Jeffrey Friedman on the Financial Crisis
By Arnold Kling
Critical Review is publishing a special issue on the financial crisis. I have uploaded Jeffrey Friedman’s introduction. I strongly recommend the entire issue. The paper by Acharya and Richardson is the one that most closely reflects my own views.
Friedman’s introduction is much more than a summary. He writes,
if we take seriously the possibility that market participants are making cognitive rather than incentives-based errors, the case for regulation loses considerable force.
His point is that regulators made the same cognitive mistakes as financial executives–trusting the rating agencies, for example.
Indeed, what may have saved the world from complete economic chaos in 2008 was the fact that the regulations were loose enough that many investors and many bankers had resisted buying the “safe” securities that most banks seem to have bought. Heterogeneous behavior like that, however, is allowed for, encouraged, and rewarded by capitalism; and is either discouraged or prohibited by regulation, depending on
how tight the regulations are.
Which is more vulnerable to catastrophic failure: a relatively unregulated system, in which participants pursue diverse strategies; or a strongly regulated system? For Friedman, the latter is more vulnerable, because of the risk of promoting homogeneous behavior, so that one mistake affects everyone.
All of us have our intellectual hobby horses. Friedman’s hobby horse seems to be the existence of cognitive weakness or ignorance. He is constantly asking what happens if leaders have cognitive biases or information gaps. In general, I think when you take that problem seriously, you fear strong government.