly seems to have worked for them, so why were you surprised?

When Alan Greenspan said "I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms." I didn't believe him. How could The Compleat Randian *not* expect individuals to be looking after their personal interests first?

But the fact that Brad, whom I think is less likely to prevaricate than Greenspan, says the same thing leads me to believe that maybe Greenspan was telling the truth. You-all believed on the one hand that people are and should be rational, self-interested, selfish and greedy actors -- but you also believed the people *you* know personally, the smart and the wealthy and the powerful and the well-connected, aren't "like that".

[mike]

It is strange to me how frequently Upton Sinclair has been quoted in this blog:

"It is difficult to get a man to understand something, when his salary depends upon his not understanding it."

But never, as I recall, as it may be applied to this financial crisis. I am puzzled why Professor Delong does not ascribe a greater share of the source problems to moral hazard.

That said, I do see how smart people made dumb mistakes. This probably was self-delusion and stupidity as much as moral hazard. But it's hard not to notice that stupidity and incentives were well aligned in this case and that is a problem. Professor Delong has been too much of an apologist for the folks at Citibank.

That said, Barry, Doctor Science and others should recognize that many of the fat cats are losing, big time. There was a good bit of downside to those who made the bad decisions. Nevertheless, when the gambles are extremely large, limited liability, even a little bit, is a big problem.

[Barkley Rosser]

I am going to note something I was wrong about, and which I shared with Brad, the dollar. Like him, I have long worried about the possibility of some catastrophic collapse of the dollar due to our mounting net foreign indebtedness. I thought in fact that the collapse of the housing bubble might well bring about a broader financial collapse through that mechanism.

As it is, once we got the serious international financial crisis due to the collapse of the derivatives markets, we had this weird old effect of the dollar being viewed as the "safe haven," which, given all those deep imbalances is at some level ludicrous. But there it is, and now we are at having 90 T-bills yielding one basis point.

[krishna]

mike,
They still are going to retain enough money so as to never have to work for the rest of their lives. In real terms, I doubt this counts as much of a loss. At least not from the point of view of the very many people who are going to be unemployed (or already are).

[Neal]

The dollar will suffer sooner than later. Hedge funds are accumulating for the big payout to investors. When investors get their dollars, will they hold on to them? Why would they when the future holds a trillion or 2 in deficits for more years than one could imagine.

Remember, this economic collapse is the collapse of the new "locomotive" of the US economy. When heavy industry collapsed, and high-tech collapsed, the financial sector was the way forward, bypassing the low income future of retailing and food service. It is not a good sign when the most growth in the economy is the governmental and health care sectors--soon also to be hit in the intensifying cycle.

[Doctor Science]

mike: The "fat cats" are not losing compared to everybody else. In relative terms, they're still on top. In absolute terms, they're even more secure: they don't face unemployment, homelessness, loss of medical coverage; their children will not be eligible for reduced-price school lunches. They suffer no direct personal suffering.

[Barry]

Posted by: krishna
"I also agree with you about the economics profession. It has an excessive number of hacks in its upper rungs, and it seems to me that this sort of corruption is
incentivized because it enables better access to people with power and influence. "

Somebody had a snarky comment, after McCain got an economics advisor from Stanford (quote from memory):

'If I were a Republican presidential candidate, and wanted a science advisor [to justify junk science], I'd be advised not to go to the elite universities, but if I wanted an economics advisor [to justify junk economics], I could pick one up at any number of elite economics departments'.

[Mark]

Prof. DeLong,

Perhaps you should read The Latest Freed Man by Wallace Stevens. He wrote the poem at a time when no intelligent person could take seriously anything that was oozing out of the intellectual world...

[macheath]

Doctor Science quotes Upton Sinclair: "It is difficult to get a man to understand something, when his salary depends upon his not understanding it."

I would also commend George Orwell to all of you, as we watch this dissembling by people who made huge amounts of money from creating these problems and now are dumping them onto taxpayers:

"It is better to be controlled by bureaucrats than by common swindlers."

[Seth]

Upton Sinclair, updated for the Robert Rubins of the world: "It is difficult to get a man to understand something when he is getting 9 figure compensation to not understand it."

As for the academics, one word: groupthink.

