Last Temptation of Risk

Barry Eichengreen has an interesting article on the Last Temptation of Risk over at National Interest Online. The point is to explain how economists did not forecast the crisis. His argument is that the problem was not theory. Rather,

the problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists whose scholarship provided intellectual justification for the financial institutions’ decisions. The consequence was that scholarship that warned of potential disaster was ignored. And the result was global economic calamity on a scale not seen for four generations.

Think of agency theory. This certainly predicts the conflicts of interest between shareholders and management that induced excessive risk taking. And information theory suggests that market prices may have plenty of noise, and that sellers will know more about assets they sell than buyers. The ingredients for understanding the crisis was there. So why were they ignored?

Eichengreen argues that we were seduced. Agreeing with the de-regulatory zeitgeist led to lucrative speaking fees and consulting gigs. The Shillers of the world only prosper after the fact, the facilitators during the boom. Hence, he writes:

What got us into this mess, in other words, were not the limits of scholarly imagination. It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises. It was not that economists failed to recognize the role of social and psychological factors in decision making or that they lacked the tools needed to draw out the implications. In fact, these observations and others had been imaginatively elaborated by contributors to the literatures on agency theory, information economics and behavioral finance. Rather, the problem was a partial and blinkered reading of that literature. The consumers of economic theory, not surprisingly, tended to pick and choose those elements of that rich literature that best supported their self-serving actions. Equally reprehensibly, the producers of that theory, benefiting in ways both pecuniary and psychic, showed disturbingly little tendency to object. It is in this light that we must understand how it was that the vast majority of the economics profession remained so blissfully silent and indeed unaware of the risk of financial disaster.

Eichengreen then argues that the increased popularity of empirical economics may help us avoid this problem in the future. I am less convinced by this argument. It is just as easy to cherry pick empirical work as theory. But the major thrust of the article is well worth reading.