When a crisis shakes the foundations of a system which, until then, seemed efficient and reliable, all sorts of theories are advanced to try to explain what went wrong. Here is another one.
To explain the gravity of the current crisis, Tyler Cowen, professor of economics at George Mason University in Virginia, draws upon the writings of the mathematician Fischer Black*, who helped develop the Black & Scholes model for pricing options. In business, the first rule in decision-making concerns risk-return; a greater risk should normally generate a greater return. Fischer Black applies this principle to the economy as a whole. He concludes that for a recession to occur, many different economic sectors must slow at the same time, because of beliefs that are generally accepted but that don’t correspond to reality. It was commonly believed that individual mistakes were possible, but that such mistakes would be governed by the law of large numbers. Mistakes could occur in many different directions, causing some sectors to do well and others to do poorly, but on average, the sum of all the mistakes would not have a big impact on the overall economy. Fischer Black rejected the idea that the law of large numbers applies to the business cycle. He believed that the markets are susceptible to a sudden dose of bad luck. Until now, the current crisis has been attributed to the real estate bubble and the mistakes made by certain financial institutions. Fischer Black offers another explanation that has three aspects: 1. the growth of wealth, 2. the decision to opt for riskier investments, and 3. the underestimation of a new source of systemic risk.
1. Since 1990, global wealth has grown enormously. The collapse of communism, the globalization of the economy, and the economic growth of China (10% or more per year) contributed to this unprecedented increase in wealth. Many countries modernized their financial systems, and more and more wealth was released into the financial markets. China bought very large quantities of U.S. Treasury bills and mortgage-backed commercial paper.
2. Investors used unduly optimistic models to value their investments. They made increasingly risky investments, purchased overvalued equities, took big positions in all sorts of derivatives that they didn’t understand, and granted loans to businesses and individuals that were not creditworthy. In addition, many U.S. investment banks moved from leverage ratios of 12 to 1 to ratios of 30 to 1, thereby lowering their margin of error.
3. Investors systematically overestimated how much they could trust the judgment of other investors. For their part, purchasers of mortgagebacked commercial paper overestimated how much they could trust the judgment of both the market and the rating agencies. A commonly held view was that although financial institutions had taken big positions in risky investments, the officers of these institutions had their own money on the line as well, so these investments had to be good. The tendency to trust the judgment of others became systematic. It was logical to believe that the undertrust of some investors would offset the overtrust of others. But that is not what happened. Socially, trust has a cumulative, snowball effect. The wealthier people became, the easier and more reasonable it seemed to rely on the optimistic expectations of certain investors. The Madoff affair is a good example of this type of behaviour.
In conclusion, the present crisis stemmed from unwise investments in risky assets and an excessive degree of trust in the judgments of others. Both governments and investors fell into this trap.* Financial Analysts Journal, vol. 65, May-June 2009.