Understanding the GFC

For anyone wanting a brief rundown on why the Global Financial Crisis happened, I can highly recommend this speech to the Sydney Institute by David Gruen, head of the macro division of the Australian Treasury. David has 13 causes of the GFC, which is hardly a nutshell, but about as concise as one can reasonably get.

And there are some gems in the footnotes. For example:

…financial instruments became so complex that eventually literally no-one understood fully the nature of the instruments they were buying and selling.5

5. Andy Haldane (April 2009) analyses the problem as follows: “Consider an investor conducting due diligence on a set of financial claims: RMBS, ABS CDOs and CDO². How many pages of documentation would a diligent investor need to read to understand these products? … For simpler products, this is just about feasible – for example, around 200 pages, on average, for an RMBS investor. But an investor in a CDO² would need to read in excess of 1 billion pages to understand fully the ingredients [‘billion’ is not a misprint]”. As he puts it dryly: “With a PhD in mathematics under one arm and a Diploma in speed-reading under the other, this task would have tried the patience of even the most diligent investor. With no time to read the small-print, the instruments were instead devoured whole. Food poisoning and a lengthy loss of appetite have been the predictable consequences.”

6. As Alan Blinder (Wall Street Journal, May 2009) put it: “Take a typical trader at a bank [or] investment bank …. Darwinian selection ensures us that these folks are generally smart young people with more than the usual appetite for both money and risk-taking. Unfortunately, their compensation schemes exacerbate these natural tendencies by offering them the following sort of go-for-broke incentives when they place financial bets: Heads, you become richer than Croesus; tails, you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for a new job. These bright young people are no dummies. Faced with such skewed incentives, they place lots of big bets. If tails come up, OPM [other people’s money] will absorb almost all of the losses anyway. Whoever dreamed up this crazy compensation system? That’s a good question, and the answer leads straight to the doors of the top executives of the companies. So let’s consider the incentives facing the CEO and other top executives of a large bank or investment bank … . For them, it’s often: Heads, you become richer than Croesus ever imagined; tails, you receive a golden parachute that still leaves you richer than Croesus. So they want to flip those big coins, too. From the point of view of the companies’ shareholders—the people who provide the OPM – this is madness. To them, the gamble looks like: Heads, we get a share of the winning; tails, we absorb almost all of the losses. The conclusion is clear: Traders and managers both want to flip more coins—and at higher stakes—than the shareholders would if they had any control, which they don’t.”

14. Or, as Paul Krugman put it in answer to a question after his first Lionel Robbins lecture on 8 June, 2009: “In macroeconomics … [over recent years, US] graduate schools were divided between those that devoted most of their time to teaching models in which this sort of thing [the global financial crisis] could not happen and Departments that devoted all of their time to teaching models in which this sort of thing could not happen.”

(xposted @ andrewleigh.com)

5 thoughts on “Understanding the GFC”

  1. I didn’t notice he mentioned anything about the role of the government in influencing loan demand through its various organs, such as Fred, Fannie , CRA and various mandates.
    He clearly doesn’t seem to understand the problems, which is actually quite dangerous.
     
    It seems you don’t either, Joshua otherwise you wouldn’t be peddling such flagrant nonsense.

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  2. If the instruments were so complicated that nobody could understand them then there shouldn’t be a rational market for them. The main problems, as is pointed out in the post, are that they are gambling with OPM AND incentived to make big bets.

    Move back one link in the chain though and ask why people gave their money to brokers with such incentives. Where was the due diligence in finding out what principles drive their chosen fund manager’s decisions? Absent it seems.

    I wonder whether the market will learn anything from this or whether they will again be seduced by the siren song of riskless excess returns during the next cycle.

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  3. Ty: Maybe you should actually read the linked presentation, because he does mention that as a “proximal cause” with a lengthy footnote.

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  4. Ty — I think this post was written by Andrew Leigh, not Joshua Gans. 
    I don’t think the article tries to deal seriously with EMH. The salient point of which is simply that markets generally predict thinks better than bureaucrats.
    I thought the main omission from the Gruen paper was talking about the impact of moral hazard on the risk attitudes in the US financial markets. Ironically, he does seem to touch on this in the Australian context (by implying our moral hazard was relatively lower) but doesn’t draw the conclusion that moral hazard was one of the potential issues at play in the American system. While it’s a difficult issue to pin down, with no clear smoking gun that links cause and effect, I think the ever-growing moral hazard in financial markets is something that economists should have some concern about and I think it had a role in the current mess.

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