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Why did policy ignore the harbingers of the crisis?

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Abstract

An analysis of the monetary authorities’ reports for 2005 to 2007 reveals that they were well aware of the risks of the financial crisis. They, however, tended to overemphasise the risks outside their control and to neglect those, at least partially under their control. Central banks should and could have acted already in 2005. Academic studies and their own assessments clearly indicated an accumulation of risks. Monetary authorities didn’t react as (1) they believe in self-regulating markets, and (2) in monetary instruments’ ineffectiveness to prevent bubbles, as well as (3) their tendency to assigning an extremely low probability to potential risks. This is not untypical for expert assessments: Risk assessment for complex systems is extremely complicated. If feasible at all, it would require extraordinarily complex techniques to take into account the tight coupling of system components and their complex interaction. This will not be possible in the foreseeable future. As a result reducing the system’s complexity appears to be the only way to reduce the probability and the severity of future financial crises.

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Notes

  1. As ECBSR is published in December (and June), the December-2004 report has been included.

  2. Table 2 neglects—as almost all reports of monetary authorities and academia—the interdependence of risks. For instance, behaviour towards risks is to some extent a result of over-optimism, and the credit expansion to US households is closely related to US monetary policy and global imbalances. This paper does not aim at discussing these relationships but takes a descriptive approach in analysing the wordings used in the various reports.

  3. That the IMF considers an institutional setup of very large investors on small and narrow markets which can, by definition, move markets, as stabilising is in any case surprising.

  4. This is why term ‘academia’ is put in quotes.

  5. This is the main reason, why different risk classification had to be used in the studies.

  6. Partial exceptions are the IMF’s Stability Reports, citing references in journals, but not necessarily the rather critical ones.

  7. This refers even more to BIS, as the IMF reports appear to be more subject to editorial revision.

  8. The first shock was the Bear-Stern disaster in August 2007, the second one the omission of the bail-out of Lehman in September 2008, the third the realisation of the enormous leverage and the sheer quantity of CDOs outstanding, and the fourth the crack-up of the markets.

  9. This says indeed, that the Fed will not intervene to burst a bubble, and that it will support a new expansion if the bubble bursts; this led to a promise of a long period of low interest rates, and necessarily induced banks’ excessive leverage and risk transformation.

  10. In its monthly reports European Central Bank (ECBY) (2005) analysed that in fact “sometimes asset prices tend to exceed the level which corresponds to an adequate evaluation”, and even dared to publish that “[b]oom-bust cycles of asset prices can hurt the whole economy” (my translation G.T.). This may be one of the few hints that the higher ranks are more resistant to adjust policy than the staff.

  11. Rajan (2010, 3) describes the situation: “I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions.”

  12. The only exception is ECBSR (2007b, December, pp. 164–167) chapter “Features” with the title “The impact of short term interest rates on bank credit risk taking”: “Empirical evidence indicates that low shortterm interest rates encourage bank risk-taking. … Despite this increased risk-taking, low short-term interest rates reduce credit risk in the very short run since they reduce refinancing costs, thereby lowering the credit risk of outstanding bank loans. As the volume of outstanding bank loans is larger than that of new loans, low interest rates may make banks safer in the very short run. In the medium run, however, interest rates that are too low encourage bank risk-taking and increase credit risk in banks, thereby threatening financial stability, especially if they then return to or rise above normal levels. It is also found that banks which are less well monitored—and therefore more subject to moral hazard—take on excessive risk when interest rates are low, thus suggesting that better banking regulation and corporate governance reduce the impact of low short-term interest rates on risk-taking.” This, however, had not been the main objective of Rajan’s provoking article.

  13. Hamilton, however, was one of the analysts predicting worse times ahead in his blog, even if the probability of recession kept changing in his assessments.

  14. They, therefore, strongly emphasise that the respective paper reflects the authors’ views and not necessarily those of the International Monetary Fund, its management or its board, or of the BIS respectively.

  15. M. Prisching (personal correspondence) argues that this may be due to the experts’ trust in their technical skills, their closeness to the risk, or that admitting high risks could endanger their job. Financial experts, additionally, may have been proud of their success in coping with past crises—see 2006 (see the reports cited above) or the dot.com crisis.

  16. White (2006), 13, Head of BIS’s Monetary and Economic Department, is at least aware of this problem.

  17. The correlations between the risks are almost completely neglected in the Stability Reports, but this is true for the ‘academic’ studies as well.

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Acknowledgemens

I am grateful for helpful comments of F. Hahn, M. Knell and G. Rünstler. The views expressed herein and any remaining errors are solely my responsibility.

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  1. Österreichische Akademie der Wissenschaften, Wien and Institut für Wirtschaftsforschung, Wien, Austria

    Gunther Tichy

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  1. Gunther Tichy
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Correspondence to Gunther Tichy.

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Tichy, G. Why did policy ignore the harbingers of the crisis?. Empirica 38, 107–130 (2011). https://doi.org/10.1007/s10663-010-9143-2

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