The 2008 financial crisis and the subsequent recession left 10% of the northern hemisphere poorer than it would have been without them, based on previous income forecasts. For those who want to better understand this episodeI have long recommended four books, in particular: Manías, panics and cracs, of the economist of century XX Charles P. Kindleberger; This time it's different, by Carmen M. Reinhart and Kenneth S. Rogoff of Harvard University; The great crisis: Changes and consequences, from the financial analyst of the Financial Times Martin Wolf; Y Hall of mirrors, from my colleague at the University of California, Berkeley, Barry Eichengreen. Now, I want to add a fifth book to the list: A Crisis of Beliefs: Investor Psychology and Financial Fragility (A crisis of beliefs: Psychology and financial fragility of the investors), of the economists Nicola Gennaioli and Andrei Shleifer. (previous warning: Shleifer was my roommate in the University and in graduate school, and to this day, I attribute any recognition or fame that I may have).
A Crisis of Beliefs It is important for three reasons. First, it offers a reply to those who argue that the past decade was an inevitable result of the housing bubble in United States. Many experts continue to insist that the deflation of the bubble triggered the financial crisis. But the reality is that the bubble had already substantially deflated before the crisis erupted. Recall that in mid-2008, housing prices had returned to the levels supported by their underlying values - or even had dropped further – and employment and production in the residential construction sector had fallen to levels well below of the trend. The task of rebalancing the valuation of assets and reallocating economic resources in all sectors had already taken place.
Undoubtedly, there would still have been losses of financial assets for some 750,000 million dollars in defaults of subprime mortgages and mortgage loans. But that's only a quarter of what the global stock markets lost in seven hours on October 19, 1987. In other words, it would not have been enough to sink the global financial system. Ben Bernanke, then president of the US Federal Reserve, seemed confident in the summer of 2008 that the correction in housing prices had not unleashed any unmanageable financial crisis. At that time, he was mostly focused on the dangers of rising inflation. And then the world fell apart. The reason, Gennaioli and Shleifer show, is that beliefs changed. Investors concluded that financial markets were overwhelmed by extremely high risk, due to a number of factors. The interbank market had frozen, homeowners stopped paying their mortgages, Bear Stearns had collapsed, the US Treasury had intervened to control Freddie Mac and Fannie Mae and, above all, Lehman Brothers had declared bankruptcy .
All this led to the rapid collapse of the banking system, both the official and the one that existed in the shadows, while investors crowded to get rid of the assets they had. The greater risk they had attributed to the system became a reality. Like nurses on duty in an emergency room, they quickly evaluated the patient and were carried away by their initial diagnosis as if there were no other option. And yet, none of the consequences of the crisis was inevitable. If the Fed had had contingency plans to put institutions too big to fail under judicial administration, and had assumed its role as a lender of last resort, we would probably be living today in a very different world. Unlike those who look back and conclude that everything was an inevitable consequence of the housing bubble, Gennaioli and Shleifer recognize the central role played by the contingency in the crisis and its subsequent sequels.
The second important contribution of Gennaioli and Shleifer is to demonstrate that the "crisis of beliefs" like the one that precipitated the disaster of 2008-2009 are deeply rooted in human psychology, to the point that we will never get rid of them. Therefore, neither prudential policies nor measures to respond to crises should treat these episodes as coincidences or extraordinary exceptions. The crisis of beliefs are manifestations of a chronic malaise that must be handled.
As a result, central banks and tax authorities should not use the end of a crisis as an excuse to step back or let go of the wheel. When the ideas and the context have changed permanently, we should not expect the same cocktail of policies that favored full employment, low inflation and balanced growth before the crisis to continue functioning later. Moreover, the seeds of the next Kindleberger sequence – displacement, optimism, enthusiasm, cracking, panic, rejection, discredit – have already been planted by the same policies that were necessary to face the last recession.
The third reason why Gennaioli and Shleifer's book is important is more technical and applies directly to the field of economics. Economists have long recognized that requiring an economic agent to have rational expectations of the future tends to generate models that are deeply inapplicable in the real world. But, until now, no alternative strategy has gained ground. The scheme that compares investors to nurses on duty from Gennaioli and Shleifer should be taken into account when building models.
For ten years now, people have been looking for the positive side of the disasters of 2008-2018, with the hope that this period will lead to a more productive integration of finance, behavioral economics and macroeconomic orthodoxy. Until now, they have been searching in vain. But with the publication of A Crisis of Beliefs, there is still hope.
J. Bradford DeLong, former deputy assistant secretary of the US Treasury, is a professor of economics at the University of California at Berkeley and a research fellow at the National Office of Economic Research
Copyright: Project Syndicate, 2018.