Douglas J. Elliott and Martin Neil Baily write,

Risk taking, after all, is part of a dynamic market economy and drives economic growth, so we discourage risk taking at our peril.

Am I the only one who sees the irony in the last phrase?

Otherwise, it’s actually a good paper, and an important one. Their main narrative is one of complacency.

People “learned” that it was good to take financial risks…

Financial institutions were making high profits and convinced themselves that approaches that were clearly very lax in retrospect were sufficient to police their own risks. These risk management approaches, whose flaws should have been obvious even at the time, were accepted because they allowed behavior that was very profitable in the short term. For their part, regulators thought everything was going fine and generally relied heavily on the internal risk management approaches of the financial institutions. Even when they did independent analyses, they often bought into the same analytical approaches.

Their view is that this complacency came not from moral hazard (bankers’ belief that they would be bailed out if things went wrong) but instead from drawing overly optimistic inferences based on a period of 25 years of high growth and low inflation. Self-deception along the lines of “This Time is Different,” if you will. (Speaking of the latter, you can hear Russ Roberts interview Carmen Reinhart in the latest econtalk.) They emphasize across-the-board changes in risk premiums.

An impressive array of measures of the risk premium in the financial markets declined significantly leading up to 2006 or 2007 and then soared as the financial crisis brought a return of fear to the markets.

I stress fluctuations in the risk premium as well. See my August 2007 commentary about what was then called the subprime crisis.

Elliott and Baily are saying that beyond the housing bubble there was a more widespread increase in risk tolerance.

History shows us that such periods of irrational exuberance, particularly when fueled with high levels of liquidity, often lead to severe financial crises.

…More of the losses come from a wide range of other categories, such as commercial real estate lending, ordinary business loans, and credit cards. This does not rule out the possibility that housing started the problem and the blow was so strong that it took down the other sectors. However, it is strongly suggestive that the imbalances in other areas were also very large prior to the housing bubble bursting, reinforcing the notion of a more comprehensive bubble made up of many sectoral bubbles. In addition, it supports the notion that the bursting of other bubbles, such as in commercial real estate and the stock market, could have started a chain reaction that would have led to very large losses and that the problem did not have to begin with housing.

The idea that the bubbles went beyond the housing market may address one of the objections that people make to the Recalculation Story (some people wonder how the recalculation problem can be so difficult if it is only the housing market that was out of balance).

By the time the authors get to the end of the paper, they seem to be too exhausted to think about policy implications. All we get is,

There are many other things that could blow up and we need to be vigilant about all of them.

I don’t think it helps much to say that there can be bubbles anywhere and everywhere so policymakers need to be vigilant about all of them. I think it makes more sense to think in terms of my proposal to try to make the banking system “easy to fix” rather than engage in a the futile hope that you can make it “hard to break.”