Not Sideswiped

Lately I hear a common lament: How did we all not see that this financial crisis was coming? The discipline of economics is under attack for its inability to foresee such a massive collapse. The field of risk management is in turmoil as experts try to find better statistics that can cope with black swans. Outside of particular sectors like real estate, the hedge fund industry - that group of analysts who were supposed to be able to create wealth out of adversity - are rapidly going extinct, literally shutting up shop, one after another.

But it wasn't just Paul Krugman who warned of the US housing bubble: the Economist magazine wrote about it frequently several years ago. Back in 2003 or 2004 I saw a US network news magazine documentary about the new subprime mortgage; it predicted exactly when the defaults would start to occur and how devastating they would be. I attended lectures about the coming financial meltdown and wrote about them in blog posts like The unsustainable world economy (April 2007) and A big mess is brewing (May 2007). I quoted Thomas Palley as saying there would be a worldwide economic crash, and soon. I quoted Marcello De Cecco's ominous prediction that a big mess was brewing. I wrote not only about the coming collapse, but about proposed solutions.

So why didn't we act? There are a variety of reasons.

Ideology and greed in the Bush government
The Bush people believe that the free market is the optimum mechanism for economic activity. Arguments that the free market was not working properly were taken as attacks on their beliefs. (And yes of course this makes no sense: there is no free market, especially in the highly regulated financial sector.)

This ideological viewpoint also reduced the ability to tinker with the economy. It has been my impression that Bill Clinton and Paul Martin were tinkerers, keeping everything humming along, watching indicators, taking action when there were problems. The Bush government had a different approach: if it ain't broke, don't fix it; and the only indicator that matters is the growth of wealth. Fed chair Alan Greenspan seemed to view monetary policy as a way to rev up the economy indefinitely, rather than a tool to keep the economy healthy.

The short term, populist nature of our worldview
We were in a bubble. People were getting richer and richer. People may pity the hedge fund firms that have shut down, putting people out of work, but the hedge fund managers who made the fateful decisions got rich by riding the wave as long as they could. They get paid a percentage of their profits, and pay only 15% income tax; they made out like bandits. When their funds tanked, they didn't lose any of their previous income.

While our mutual funds were humming along, we little guys were happy too. Any government action to dampen the boom would not have been well received by voters.

The "blind eye" effect
People on the left have been warning about the rapid change in wealth distribution. This was not just esoteric critism: it was widely discussed. In 1980, CEOs made on average 13 times the minimum wage. By the 2000s, they are making 1,000 times the minimum wage. The percentage of wealth held by the top 1% has skyrocketed. The problem wasn't that policy makers didn't know about this; the problem was that it was framed as a moral issue, rather than an economic one. Now we see that this change has made the entire economy more vulnerable - that the stabilizing force of the middle class is diminished.

International dominance of the US
Without the US, the rest of the world was unable to act. Like it or not, the US is G1. We can't replace Bretton-Woods without US involvement. There were things that individual countries could do (Iceland's decision to deregulate its banks in 2001, which led to the collapse of its entire economy, is Iceland's fault alone) but a broad international movement to avoid the crisis was not possible. And most of the changes to regulation cannot be done unless they're done by international agreement. Otherwise, countries that increase regulation will just see an outflow of capital to countries that don't regulate.

Lack of built-in anti-cyclical economic stabilizers
Many of our financial regulations are actually pro-cyclical. We need to accept that business cycles happen and plan for them, rather than ride the bubbles in vain hope they'll never end.

We need to re-evaluate how we value assets, as mark-to-market valuation appears to be a contributor to the growing intensity of business cycles. In addition, we need to do some things to dampen booms and prepare for busts, like change bank leverage requirements depending on market conditions (tightening them in booms and loosening them in busts). We also should prepare for busts by collecting bailout money from financial institutions during booms (we can start, after this crisis, by recouping our current bailout costs). We should increase the social safety net significantly, so that when people lose their jobs they get decent unemployment insurance; this is an automatic fiscal stimulator that kicks in at just the right moment and in the most effective way.

Wealth is like water. It finds every crack and seeps through. It creates floods that wash away everything in its way. The economic system is like plumbing in a house. It must be leak-proof and flood-proof. It must regulate the flow of something that will try its darnedest to break through.

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