Book review: "Engineering The Financial Crisis" by Friedman & Kraus
Monday, December 19, 2011 at 07:00AM "Engineering The Financial Crisis" by Jeffrey Friedman & Wladimir Kraus, University of Pennsylvania Press. Available from Marston Book Services, 160 Milton Park, Abingdon, Oxon, OX14 4SD, England / direct.orders@marston.co.uk. Price £29.50
This is a superb book, which deserves to be read by anyone who is serious about trying to understand how the Banking Crisis happened.
It has insights to offer on more general topics as well. These relate inter alia to the (alleged) delusions of the economics profession, the futility of some common expectations of democratic policy-making, and even to the limitations of human capacity to manage the complex systems that now dominate our lives. We think we understand these systems because it is we (or people like us) who constructed them, but even the most sophisticated of us are sometimes caught out.
A long time ago, the American wit H.L.Mencken observed
for every complex problem there is an answer that is clear, simple, and wrong.
The response of commentators, wherever located, to the Banking Crisis illustrate this quite well. The standard narrative (hereinafter "TSN"), not just in Ireland, is that what happened in 2008 followed years of reckless behaviour accompanied - indeed encouraged - by inflated salaries and ridiculous "bonus" payments to bankers. When the inevitable "feco-ventilatory intersection event" occurred, these same bankers then turned around and expected to be rescued from the consequences of their folly.
As Friedman & Kraus point out
... [these views have] immediate and important consequences. The informed public's impressions of the crisis are based in part on journalists' and scholars' hasty pronouncements. These impressions have now hardened into convictions. Political movements of the right and the left are already acting upon dogmas about the crisis that have little or no basis in fact, and policy changes have been made on the basis of these dogmas.
They go on to pick apart systematically the most popular U.S. explanations for the Crisis - which overlap with the most popular in Ireland, too - test them against the facts, and, one by one, discard them as unsatisfactory. (The authors might put it more strongly than that).
For example, they show that, as indeed in Ireland, the banks that failed most disastrously were also the ones led by men whose personal shareholdings were highest. This is counter-intuitive, as well as inconsistent with TSN.
They also show, in what they appear to regard as their most controversial finding, that the banks consistently chose security over high returns. This, too, is inconsistent with TSN, which takes it as axiomatic that "moral hazard" wreaked havoc by encouraging executives to take excessive risks, since it was (supposedly) a "tails I win, heads you lose" situation.
"The Right Kind of Regulation" ?
The book authors go on to propound their own explanation, which could be briefly summarised as
it was the Basel rules wot done it.
That is their précis, not mine. (The wording is not theirs, though).
And, more fundamentally,
the crisis was caused by ignorance on all sides.
That ignorance was not necessarily attributable to incompetence or similar faults. Nor was it otherwise culpable: it was a consequence, possibly not completely avoidable, of the complexity of the systems which had to be understood, and managed. Friedman & Kraus describe it as "radical ignorance".
In doing so, they "take a pop" - one of several, mainly at him, but at the economics community generally - at Joe Stiglitz, the Nobel laureate:
Essentially, his solution to this problem is consistently to downplay the possibility of human error - that is, to deny that human beings (or at least uncorrupt human beings such as himself) are fallible. ...
Simply turning over all power to a Nobel laureate economist such as Stiglitz is no answer. There are many Nobel laureate economists, and they quite frequently disagree with one another. Which one of them should be the economist-king who will ensure that regulators do not make even worse mistakes next time ?
...If economists are our most important advisers, but their world-views have no place for genuine human error, we are in deep trouble
While the book is about only the U.S. dimension of the crisis - the authors say that all the data available there is not available for Europe or elsewhere - I believe that the basic analysis is accurate for Ireland as well.
What we have (or had) in common was an unquestioning belief that property values could never fall significantly. While I was previously aware of this fateful delusion, this book has brought home to me more than before the extent to which the Basel rules not only sanctified it, but incentivised banks to become more property-focussed.
In view of where we are now, the fact that the same conventions, in effect, also encouraged banks to over-lend to badly-run sovereign states is noteworthy as well.
Remembering that our own Nyberg report laid so much emphasis on the role of "group-think", the book’s observations on what it describes as "homogenisation" as a necessary effect of regulation are thought-provoking.
Another insight which merits attention, and helps to explain why "the bail-out keeps clocking up the billions", is the inappropriateness of the term "cushion" to describe minimum capital standards for banks. As the authors say, "hard-floor" would be a more accurate short-hand: as soon as a bank hits that level, those in control are in imminent peril of losing that control. They are naturally, and this is the intention, impelled to either raise fresh capital or to shrink loan-books.
That looks fine in theory, and may be considered to work well for a crisis confined to a single bank. As we have found, it does not work well in circumstances when there is a system-wide, and international, problem. In that situation, it is illusory to suggest that borrowers can repay quickly (or perhaps at all), and this will be so well-known that the normal suppliers of capital will not re-capitalise lenders.
In another finding which TSN ignores, Friedman & Kraus point out that
even the commercial banks that actually became insolvent had significantly higher regulatory capital levels than required by law
It is difficult to quarrel with their observation on that, viz.
This suggests that the chief cause of their insolvency was not (as a rule) deliberate risk taking but ... risk taking in which the bankers were ignorant of the true level of risk
I do not agree with every judgement of the authors. For example, contrary to their view, not every economist - and none of those who taught and still teach me - believes that any economist has precisely modelled reality. Also, while generally correct as to it having a major direct role in causation, their implicit view that remuneration models were of no relevance at all is one that I am not yet prepared to accept. As Steve Randy Waldman remarked recently on Twitter:
to the frustration of social scientists everywhere, a thing can be an important factor yet neither a necessary or sufficient cause...
Nevertheless I am grateful to them for their scholarship, and for their clear presentation of it, to which I cannot do adequate justice in a short review.
I heartily commend this book.
Reader Comments (3)
I have read several very insightful analyses of the failure. Each made complete sense. Yet each was different. In addition I find it extremely unlikely that the cause of our failures in Ireland was the same as that in the US. It just makes no sense.
My hope is that while I am pretty sure no one really has a comprehensive understanding of the exact cause(s), which is quite disturbing, the actions being taken, especially in Europe, will be enough to make a repeat of the same catastrophe very unlikely.
I would be interested in your list - indeed, in everyone's list - of "very insightful analyses of the failure [which]... make complete sense".
If you interpret my view to be that "the cause of our failures in Ireland was the same as that in the US", then, except in the sense that shared human frailty can be described as "a" or "the" cause, you are incorrect.
I do say that there are several common features, though, and indeed that the common features may be the most important causes of what was in both places a series of events with multi-factorial causation.