Famous Last Words

A good example of the stuff I was talking about in my Animal Spirits review is this 2006 speech by Ben Bernanke on the subject of risk management in the financial sector. Bernanke began with the observation that “banks have invested in risk management for the good economic reason that their shareholders and creditors demand it.” And then he concluded:

The ongoing work on this framework has already led large, complex banking organizations to improve their systems for identifying, measuring, and managing their risks. Indeed, banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks. The banking agencies will continue to promote supervisory approaches that complement and support banks’ own efforts to enhance their risk-management capabilities.

What’s striking about this isn’t just it’s total wrongness in hindsight. It’s the nature of the logic Bernanke employs. Basically, Bernanke just assumes that everything is working well. If bank managers are doing a bunch of stuff in the field of risk-management, it must be the case that risk-management is improving. After all, it’s in the interests of creditors and shareholders for risk to be managed well, so that must be what’s happening. There’s no need to assess, in detail, whether or not things are actually improving. And there’s no consideration of the possibility that shareholders don’t really care, and bondholders are assuming (rightly, as it turns out) that loans to major financial institutions come with an implicit federal guarantee so managers are just mucking around to boost short-term profits and aren’t really inquiring too closely into the details.

In retrospect, though, that’s exactly what was happening. But a combination of financial industry political clout and strong neo-classical ideology made it impossible for the key policy player to see it. And not only did he not see it, he specifically gave his seal of approval to the casino.