The Kool-Aid Factor
By Arnold Kling
Nobel Laureate Eric Maskin says,
I think most of the pieces for understanding the current financial mess were in place well before the crisis occurred. If only they hadn’t been ignored. We’re not going to eliminate financial crises altogether, but we can certainly do a better job of preventing and containing them.
Pointer from Tyler Cowen.
I would say that there is a sense in which Eric Maskin does not understand why the financial crisis took place, and he may never understand. It is not the case, as he implies, that regulators did not understand how banks provide liquidity or that their leverage requires regulation. The problems have more to do with institutions and adaptations, as I explain in Not What They Had in Mind.
One way to describe what Maskin is missing is what might be termed the Kool-Aid Factor. That is, regulators were drinking from the same Kool-Aid as the financial executives, believing that new financial instruments had dramatically lowered risk and made the system more stable. Danny Kaufmann calls this Kool-Aid factor “cognitive capture.”
In Maskin’s world, regulation is imperfect only if regulators are ignorant of economic theory or ideologically blind. In the real world, the Kool-Aid factor matters.