When The Impossible Happens

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To believe in 2006 that a nationwide decline in home prices was unlikely seemed to me, even at the time, to be a strange belief. But I could see how a rational person might disagree with me. But to believe that a nationwide decline in home prices was impossible and to believe it with sufficient confidence that you would stake a multi-billion dollar enterprise on it was bizarre. But bizarre squared was that the people who were doing this didn’t characterize themselves as making an aggressive, high-risk / high-reward bet on a debatable proposition that they believed in. Instead, they characterized it as part of prudent, nearly risk-free financial management. Yesterday, an anonymous Economist blogger went back over that weirdness:

The data used to stress test mortgage assets was based on the experience of Texas and other oil-patch states in the 1970s and 80s. It provided an instance of a housing bubble that led to falling house prices. The problem was, since the Depression, house prices had never fallen on a national level. There existed no data that contained a large and positive correlation of home price across different regions and also had prices falling. This is the limitation of historical data; you use the past to predict the future. When you enter a new regime you are left with your own ad-hoc judgement. Rather than take on that sort of responsibility, most prefer to base their assumptions on historical data.

I find it hard to believe everyone honestly thought housing prices would increase forever. The problem is that decisions were made as if they would. Maybe it was a failure of management to look critically at assumptions and realise they did not jive with being in a national housing bubble.

In terms of either common sense, or pretty elementary social psychology, this is pretty easy to understand. People like to be following a clear model, and they like to be able to say they’re following a clear model. People also like to be doing what other people are doing. And people really don’t like to be annoyed by subordinates who complain that the status quo is mistaken, but who don’t have a clear solution to the problem to offer. What’s more, the world of high finance is pretty homogeneous—lots of men, lots of people from a small number of schools—which further encourages groupthink.

At the same time, the conventions of free market economics say that the scenario that unfolded is impossible. If a bunch of banks were making a systematic error—overlooking the fact that their historical data was a finite set that neglected a possibility that was clearly possible in theory, and that therefore the banks’ risk profiles were out of whack with their claims—then the market should have corrected that. Either the market magic of the bond rating system should have corrected it, or else a dissenter should have been able to raise massive funds from investors by starting his own firm making different bets. Much as the banks’ models said that systematic house price declines were impossible, even though they are, the politically hegemonic theory of economics said that systematic market failure was impossible. And it said that even though the phenomenon of herd behavior is extremely well-known both as a matter of social science research inside and outside the world of economics and as a matter of commonplace folk psychology.

The big conceptual shoe that hasn’t dropped, as far as I’m concerned, in the financial crisis is that that entire line of economic theorizing hasn’t yet taken the hit in prestige that it deserves. I’ll link again to my review of Animal Spirits and just say that I hope in the future the basic facts about irrationality won’t just be something that “everyone knows” but also something that we actually take seriously when thinking about big policy issues.