2008 was a traumatic experience for homeowners, workers, and for economic
theories that markets worked well. Literally millions of people lost their home. Tens of
millions of people lost their jobs. The regulators had such belief in the
efficiency of the financial markets–in being good for the bankers, they will be good for
all of our society. That, too, turned out to be wrong. The very idea that the markets were
efficient and stable was totally devastated. Before the crisis, scarce capital was allocated
clearly to uses that were not good. Building shoddy homes in the middle of the Nevada desert
that will shortly remain empty and be destroyed. Afterwards, the shortfall between the economy’s
potential to produce and its actual production is in the trillions and trillions of dollars.
No government has ever wasted money on the scale or the consequences of the US financial crisis.
Our belief, our understanding that markets are efficient is based on a very simple model–perfect
competition, perfect information. A kind of rationality that people really think through
the consequences of their actions and another very important assumption is no externality;
there is nothing that I do that has effects on others that is not already taken into account
by the market. All of those assumptions were wrong and were proven wrong by the crisis.
Economists usually begin by thinking about incentives, that people have incentives to
behave badly and the answer is yes. What were those incentives and why were there those
incentives? And in fact they had incentives to create incentive structures that were bad.
In the late 90s we formed these mega mega banks. These banks became ‘too big to fail’. If you take
a risk and you win you walk off with the profits but if you gamble and lose the government picks
up your losses. There is an innate incentive to undertake excessive risk, exactly what they did.
When you have an economic system like that the ‘too big to fail’ banks can get access
to capital to lower interest rate. Because those who lend out money say there’s no risk
because the big government will bail it out if they make a mistake. So, the ‘too big to fail’
banks get bigger and bigger, so the system has a dynamic instability to become even more distorted.
Inside the firm you look at the incentive structures; managers of the banks got a
large percentage of the profits if things did well. If, as a result of those gambles,
the next year they lost, they didn’t have to bear the consequences. As an economist
I looked at the incentive structures and predictably they led to bad behaviour.
Many of us believed before the crisis you needed good regulation. Those who were caught up in the
euphoria of the pre-2008 world pretended that there were no externalities. We’ve
had economic fluctuations before. When banks go down many people suffer and that’s especially
true when we have ‘too big to fail’ banks. The reason they’re ‘too big to fail’ is because
there are these macroeconomic consequences. So, we have this vocabulary that recognizes
that there are macroeconomic consequences and we had regulators that pretended that there weren’t.
It was what you might call a perfect storm, perfect recipe, for a massive market failure.
The basic lesson that I think should be taken away from the crisis of 2008–markets
on their own are not efficient or stable. We realized that there are these externalities,
there are things that one person can do, one organization can do, that affect others.
We’re never going to get to what we would say is a perfect working system but we can
get something much better than we are now. We’re always trying to strive to get the
right balance. We know that a system in which the state does everything doesn’t work. The big
lesson of the crisis of 2008 was that we could lose balance on the other side too.