We are two years out from the 2008 death-spiral of our financial system. In stages, we have gone from shock and fear, to analysis and reform, to revisionism and critique. But the work of establishing a robust and resilient global financial system is surely not complete. Indeed, we have yet to pose the full set of questions, let alone implement the answers.
On a narrow, technical economic level, we have a good idea what went wrong. Within a year of the meltdown, several high-level reports got the basics down pretty well. I refer in particular to the reports of the Bank for International Settlements (BIS), the Financial Stability Forum (headed by Mario Draghi), the Institute of International Finance (chaired by Josef Ackermann of Deutsche Bank), the Group of Thirty and the Corrigan group (CRMPG). As good as these reports are, however, they are limited. As befit the times, they focused most on monetary and banking regulation to strengthen the dikes, but they don’t take us to highlands, above the flood line. To start that ascent, we need a basic understanding of two conditions that our forebears had a better grasp of: risk and uncertainty.
We generally speak as if risk and uncertainty were synonyms. They are not, and appreciating the distinction between these two fundamental elements of free markets is critical for knowing what government can and ought to do in its relation to the economy.
A Distinction with a Difference
Risk and uncertainty are no more similar than a common house cat and a leopard. One can be domesticated, the other merely kept at a safe distance. The main problem of the past few decades is that increasingly we mistook the leopard for a house cat, with catastrophic results.
Risk presumes certain rules to be at work, certain parameters to be in place; uncertainty is about changes in rules and the sundering of parameters. Risk is intrinsic to a set of circumstances; uncertainty applies to the bounding circumstances themselves. By way of example, consider a fisherman who fishes the same river over many years. He takes a kind of risk, makes a certain kind of bet, each time he throws in his line. He will do well if he is familiar with the terrain. But an earthquake or avalanche upstream could change the terrain and the course of the river, leaving the fisherman high, dry and bankrupt.
John Maynard Keynes, Hyman Minsky and others wrestled with these issues in the decades before World War II. Risk can be managed, but uncertainty cannot. Frank Knight, the “grand old man” of Chicago, explained in his 1921 dissertation, Risk, Uncertainty and Profit, that risk is randomness with knowable probabilities, and uncertainty is randomness with unknowable probabilities. Donald Rumsfeld gave the same distinction a modern twist with his “known unknowns” and “unknown unknowns” in the context of the Iraq War.
In the practical terms of finance, the difference is this: When someone buys a collateralized debt obligation (CDO) backed by a thousand mortgages, theoretically that buyer can analyze the borrowers, their income levels, the prepayment terms and so on, or he can depend on ratings agencies to do so—all articles of risk management. But the buyer cannot possibly determine just what might disrupt the structural assumptions behind the entire enterprise of housing finance, such as the possibility that the tools employed to manage risk might themselves generate risk. If I said to the CDO buyer before the crash, “What about the risk of default?” he or she might answer, “Don’t worry, I’ve factored that in.” That’s the voice of risk awareness speaking. But if I say, “These times are good, but they can’t last forever, can they?” and the response is, “I think they will”, then that’s the voice of hubris, which has forgotten uncertainty.
This mistake, thinking that uncertainty, which cannot be tamed, could be transformed into manageable risk, which can be, penetrated our conventional wisdom on the management of free markets before the crash. Conventional wisdom concluded that the dispersion of market risk, with technologically complex instruments and models to manage it, supported by the liquidity of a massive financial system, could manage uncertainty in whatever form it arose. We thought that free markets would handle uncertainty when they managed risk. But they did not, because they cannot. Our financial leadership in both the public and private sectors came to rely on efficient, rational and self-equilibrating markets. We caricatured our models and ignored the excesses that spring from complacency in the face of good times.
Complacency at Work
What is particularly remarkable about our having forgotten or ignored the distinction between risk and uncertainty is that some of us, at least, should have known better by dint of our own experience. I have been on the playing fields of finance for all the crises from the 1970s through 2000. At the World Bank for more than twenty years, I had a front-row seat to watch the successes and failures in economic development around the world, and I experienced as a player the effects of both on financial markets. These decades were frequently punctuated by crisis. I remember when Mexico defaulted on its sovereign debt in 1982, leaving U.S. financial leaders to tremble in fear that the U.S. banking system would not withstand the shock. That did not happen: Wise Men (there were very few women in upper ranks then) helped the United States recover from that crisis with both an understanding of the need for higher capital adequacy and regulatory attentiveness to international exposures of the banks.
