Sunday, April 26, 2009
Posner, Richard A. "Why the Economic Crisis Was Not Anticipated." CHRONICLE OF HIGHER EDUCATION April 17, 2009.
An article in the October 11 New York Times attributed the almost universal failure to anticipate our current economic crisis to "insanity" — more precisely, to a psychological inability to give proper weight to past events, so that if there is prosperity today we assume that it will last forever, even though we know that in the past booms have always been followed by busts. But experts on the business cycle, such as Federal Reserve Chairman Ben Bernanke, are not confined to basing predictions on naïve extrapolation. So why did he and other experts, inside and outside of government, neglect warning signs of a coming crash? Real-estate bubbles are common. The supply of "good" land is fixed in the short run, the housing stock is extremely durable and therefore does not expand rapidly when demand increases, and land and the improvements on it cannot be sold short. And the bursting of a real-estate bubble can lead to bank insolvencies — as it did in Japan in the 1990s — because most real estate has heavy indebtedness, financed by banks or other financial intermediaries, and real-estate debt is a significant fraction of all debt. When the rise in housing prices began to slow in 2005 after an increase of more than 60 percent since 2000, the press began talking about a housing bubble. Newspaper articles featured such headlines as "Housing Bubble Is Real, So Don't Get Hurt When It Finally Pops," "If Housing Bubble Pops, Look Out!," and "Hear a Pop? Watch Out." Yet in October of that year, Bernanke, then on the Fed's board of governors, denied there was a housing bubble, saying that "these price increases largely reflect strong economic fundamentals." The alarm bells were sounded ever more loudly in the following years. On August 17, 2008 — just a month before the financial tsunami struck — The New York Times Magazine published an article revealingly titled "Dr. Doom" about an economist at New York University named Nouriel Roubini, who, for years, had been predicting with uncanny accuracy what has happened. Two years earlier Roubini had "announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide, and the global financial system shuddering to a halt. These developments, he went on, could cripple or destroy hedge funds, investment banks, and other major financial institutions like Fannie Mae and Freddie Mac." No one in a position of authority in government, and very few in business or academe, heeded the warnings. In May 2007 Bernanke said, "We see no serious broader spillover to banks or thrift institutions from the problems in the subprime market," though by then many banks and thrift institutions were insolvent. In February 2008 he said, "I expect there will be some failures," referring to smaller regional banks that had invested heavily in mortgage-backed securities, but "among the largest banks, the capital ratios remain good, and I don't anticipate any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system." The financial crisis, when it finally struck the nation full-blown in September 2008, caught the government, the financial community, and the economics profession unawares. . . . And not just Republican officials and the economists who advise them. President Bill Clinton's economic policies were shaped by establishment Wall Street figures, such as Robert Rubin, along with economists like Alan Greenspan, a conservative, and Lawrence H. Summers, a moderate. The many positive experiences with deregulation and privatization, the many economic success stories that followed the collapse of communism, and the many failure stories of countries that curtail economic freedom supported this belief system and made it bipartisan. There hadn't been a depression in the United States since the 1930s, and economists believed and were assuring the public that there would never be another one because they had learned how to prevent depressions. Overconfidence is a common cause of being surprised. . . . Read the rest here: http://chronicle.com/temp/reprint.php?id=1n299m9tcq02w99lgc8x14v0qdc9cmpd.