Radical Ignorance in the Financial Crisis

by Sandy Ikeda

Jeffrey Friedman and Wladimir Kraus have a new book out, Engineering the Financial Crisis, (Univ. Penn Press) that grew out of research that first appeared in Critical Review back in 2009 on the “Causes of the Crisis.”  Friedman’s lead article in that issue did an excellent job of providing a detailed but readable description of the institutional setting of the crisis and an account of the complex events, domestic and international, that led to it.  I’ve only skimmed the book, but it appears offer a similar kind of useful description and analysis of these and many other events surrounding the crisis.

What distinguishes this book, and what may be of particular interest to readers of this blog, is it’s explicitly Austrian perspective on the role of ignorance, in the private but especially the public sector, as the analytical starting point of the crisis.

The meta-mistake that economists make in ignoring ignorance (or in reducing it to “rational” or deliberate ignorance or to “asymmetric information,” where one party does know the truth) is suggestive, we think, of the problems that modern democracy faces:  If economists are our most important advisers, but their worldviews have no place for genuine human error, we are in deep trouble (151).

A rationalist constructivist hubris led public authorities to create a “hybrid capitalism” that incited entrepreneurs to ever riskier investments, the consequences of which no one could foresee though they perhaps might have imagined.  The book’s title Engineering the Financial Crisis captures that idea well.

8 thoughts on “Radical Ignorance in the Financial Crisis

  1. This is one of the best books I’ve read on the financial crisis. I wrote a review for it, but so far I can’t really find anywhere to publish it. Nevertheless, I find the most value in their dedicated exploration of the regulations which governed the pattern of investment made during the years leading to the financial crisis. Their discussion on radical ignorance is very important, but the book emphasizes the role of empiricism and so the point on radical ignorance is lost (let’s face it, discussion here on radical ignorance doesn’t match Friedman’s work on the topic in his dedicated articles on the subject).

    Anyways, I suggest to everyone to read “Engineering the Financial Crisis.” It will be time very well spent.

  2. I have not yet read this book but it sounds very promising. Having a clear explanation of how a pivotal financial mechanism malfunctioned, it appears to be distinct from the many other books on the crisis– much of the literature describes what people did without really explaining.

  3. I’m grateful to Sandy for his warm comments, but the title of the book can be misleading: we detect no “engineering mentality” among the regulators, no view of markets as disorderly and regulation, let alone planning, as orderly. Instead we detect standard-issue “economism,” where markets are fine as long as incentives are properly aligned, but where the role of regulation is, for example, to correct for moral hazard.

    The banking regulators thought deposit insurance created a moral hazard that called for capital-adequacy requirements as a corrective. The accounting regulators thought that principal-agent problems in publicly owned corporations created moral hazards that called for mark-to-market accounting as a corrective.

    Note that in the latter case, “market prices” were actually fetishized by the regulators as accurate conglomerations of economic “information.” So rather than a planning mentality, we find an “economists’ mentality,” which interprets Hayek’s 1945 paper as showing the omniscience of markets–as long as incentives are properly aligned.

    We point out, following Peter Boettke’s 1998 article in Critical Review, that there’s common ground in this economism between Stigler and Stiglitz, depending on whether one thinks that incentives are or are not regularly aligned properly in markets. But what this form of economism leaves out is that even with properly aligned incentives, market participants can err grievously because of what they do not know. And the same holds for market regulators.

    Indeed, we find regulators trying ardently to do what they are supposed to do, which is solve or prevent social and economic problems. Very much in the spirit of Sandy’s work, the regulators’ moves at each step were rational–but in light of what they didn’t know, mistaken. So radical ignorance is integral to the empirical story we tell, about how the regulators’ inadvertent errors homogenized market behavior, first by herding banks into buying “safe” high-rated mortgage-backed bonds; then by enforcing on banks a market panic about the value of those bonds, by writing down the amount of banks’ capital dollar for dollar as markets underpriced the bonds.

    Engineering the Financial Crisis is thus an attempt to analyze the crisis from an “Austrian” perspective–if that means a perspective that is aware of the possibility of human error by capitalists and regulators alike.

    Jeffrey Friedman

  4. I have not read the book. But I must respond to Jeffrey Friedman’s statement that “we find regulators trying ardently to do what they are supposed to do, which is solve or prevent social and economic problems.” Nothing could be further from the truth in financial services.

    Regulatory capture works everywhere, but nowhere is it more advanced than in the regulation of financial services. This has been made evident with the SEC and its kid glove treatment of the securities industry (notoriously so in the Madoff case). Nowhere is it seen more systematically than in the revolving door between the NY Fed and Goldman Sachs.

    Let’s take regulators not at their word, but examine their deeds. What “social and economic problems” have they avoided in recent years? Of course, we could explain their manifest failures by suggesting they are Keystone Kops and just not competent. I think the evidence better fits the thesis that they are rationally self-interested.

  5. The book is really engaging and convincing. I can’t resist asking a question since one of the author is commenting here. I hope Wladimir joins in to answer.

    The fact that capital levels have been higher than regulatory minimums in big banks is seen as proof that there was no significant moral hazard. The argument is that if there had been moral hazard, SIFIs would have held zero capital in excess of prudential ratios in a bet to maximize their Too Big to Fail revenues.

    I’m bought to the ignorance argument, and you tackle the moral hazard story from many more angles than that, but let me play the devil’s advocate. Capital regulation is not a hard threshold or an automatic bankruptcy trigger. There are both forbearance and preemptive threat involved in the initiation of bank bankruptcies. Since the introduction of the FDIC post-mortems on failed banks reveal they were all insolvent for as long as months (years during the S&L crisis of the 80s) before they underwent bankruptcy resolution (Kaufman & Scott, 2003, The Independant Review), further illustrating Jerry O’Driscoll’s point about regulatory capture. But it should also be noted that even before the Dodd-Frank Act the FDIC could initiate the declaration of insolvency preemptively before banks were even below prudential ratios (Bliss & Kaufman, 2007, Virginia Business and Law Review). In fact, the rule seems to be so discretionary that I’m left wondering whether the existence of capital in excess of prudential rules really says anything about moral hazard.

    And even leaving aside those considerations, wouldn’t banks having zero capital in excess of the regulatory minimum be a corner solution?

  6. I don’t know what’s said about moral hazard in the book, but sampling at the reviews it looks like the argument is that bankers didn’t know about the risks they were taking.

    Now, is it an argument against moral hazard? If you take the asymmetric information models in which there is always some agent who knows the truth, maybe yes.

    But in a market process approach, the fact that risks are socialized means that agents cannot have any information about risks, and that risk taking is biased on average toward excesses.

    As Machlup once remarked in a methodological essay about the determination of price markups in firms in cyclical upturns and downturns, the key is not whether market agents understand what they do, is whether they act as if they are led by an invisible hand, and the invisible hand with systemic moral hazard won’t lead to financial stability and allocative efficiency.

  7. Bedard: I think that capital in excess of minimum requirements doesn’t mean much, except that the optimal capital structure is higher than that specified by regulations even in the presence of perverse incentives due to public guarantees.

    in the end no “risk socialization technology” that is not 100% effective in removing risks will reduce risk buffers (such as capital) and risk premia to zero. it will just push them to lower levels than economically sound. if the effect is 0.01% it’s irrelevant, when junk bonds are traded as Deutsch Bund is of fundamental importance.

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