The fix for the Mexico crisis, however, laid the ground for the next crisis. We had the idea that it would be better if risks were diffused by opening securities markets to developing countries. That contributed to subsequent crises, such as in Mexico and Russia. Capital markets were opened and liberalized beyond institutional capabilities to manage them, leading to the most remarkable crisis—in Asia. The world’s “miracle continent” stumbled, and for a few weeks the financial officials of the world’s wealthiest countries cowered.
In hindsight, the stunning thing is that every one of these crises seemed to emanate from a period of almost preternatural financial calm and well-being. Indeed, each period of calm seemed even calmer and more prosperous than the one before. Though crises kept happening, more and more people joined the chorus announcing, each time, that we had now figured out how to manage away crises.
We had domestic as well as international troubles, of course, but the same pattern repeated. In the mid- and late 1970s, we experienced a crisis with inflation. In 1981, Paul Volcker at the Fed brought inflation to heel with the support and encouragement of President Ronald Reagan. The solution gave rise to a steep recession, but we rebounded from it, and avidly spent our profits. The 1980s then yielded what seemed at the time like massive budget deficits, but a 1990 budget agreement and later the Clinton-Gingrich unholy alliance on spending controls and relatively sane tax policies yielded a new period of calm and optimism. That optimism, however, ended up generating what seemed the mother of all bubbles: the tech bubble. We managed to ring that one with fences too, thereby setting the stage for the grandmother of all bubbles in the housing and credit bubble.
Up and down this roller coaster we were told that we were experiencing a “Goldilocks” economy—not too hot, not too cold, but just right. We didn’t understand that having confidence that such a thing exists creates its own bubble. The porridge is always either too hot, too cold—or toxic. “The great moderation” has become an ironic tagline, right up there with “Mission Accomplished” and “Dow 36,000.” It has done so because randomness with unknowable properties, “unknown unknowns”, is an endemic, not contingent, feature of market economies, and it will always spite, in due course, the runaway herd. That much about uncertainty is certain.
The fundamental revolution in our thinking that needs to come out of this crisis, therefore, is simple: We must manage modern financial systems with an appreciation of unavoidable uncertainty. That said, it is a challenge to explain how something so solidly a part of human understanding for so long could ever have been ignored so thoroughly by so many thoughtful people. The root of the explanation, however, is that we were not on the lookout for the excesses that spring from the complacency born of good times. Let me offer four examples of this complacency from my own experiences in public finance.
The first example illustrates macroeconomic myopia. We see things happening in the macroeconomic world and routinely fail to apply their implications to whatever we are doing on the microeconomic level. People who have operating jobs on Wall Street find it very difficult to manage against what is potentially unsustainable, so they carry on as though whatever is keeping their balloon up in the air is going to continue.
Consider recent events in this light. When we looked at the global imbalances in credit, currencies and trade, we thought they were largely a balance-of-payments problem. We wondered whether the inevitable adjustment would come about through a gradual re-pricing of the U.S. dollar against the renminbi, or through a foreign exchange crisis. Could we get the Chinese to stoke their own domestic demand while we curbed our fiscal profligacy? Soft landing or hard? Those were the options we entertained. And then, seemingly out of nowhere, came the crisis, which moved European and Asian creditors to question for the first time why they were holding complex securities tied to condos in places they had never even been.
The crisis often arrives not as you expect it might, but in disguise. The global imbalance fed a credit glut in the United States, with interest rates too low for too long, leading many investors to search for higher returns on (supposedly) low-risk assets, as designated by rating agencies. Growing complexities in securitization, financial innovation and global distribution invited belief that the link between risk and return had somehow been suspended. When troubles became apparent, trillions of dollars headed for the exits at the same time. The lesson is that we have to look around the corner, not just at the oncoming traffic.
The second form of complacency concerns the misreading of good news. In June 2008, the annual report of the Bank of International Settlements observed that the biggest policy mistake of the boom period was misreading the positive supply shock of inexpensive manufactured imports. Those imports caused inflation to be artificially depressed, making it possible for monetary policy to loosen up, thus creating a credit bubble. The problem, in retrospect, was that the oil shocks had made us attentive to managing a negative supply shock but not a positive supply shock. The result was that we imported a financial crisis through the trade account via excess credit. Yes, inflation was tamed, but it was too tame in our Goldilocks world. The symptom of the illness came disguised as evidence of a cure.
A third form of complacency is the problem of prudence. We like to pretend that there are bad guys and good guys in this drama, with the good guys always prudent and the bad guys always reckless. It doesn’t work like that. It may sound odd, but sometimes prudence is no friend of stability. Indeed, much of what we take to be prudential behavior in a microeconomic setting can produce massive pro-cyclical feedback at times of stress. This means that rationally hedged behavior on an individual level can add up to collectively unsustainable behavior. In plain English: too much of a good thing.
