This is a busy enough time for college teachers, but it must be hell for those who are authors of finance and economics textbooks. They must be burning the midnight oil every night as they revise their works to remove embarrassing assertions disproved by recent events: markets are always efficient, securitizing debt is the greatest human invention since the wheel, sophisticated financial analysts can measure risk down to the micron and central banks should monitor ‘core inflation’ but ignore prices of assets like houses or corporate stocks.
More than a year after it started, we are far from the end of the Panic of 2007. No one knows how it all will play out. But what has happened so far demonstrates that many people, including the highest-paid CEOs and analysts on Wall Street, the vaunted research staff of the Federal Reserve and regulators from myriad federal agencies all were fundamentally wrong in their assumptions and procedures.
So were many bread-and-butter economists like me who witnessed all the same warning signs of an unsustainable bubble but continued to mumble to ourselves, “Well, there are some problems, but we are not facing a major financial crisis like 1929 or 1907, and we never will. We are too smart for that now.”
We were all like the deceased Metrolink train engineer who apparently drove right past two warning signals into the path of an oncoming freight train.
Yes, Warren Buffet did describe financial derivatives as “toxic waste.” George Soros did mutter about bubbles. Ex-Treasury Secretary Robert Rubin did give the odd speech here and there warning about excessive leveraging by financial firms — and then urged the financial firms he helped manage to leverage themselves even more to be competitive.
New York University economist Nouriel Roubini did sound prescient warnings for a long time — and was long dismissed as a kook by other economists. And ink-stained wretches like me can point to a few columns in which we warned about chronic budget deficits financed by borrowing abroad, excessive money growth and the fallacy that rising house prices necessarily were good for our whole society.
But as a group, economists have failed about as badly as one can. The question is whether we will be willing to learn from our mistakes.
After decades of study, economists apparently cannot predict when a financial crisis will break out. But we didn’t lack warning signs. We now recognize that monetary policy was too lax, that leverage was too high, that mortgage origination often had crossed over into fraud, that loan underwriting and securities rating were sloppy, that risk was not accurately priced and that households were taking on too much debt, too fast.
There is a fundamental question here: Is the economic and financial theory we teach fundamentally sound and the current debacle due to once-in-a-century multiple coincidences? Or, did our faith in the efficiency of markets and in financial firms’ ability to manage risk in all circumstances blind us to warnings that should have been obvious? I think the latter, but the jury will be out for years.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.