Shiller’s Question…

Posted on Wednesday 31 December 2008

Back when the financial crisis was first becoming apparent and I was poring over the Internet trying to understand what was happening, I ran across Dr. Robert Shiller – the expert on financial "bubbles." At the time, I didn’t really get the full concept. In several of his articles, he mused on the question, something like, "Why don’t people see that the escalating prices are ‘a bubble’ until it crashes?" Then he goes off on various psychological theories that might explain why.

At the time, I didn’t understand "bubbles" very well, and I thought his formulations of the psychology were naive. I apologize for my own naivity. Shiller’s question is not only the best question around, his version of it isn’t big enough. The current series in the Washington Post on the financial crisis is chilling, but throughout it, Shiller’s question fills the spaces between the paragraphs, "Why didn’t these people see what they were doing?" They were building a house that could not stand. Here’s a guide to the first part of the Washington Post series:

Explaining the Crisis

First, it’s Pulitzer Prize level Journalism [it’s just a shame it wasn’t investigated and published several years ago when it might have helped]. Anyone who reads this series and still doesn’t see this crisis as the result of regulatory failure should simply read it again. That is what it says. But the first series doesn’t hold a candle to current one on A.I.G. – another Pulitzer in the making. But as good as the Journalism is, it’s very hard to read without screaming Shiller’s question out loud, "Why didn’t these people see what they were doing?":

Investigating AIG
  • The Beautiful Machine
    Part 1 of 3 | Greed on Wall Street and blindness in Washington certainly helped cause the financial system’s crash. But a deeper explanation begins 20 years ago with a bold experiment to master the variable that has defeated so many visionaries: Risk.
  • A Crack in the System
    "…it was a logical extension of what the firm had been doing all along: discovering gaps in regulations and markets."
    Part 2 of 3 | By 1998, AIG Financial Products had made hundreds of millions of dollars and had captured Wall Street’s attention with its precise, finely balanced system for managing risk. Then it subtly turned in a dangerous direction.
  • Downgrades And Downfall
    Part 3 of 3 | How could a single unit of AIG cause the giant company’s near-ruin and become a fulcrum of the global financial crisis? By straying from its own rules for managing risk and then failing to anticipate the consequences.
There’s no way to summarize this story. You might as well bite the bullet and read it all [several times]. Since we know how it all comes out, it’s hard to read the layers of decisions they made along the way because their folly is so clear in retrospect. Even after the fact, they justify their decisions along the way, knowing how things came out. It’s reminiscent of Bush saying, "How could anyone have predicted the Insurgency?" There are some heros along the way – Brooksley Born for one, Eliot Spitzer for another. Interestingly, so far, there aren’t many super-rogues – certainly no Bernard Madoff’s. It’s just a story of people taking on risk, getting used to it, and then taking on more – blinded apparently by the rewards and ignoring where they were heading. Where it has ended, all they ended up owning was risk [risky risk at that]. And what they were risking was not just their profits, it was their own company and our entire economy. And finally:
In October, SEC chairman  Christopher Cox appeared at a roundtable discussion that the agency was hosting at its Washington headquarters. He delivered a tough, grim message: The federal government had failed taxpayers by not regulating the swaps market.

"The regulatory blackhole for credit-default swaps is one of the most significant issues we are confronting in the current credit crisis," Cox said, "and it requires immediate legislative action."

He tried to put the regulatory failure into context. "The market for CDS is barely 10 years old. It has doubled in size since just two years ago," he said. "It has grown between the gaps and seams of the current regulatory system, where neither the commission nor any other government agency can reach it. No one has regulatory authority over credit-default swaps — not even to require basic reporting or disclosure."

He went on: "The over-the-counter credit-default swaps market has drawn the world’s major financial institutions and others into a tangled web of interconnections where the failure of any one institution might jeopardize the entire financial system. This is an unacceptable situation for a free-market economy."
    December 30, 2008 | 12:19 PM

    I’m sorry to go off topic but I just finished the Vanity Fair article on the Bush Presidency etc. Matthew Dowd who was a big player in getting Bush in the White House calls the Bush era “failed opportunities” I’d call it incompetence and criminal.

    December 30, 2008 | 1:35 PM

    Correction to the above comment . Dowd’s words to decribe the Bush era is “missed opportunies”

Sorry, the comment form is closed at this time.