Why Everyone Owes Everyone and No One Can Pay

Why did the bankers lend so wildly? Mr. Lanchester, whose father worked for that once staid colonial enterprise, the Hong Kong & Shanghai Banking Corp., observes that banking is, or at least should be, a rather a simple business. Bankers ought to know whom they are lending to and build in a margin of safety against the risk of default.

But modern finance changed the game. Financial innovation allowed loans to be passed on with no individual or institution concerned for their repayment. Risk assessment was no longer a matter of personal judgment but instead the burden of mathematical models. But the models, Mr. Lanchester says, were "philosophically flawed." They determined, for instance, that a sudden national collapse in American housing prices was a near-impossibility.

The weaknesses of quantitative risk models have been well known for years. In 2007, the Royal Bank's own chief risk officer even wrote a powerful critique of the value-at-risk models used to gauge banking exposures. Yet bankers persisted in using their faulty models because they generated profits, in the short run at least. Given over to a collective bout of wishful thinking, the bankers ignored the numerous "funny smells" emanating from the financial system.

Mr. Lanchester compares the shift in finance over recent decades to the rise of modernism in the arts. It constituted a "break with common sense, a turn towards self-referentiality and abstraction, and notions that couldn't be displayed in workaday English." Finance had become as rotten as modern literary criticism. The bookish Mr. Lanchester senses a "weird familiarity about the current crisis: value, in the realm of finance capital, parallels the elusive nature of meaning in deconstructionism."

Other villains of the piece include "Maestro" Alan Greenspan, the longtime chairman of the Federal Reserve, for keeping interest rates too low after the tech bubble burst in 2000; credit-ratings agencies for their flawed ratings; regulators for failing to regulate; and academic economists for failing to warn of impending troubles. Mr. Lanchester cites an American university provost who complains of having "an entire department of economists who can provide a brilliant ex post facto explanation of what happened—and not a single one of them saw it coming." The dominant paradigm of efficient markets and rational expectations had left them intellectually disinclined and theoretically ill-equipped to predict a catastrophe.

via online.wsj.com

Comments

[Dale]

You know, if academic economists can't stick their neck out, who can? I suspect many of them have their salaries supplemented by interests outside of academe, but compared to the transparent conflict of interest of the Wall Street financial analyst, you would think that there are a few economists who don't drink the Kool Aid, and can anticipate a bear market when one looms on the horizon.

We're not asking them to become Keynsians overnight, or to disregard their years of Friedmanite indoctrination (though that might be nice). Just to plug the available data into your average boom-and-bust models once in a while.