Rethinking The Financial Crisis

Rethinking The Financial Crisis

We’re approaching the tenth anniversary of the financial crisis, and we can expect a deluge of reflections on the causes and consequences of the worst economic downturn since the Great Depression.

Noah Smith, writing in Bloomberg, argues provocatively that the conventional wisdom might have a better understanding of what happened than the economic consensus. Recent developments in economic thought following the Great Recession, writes Smith,

don’t feel like a big break with the status quo. Most importantly, the basic notion of recessions as driven by rational actors’ responses to unpredictable, sudden events — or shocks, as economists call them — remains in place.

That would come as a jarring surprise to many outside academia. To lots of people, it seems obvious that the 2008 crisis was long in the making — the product of years of financial and regulatory folly. In general, the notion that economic booms cause busts, instead of being random unrelated events — an idea advanced by the maverick economist Hyman Minsky — seems to have much more currency beyond the ivory tower than within it.

Smith highlights new research that challenges the expert consensus. In a presentation on their upcoming book A Crisis of Beliefs: Investor Psychology and Financial Fragility, behavioral finance specialists Nicola Gennaioli and Andrei Shleifer,

explain these patterns by turning to their own preferred theory of human irrationality — the theory of extrapolative expectations. Basically, this theory holds that when asset prices rise — home values, stocks and so on — without a break, investors start to believe that this trend represents a new normal. They pile into the asset, pumping up the price even more, and seeming to confirm the idea that the trend will never end. But when the extrapolators’ money runs out, reality sets in and a crash ensues.

It’s a relatively new idea in academia that seems to be gaining traction with important implications for macroprudential policy. If busts are the results of “irrational exuberance,” we should craft policy that moves away from excessive leverage and toward greater equity financing to reduce the risk of future financial meltdowns.

For a thorough discussion on how the current macroprudential zeitgeist is misinformed, be sure to read Anat Admati’s “It Takes a Village to Maintain a Dangerous Financial System.”

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By |2018-07-31T09:03:57-07:00July 31st, 2018|Blog, Financial Regulation|