Let me offer a personal example: During my tenure as Treasurer of the World Bank, derivative transactions were becoming too complex for my tastes, so I decided that we should either make those positions safer or pull out of that market. We accomplished that with what we called “collateralized swaps.” This required more collateral to be posted by a counterparty to a transaction in case of a credit downgrade. We knew this was a prudent move that would reduce our risks of loss. As we initiated this program, however, I thought to myself that this prudent behavior would be strongly pro-cyclical in its effects during a major downturn. Excellent discipline in normal times could, if enforced across the market, cause systemic turmoil in times of generalized trouble through chain effects. One loss triggers another as assets decline in value and each player scrambles for protection by demanding payments from another.
This point, raised to scale, is extremely important. We ask businesses to optimize the use of capital, minimize risks, maintain steady income growth, and so on. Then when they do it, they get clobbered during a period of unwinding caused by our own regulatory inattention to uncertainty. For us to cry foul when the system is in meltdown is the ultimate example of moving the goal posts at the toughest point in the game.
Fourth is the problem of data naivety, or what I call daivety. This is the problem of believing the numbers too much. Just as the fact that prudence can have a downside is a counterintuitive proposition, this one is too. Empirical work can help us see trends in the past that may shape the future, but no amount of data can remove the gauzy uncertainty that blocks what we cannot see and count. No judgments reside in the data. Yet sometimes we fall so in love with what we can measure that we surrender all common sense about the critical factors we cannot measure. Take the argument for Social Security private accounts: Such accounts look good for a hypothetical perpetual investor who is evenly invested in the market over a span of decades and doesn’t plan to liquidate those investments at any particular time. But that’s not how Americans live, save and retire.
We ignore the microeconomics, misread good news, overlook systemic aspects of prudence and then misinterpret what our economic models tell us—all to wish away an uncertain future. Some of this inheres in human nature, so it constitutes a problem we will never solve once and for all. But can we manage it better?
The Necessary Evil
We are trying to manage it. We have seen a major effort lately at regulatory reform that may help us address some of the blind spots we have created. But our efforts fall far short of adequate, and the reason is that our political economy is unsuited to changing the culture of a sector as complex and well protected as finance. New designs for more government intrusion in the private sector in the United States are certainly not in fashion at this moment in our history.
Yet to manage uncertainty, we need to make government a more intrusive player in our market economy than many of us might prefer. Who else can stand outside the market and lean against the wind or arrest the stampeding herd? But it will require a government with a very different mindset than that which it possesses today.
This is a political issue as well as an intellectual one. The first-order tasks are already underway. We are undertaking to increase capital requirements for banks, decrease the use of leverage throughout the financial system, and create special resolution procedures so big banks can be put down, as they say in the medical profession, with grace, love and certainty.
We can do even more, however. Lord Adair Turner, Chairman of the UK Financial Services Authority, has most thoughtfully raised questions about the beliefs, structure and practice that define our modern financial culture. My own suggestions overlap to some degree. Fundamentally, however, he is taking the lead in analyzing how we go about credit creation to support economic growth. When we interfere with markets in the name of stability, we should be clear-eyed about the effects on growth—which means, when you see risks of instability with virtually no payoff in growth, government action should be less contested.
For example, we should dethrone debt. Equity is hopelessly disadvantaged by the tax benefits of debt. Making interest payments deductible expenses distorts behavior ranging from what individuals borrow to buy a home to what corporations borrow to fund acquisitions and operations. This is, to be sure, a big and complex issue, but the principle involved is not in question. As Jack Kemp used to say, if you want less of something, tax it; if you want more of something, don’t. If we want less debt, then the obvious thing to do is tax it. We need to draw public attention to the imbalances that come with that distortion. Debt is so structurally embedded that any transition away from the status quo will need to be carefully managed for a long time. But the journey needs to begin somewhere, and it needs to begin now.
Next on my list is access to credit. The United States grew and prospered as its financial system grew ever more democratic. We became both great and fair by opening up access to credit. It is a source of national pride. But, of course, now things have gone much too far. We tend to treat credit as a right detached from credit worthiness. In the run-up to the crisis, getting a credit card was about as easy as getting a library card. But a credit card is like an automobile: It requires knowledge to operate, and in the wrong hands it can cause lots of damage. Credit cannot be unconditional.
