Mark Thoma on the Risk Premium
By Arnold Kling
Tyler Cowen focuses on the misallocation of risk due to government induced moral hazard. My own view is that misallocation of risk did play a role, but I think risk misallocation due to market failures, i.e. the failure of regulation, was more important in generating the crisis than moral hazard brought about by implicit or explicit government guarantees. I also think the misperception of risk was important, perhaps even more important than the misallocation of risk (though these are sometimes hard to separate)
I tend to agree with Mark, at least as far as the mortgage/housing crisis is concerned. I see a multiplicative effect of misallocation and misperception of risk. The primary misallocation was due to institutional factors, especially bank capital regulations, that raised the demand for AAA and AA securities. The primary misperception was the view taken by rating agencies, and probably by the key sellers of credit default swaps, that house prices could never fall nationwide. These misperceptions allowed the creation of artificially highly-rated securities to meet the artificially high demand.
A deep, Minsky-esque question is whether misperception of risk is inherently cyclical. It could be that, at certain points in history, an epidemic of bad judgment concerning risk is pretty much inevitable. When the epidemic occurs, it carries with it government regulators as well as private investors.