[Jack]

This admission of error is welcome. It is interesting to note the contrast with Bob Rubin, someone for whom this blog in the past has had nothing but immense praise for his public service, and who has not only proven incomptetent at his job at Citigroup but has been unwilling to admit to that by now very obvious incompetence. This displays a complete lack of character, and it should give one pause to note the strong connections between Rubin and many of those soon to be advising President Obama economic matters. Let's hope they do not share his moral and professional shortcomings.

[KnotRP]

Some were in on the con, and some were used by the first group to keep the herd calm.
The former group got rich, by fleecing everyone else (including taxpayers, eventually).
The later group has now lost their reputation, because they were gullible.
The former group will now point to the later group as cover for their actions:

"They didn't see me stuffing other people's money in my pockets despite offerring no real economic value add,
so how was *I* supposed to see it? I'm shocked...shocked...I tell ya."

Your winnings, sir.

Economists are people who don't understand why they get paid for being consistently wrong,
but don't question it.

[KnotRP]

BTW - since you are in a corrective mode, you should replace that "or" between (1) and (2) with an "and", and reverse the order.

[Dipper]

Is there not a danger of hindsight bias here - that because its happened it was inevitable that it would?

One key event in particular stands out - the failure of Lehman Brothers. This pitched the crisis from bad to absolutely desperate. But it wasn't inevitable. It happened (or rather a rescue didn't happen) because of the egos and attitudes of the main participants, and as such it was not predictable.

[KnotRP]

Dipper - Bernanke claimed, in today's speech, that they could not LEGALLY save Lehman Brothers...he also (I think) said that the laws have since been changed.

It was inevitable, because the people running the show are deluded and therefore behind the curve.

[Neal]

From Bloomberg, today

.....One option is for the Fed to buy “longer-term Treasury or agency securities on the open market in substantial quantities,” Bernanke said. “This approach might influence the yields on these securities, thus helping to spur aggregate demand.”....

This should take care of the missing #1.

[Doctor Science]

"because of the egos and attitudes of the main participants, and as such it was not predictable"

My argument is that the ego and attitudes of the main players were *entirely* predictable, especially given that economics is about predicting human behavior. The collapse of Lehman specifically might be contingent, but that institutions without enough insider support would fail was completely foreseeable.

[justsayin]

There is no shortage of intellectualization about the whys and wherefores of what went wrong.

To simplify: Culture of Greed, incompetence, and naivete resulting in accumulation of great wealth for a few and the fleecing of many.

The remedy: San Mateo County has fired the opening salvo in filing its lawsuit against Lehman Bros. executives. This should be only the beginning in legal (class) actions taken by the fleeced against those who were guilty of misfeasance or malfeasance.

The threat of being personally bankrupted like their victims should focus a lot of people's attentions on the roles they played.

[nathan]

A hedge against bankruptcy may be a government job.

iPhone's are nifty

[MNPundit]

(4) the discovery that the rating agencies had failed in their assessment of lower-tail risk to make the standard analytical judgment: that when things get really bad all correlations go to one.

I knew that since 2003 and I am no economist. Enron and AA was very eye-opening in that respect. That said, since I am no economist I assumed 1 and 2 and nothing else because I am no economist.

[Don the libertarian Democrat]

Here's a paper from 2005 on CDOs:

http://www.msfinance.ch/pdfs/AnnelisLuescher.pdf

Here's an investor in 2005:

http://www.321gold.com/editorials/willie/willie101405.html

Anyone reading these would have had real problems with CDOs.

The housing bubble was clear to a lot of people who sold their houses last year before the huge drop in prices.

[Twofish]

What I'm worried about is that obvious thing that we will all be talking about a year or two or ten from now, that we aren't seeing.

The two lessons I draw out of this is:

1) we just don't understand everything about how the economy works, and any economic system that assumes that we can understand and predict the economy is flawed

and

2) the important thing is to reduce the speed at which events happen so that we can figure out what is going on, and to have enough buffers and reserves in the system so that when something unexpected does happen, you have the resources to deal with it.

So rather then trying to predict the ways that things can catch on fire, you need to have enough water to deal with the situation even if you have no idea what you are going to use it for.

[Twofish]

The other question that I have is what have we learned in the crash of 2008 that will help us deal with the crash of 2016. I think one lesson is that the business cycle still exists and there will be a crash of 2016.

[Steve Olsen]

The answer is fairly simple. This game of greed combined with corruption and is being played for all the money in the world, and the rascals are effectively winning.

[Alex]

For these pundits, the most dismal indicator is that we have a Republican Administration.

Indeed, and it was damned accurate.