It is worth noting in this regard that the U.S. military has discovered that the indebtedness of its soldiers is a security risk. It can’t mobilize soldiers who are financially prone to blackmail, so the military has won the right to restrict payday loans, usurious interest rates and other abuses of its soldiers. Other major security agencies, including several police forces, are eager to set similar restrictions. There is a lesson here. If credit-at-will is making it harder to defend the nation, then we need to treat it like we treat legal painkillers: Regulate it to protect both the patient and society as a whole.
This is not to say that I support government restrictions of credit for the sake of anyone’s personal virtue. It is not government’s role, per se, to promote virtue on the part of consumers or investors. But credit providers must not be allowed to push credit to those unable to carry it, nor should they be empowered to run roughshod over a financially illiterate public. In addition to consumer protection, we have learned that regulatory oversight of credit has an important place in securing our financial stability.
Lastly, I join with those who question whether the financial sector itself has grown so large that its marginal benefits are outweighed by the costs of the uncertainty it breeds and nurtures. Many have expressed concern about institutions being “too big to fail” (or they mean, rather, too interconnected to fail). I am more concerned about the sector as a whole being so big that it can take us all down when it stumbles.
Of course, the defenders of the status quo preach that they create liquidity by trading amongst themselves and that this enhances efficiency, lowers the cost of capital and boosts prosperity. But our intuition and recent experience tell us otherwise. Certainly, liquidity is important to our modern economy, and no one should pretend otherwise. But neither should anyone pretend that all transactions in finance are welfare-enhancing across society. Our high priests of finance were peddling a theology that any transaction between a buyer and a seller provides a public good, but theology is all that is—and a most self-serving one at that.
No one is proposing fixed controls on the size of the industry. We will never know what is the best size in a dynamic and increasingly complex economy. What we need, rather, are speed bumps, rumble strips, pot holes—anything that inconveniences market magicians as they try to load up on leveraged risk. The most obvious solution would be taxes on intra-industry transactions. That would be a radical step, to be sure. But it is a starting point to discuss how to put brakes on those who have no sense of speed limits.
Can we expect any of these things to come about under the current circumstances of our political economy? On the one hand, we seem hardwired to remain inactive as trouble brews. There is little will within our political class to seriously reconsider the role of government in relation to markets, despite all that has befallen us in recent times. On the other hand, there are the makings of a mob looking to ding the paychecks of bankers, which is a poor foundation for fundamental reform. Perhaps we await the coming generation of Nobel Prize-caliber thinkers to provide us the concepts that will bring government into the void left by the shortcomings of rational expectations and self-equilibrating markets. Clearly, we need new and practical ideas in many areas. If anything is certain, it is that conventional wisdom is in shambles.
But we need more than good ideas; we need a willingness to accept and act on them. On that count I am deeply concerned. Recall our house cat and leopard. We abide a government that steadily creates risks to a greater extent than the private sector did or ever could. We are the producer of the world’s greatest currency, and whatever else that means, it means that we can borrow well beyond our own peril. Certainly, government itself should never increase its own risks while it ignores uncertainty. And yet that is precisely what our fiscal policy has been doing. Look at the biggest measurable risk looming on the horizon: the unsustainable and growing fiscal imbalances that come from overspending, overpromising and undertaxing. If successive officeholders in Congress and the White House cannot even manage mere ordinary risk, then, sure as the sun will rise tomorrow morning, the uncertainty ahead will hit us when we have little or no margin left for action.
A famous maxim traced back to Herbert Stein holds that “if something cannot go on, it will stop.” Our mounting fiscal imbalance will be corrected through a plan to regain sustainability or by a crisis that befalls us because we have no plan. We are a great country with the great luxury of having the wherewithal to recover and learn from our mistakes. But our government is lagging the lesson book. It has not even begun to take stock of the fundamental and decisive role it played in bringing us to this unhappy pass. In the run-up to the housing bubble, there was a party that Congress was more than happy to attend. Bankers, realtors, inspectors and appraisers were having a great time, too. So were the poor-credit homeowners who felt they had finally nabbed a piece of the American dream. Finally, let us not forget all the middle-class homeowners who were using their homes as ATMs.
It couldn’t go on, and so it didn’t. The unsustainable has been unsustained, the party is over, and the populists are rising up in its wake. But they have risen not calling for fundamental reforms of existing entitlement programs. Rather, they want less government, which translates in current circumstances into more risk, more uncertainty—exactly what we don’t need. Perhaps the new Congress will bring a loud voice for fiscal balance, but the campaigns surely offered no thoughtful plans on that score.
Everyone likes a good tea party. But a lot depends on the distinction between what we need to drink for nourishment and what we’re wise to dump over the side. Ideas matter, but political courage and craft matter more. It starts with a narrative that harnesses the well-founded anger of the electorate to a story that opens the possibility of a happy ending.