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.”
READER COMMENTS
Ryan Vann
Nov 25 2009 at 10:53am
“Am I the only one who sees the irony in the last phrase?”
It’s economic poetry, and a true paradox. Risk taking below sufficient levels is risky business indeed.
I agree with your conclusion about how best to design out banking system. Robustity and flexibility is essential for any system to function very long.
ThomasL
Nov 25 2009 at 1:08pm
“…drawing overly optimistic inferences based on a period of 25 years of high growth and low inflation.”
That reminds me a lot of Taleb’s work.
CJ Smith
Nov 25 2009 at 2:57pm
“Risk taking, after all, is part of a dynamic market economy and drives economic growth, so we discourage risk taking at our peril.”
If we read this statement to mean we should encourage and reward taking risks primarily for the purpose of taking risks, per se, then these guys are a few bricks shy of a stack. Basic finance – you balance risk (probability of sucessful outcome) versus return (reward for success outcome); but two primary components of your required return on investment are:
1. the amount of cross-colleratalized default risk already in place (you can afford greater risks of loss when the loss will only cause failure of that project, but when the loss will cause not only the failure of the project but also jeopardize your ability to service other projects, your risk tolerance should decrease, leading to a higher required ROR). Put another way, for each additional risky project you are involved in, your required ROR should be incrementally higher.
2. your debt (risk) to equity ratio – when your loss will only minimally or insignificantly impact your total equity, your risk tolerance should be high, but when the potential loss is significant relative to your equity, your risk tolerance should be low. Put another way, you would have a high risk tolerance for betting $1 on the lottery, but a significantly lower risk tolerance for risking your entire earnings/assets on the lottery.
That being said, I think the observation that irrational exuberance caused skewed risk assessments and greater risk tolerance systemn-wide is a valid and supportable observation. Investors were taking riskier and riskier investments, and exposing greater and greater portions of their equity to loss than ever before, on the mistaken belief that the market couldn’t fail or suffer a reset – or at least not on their watch…. Anecdotally, there are any number of similar bubbles – the dot-com bubble, the oil bubble, etc. The difference in this situation was that the exuberance expanded from housing into mortgage lending, into securitized debt instruments, into commercial (non-real estate) lending, into personal lending, with collateral effects on spending and saving at all levels. There are any number of interviews and/or hearing testimony from bank executives where they give lip service to the possiblity of a negative outcome, but emphasize that they irrationally beleived there would never be a downside. – or at least not on their watch….
“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.””
Arnold, I agree with your statement in principle, from a policy perspective. However, if you restate the proposition as “try to make the banking system “easy to fix” rather than engage in the futile hope that you can prevent a similar break in the future,” you might see the political and policy hot potato.
Yes, providing for a faster reset and recovery after a hypothethecal future market failure/reset is an admirable goal, but voters and policy makers don’t want any form of reset at all; or if a reset must occur, they want it as minimal as possible, as the reset negatively impacts them. To use an analogy (I hate analogies, and expect to be picked apart by everyone who says the analogy isn’t vaild), would the public prefer (or would good policy dictate) that we focus on more rapid clean-up and restoration of service after the train wreck, or avoiding or minimizing the train wreck in the first place? If you assume that, regardless of efforts to prevent it, the train wreck will occur, and nothing we can do will minimize the severity of the damage, then your proposition is the perfectly rational first choice. But if prior restraint measures could cause minimization or even avoidance of the train wreck, then your proposition may not be the best solution.
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