Ever since the subprime crisis spilled over into other segments of the financial markets – and quickly spread across the broader economy – many opinions have been offered about what went wrong and who is to blame.
The finger pointing went in all directions and covered all the major agents in the economy: bankers, central bankers, rating and government agencies, media, real estate investors, corporations, consumers, politicians, risk managers, regulators, board members, asset managers, speculators, accountants; yes, even consumers and borrowers were accused of reckless spending and borrowing.
It seems that the only group who escaped the blaming were the so-called NINJAs: persons with No Income, No Jobs and No Assets.
The typical factors that caused the economic malaise, it was soon agreed, include excessive bonuses, poor governance, moral hazard, greed, poor regulation and supervision, easy and cheap money, too much leverage, weak accounting rules and bad macroeconomic policies.
Take what was said by Dr. Nout Wellink, the President of the Dutch Central Bank in a recent interview in Het Financieele Dagblad of 27 March, where he was questioned about his responsibilities in the mess we are now in and particularly regarding the sudden financial support ING needed due to the Alt-A mortgages on the books of ING Direct:
”Here you see the entire problem in a nutshell: an accounting problem, the non-functioning of the markets, and insufficient supervision over the US mortgage market. There are many factors which played a role and the interaction between all these factors we have not seen before. I think it is very risky that people tend to accuse John, Peter or Gerard of everything. And if you focus on one specific group, you might take the wrong measures“.
Thus single minded thinking does not help much when it comes to finding ways to improve next time.
Some time ago I visited the historic Museum of London where part of the exhibition covered the Great Fire of London of 1666, in which thousands of people died and a large part of the medieval city inside the old Roman walls was destroyed.
Soon after the fire ended, the question was heavily debated about who had caused this deathly fire, and after a couple of days it turned into a spiral of witch hunting. First a baker was accused but he said he could not be the cause because the fire started on a Saturday, on a day he does not use the oven since no bread is sold on Sunday.
Then the finger pointing turned to the French and Dutch, given that they were at war with the English, shortly to be followed by the Catholics accusing the Calvinists and vice versa.
After six months of quarrelling and fighting King Charles the Second asked everyone to stop the finger pointing and added the wise words that none of the above should be seen as the reasons of the deadly damage caused by the fire. According to him the real reason behind the reason was that various factors caused the fire to spill over in such damaging way, including the dry weather, strong unfavourable wind, the poor housing construction, too many houses too close to each other without proper fire protection, and all this at the same time! This created a toxic process which hardly anybody could have foreseen. Today we sometimes refer to such an environment as “the Perfect Storm.”
Similarly, one can question whether agents like bankers, regulators, government officials or factors like bonuses, greed and lack of governance were the real reasons behind the financial and economic fire of today. Even if they all played an important role, were there more fundamental reasons why these reasons (related to people and things) played out as they did? Or was it the toxic combination of the known known’s and unknown unknown’s?
If there is one thing about which most of the blaming parties have agreed upon then it is that things have become too complex. Interestingly, this collectively admission of having created too much complexity was not heard in the booming years. As one could read in annual reports and other publications produced by many of the above agents, after making some observations that they were coping with increased complexities, the final verdict by almost any party blamed today was that they were in control and that they understood very well or at least better the risks which that they had taken on.
The general mindset was that risks were there to be taken to grow the economy, to increase shareholder value or enlarge value to society and that risk perception was rightly low and could be priced at record low yields because of very good risk models and enhanced control and governance measures taken. Adding, of course, that further improvements were needed.
Or, in other words, we were managing the place well and we all could sleep well at night.
“It is the psychology, stupid!”
Perhaps most people did indeed genuinely believe that this was indeed the case. Yet in a booming period when the collective belief is that “everything goes up”, it obscures almost any weak point in our thinking and (not) acting as human beings.
Yet if some of the blacks swans arrive – as so insightfully described in Nassim Nicholas Taleb’s popular book “Black swans” – and our collective belief turns subsequently into fear, fuelled by the collective belief that ‘everything goes down’ then the asset value destruction seems to fall like a stone. Acceleration takes place, because people tend to exaggerate on the upside as well on the downside. It seems only to stop falling when our collective belief turns into a mood that things are going up, stopping the fire which is destroying what we have built and accumulated.
The real reason behind the reasons
Might it be that the real reason behind the aforementioned reasons is that we, as various people already argued that we, collectively, have made our world so complex that we have to conclude that we do not have enough brainpower to understand properly all the complexities we have created? This includes corporate, regulatory, behavioural, financial, societal, political complexities in all forms and have been created by all stakeholders, more “us” and less by “them”.
More and more people have now started admitting that they just did not know and even that they just did not know what they did not know.
The ‘unknown unknowns’ have landed us in a vicious cycle that we collectively believe that everything will continue to go down, causing the massive asset value devaluations we have so far seen happening, which not only makes many assets on the balance sheets of financial agents like banks, shadow banks, pension funds and corporations ‘toxic’ and of low value, but also devalues our own personal wealth position in a very harsh way.
Only until we, as economic agents, have enough collective belief that everything goes up, the measures taken will start to become effective.
It is therefore important that people include in their thinking the critical reasons behind the reasons when discussing which measures should or should not be taken and how to prevent the next economic or financial ‘fire’.
The new era
When we have entered a new era where we start believing again that we have created a better world by introducing better and smarter regulations, stricter governance, with higher capital ratios and with even better incentives schemes, we should be mindful that we sooner or later may fall into a similar trap from boom to bust, at least assuming we still are thinking and acting fuelled by the same genes we have carried since the beginning of mankind.
While fixing all the past problems is as such necessary and desirable, we can only avoid laying the seeds for the next downturn if we constantly remind ourselves that for several issues we don’t have enough brains to really understand all the (new) complexities we have by then created and have to work with.
This humbling recognition should encourage us to increase our efforts to reduce complexity. Given that we will likely not succeed in this, we should be more conscious of our severe limitations in whatever we start fixing what went wrong. This could mean more capital and less risky assets and lower ambitious growth rates and not only for banks but for all economic agents.
Recognising this will be a big step forward, and will be of help when building a more stable world.