[nathan]

edit: there should have been no apostrophe in my previous post.

iPhones are nifty

My iPhone automatically put in the apostrophe

[Neal]

Shortest answer for why---everyone got their rewards up front.

Final result didn't matter. Any deal was better than no deal.

[Massimo GIANNINI]

Philosophers or economists? They puzzles
at http://mgiannini.blogspot.com/2008/12/philosophers-or-economists-they-puzzles.html

[PeonInChief]

Three reasons why people didn't see it:

(1) The richest third of the population (including virtually all the paid economists in the country) has no idea how the bottom 2/3rds lives. They didn't realize that low and moderate income people who were buying houses with these exotic mortgages could not possibly hope to pay them off--not even if every household member worked 24/7. Not enough wages; not enough hours. I remember real estate types suggesting that, whatever happened, people would manage to pay the mortgage. Uh, we know what happened with that one.

(2) Economists really love studying things like SIVs, CDSs and other alphabet soup stuff. It's like, whoa, you can make money off that--never thought of it. They look at how it makes money, not how it can go wrong. That's not part of the program.

(3) All the major players have fallen in love with the free market--and those of us who didn't get with the program are Neanderthal redneck trailer trash who don't see the Shining City on the Hill. That said free market has been crashing for some years now just doesn't compute, when admitting that would put you among the Neanderthal rednecks.

[Doctor Science]

Neal: I think that's the most succinct summary yet for why the meltdown happened, but it doesn't explain why smart guys like Brad didn't see it coming. Specifically, why didn't more people realize that "any deal is better than no deal" would inevitably lead to a lot of really bad deals?

[rex]

Simply put, orthodox economists got it horribly wrong because they still believe (or act as if they believe) that markets are efficient, despite an overwhelming mountain of evidence to the contrary.

If your model assumes efficient markets that return to equilibrium, then you'll never see the train wreck coming. Your model says train wrecks are impossible!!!!

I think George Cooper sums it up well in his book, "The Origin of Financial Crises."

"Reliance on quantitative risk management systems, developed from theories based on the premise of market efficiency, has introduced the new problem of 'unknown knowns' into our financial system. Unknown knowns are the things we've convinced ourselves we know, but which we do not know... Risk management based on the Efficient Market Hypothesis is like the proverbial chocolate teapot; it works only while not in use."

[Bill Stepp]

I think one reason why so many pundits et al. missed the housing/mortgage security collapse can be found in considering the previous boom in tech and telco stocks.
More people were skeptical of the sustainability of that boom, I suspect, because much of it was composed of dodgy IPOs--companies that had little or no revenue and cash flow, and indeed in some cases hardly any business at all. Therefore, it was easier in a sense to "see" that it might follow the path of previous stock boom and bust cycles, which indeed is what happened, mutatis mutandis.
The housing/mortgage security boom and
bust was different in the sense that it had little to no IPO component. In a sense it had the imprematur of government in the form of nonprime mortgage lending standards, some of which were written into the law. It was perhaps therefore more difficult to "see" the unsustainability of the housing boom, although certainly there were skeptics, including some hedge fund managers who bet against that market.
Btw, I just read Lawrence H. White's Cato Unbound essay on the causes of the housing/mortgage securitiy boom and bust, and I see you are to follow him.
I don't envy you, as he has clearly forclosed the validity of a Keynesian response (a decline in aggregate demand, which obviously had nothing to do with it), which I assume would have been your trump card Deregulation had nothing to do with it either.

[Barkley Rosser]

Bill,

Sorry, but from the moment that the second edition of Robert Shiller's Irrational Exuberance appeared in 2005, there was mighty little excuse for anybody serious to deny that there was a housing bubble. Those who did pointed to the then very low interest rates, although there was clearly no reason for those to persist indefinitely. Shiller unequivocally demonstrated that by 2005 we were seeing by far the highest house price to rent and house price to income ratios ever seen in US history. Those ratios, appropriately adjusted for interest rates, are the fundamentals, and we were clearly way out of line.

Now, it was not as easy to see all those nasty links with the derivatives market and how insane it had gotten. Indeed, some of the worst insanity did not happen until the first half of 2006 when the volume of derivatives rose by about 50% during the last spurt of the US housing bubble, which peaked out about mid-2006. By September, Geithner gave his "nightmare" speech in Hong Kong that laid a lot of it out, but it was so carefully couched that many did not get it. But the Fed knew we were into deep doo doo, even if many others did not.