1. WARNINGS IGNORED AND THE CONVENTIONAL WISDOM
Acommon reaction to extreme events is to say they couldn't have been predicted. Japan's aerial assault on Pearl Harbor; the terrorist strikes against New York and Washington on September 11, 2001; Hurricane Katrina's devastating path through New Orleans—in each of these cases, the authorities claimed to have had no inkling of what was coming. Strictly speaking, this must have been true: had the people in charge known more, they would have taken preemptive action. But lack of firm knowledge rarely equates with complete ignorance. In 1941, numerous American experts on imperial Japan considered an attack on the U.S. Pacific Fleet an urgent threat; prior to 9/11, al-Qaeda had made no secret of its intention to strike the United States again—the CIA and the FBI had some of the actual plotters under observation; as far back as 1986, experts working for the Army Corps of Engineers expressed concerns about the design of the levees
protecting New Orleans.
What prevented the authorities from averting these disasters wasn't
so much a lack of timely warnings as a dearth of imagination. The in
dividuals in charge weren't particularly venal or shortsighted; even
their negligence was within the usual bounds. They simply couldn't conceive of Japan bombing Hawaii; of jihadists flying civilian jets into Manhattan skyscrapers; of a flood surge in the Gulf of Mexico breaching more than fifty levees simultaneously. These catastrophic eventualities weren't regarded as low-probability outcomes, which is the mathematical definition of extreme events: they weren't within the range of possibilities that were considered at all.
The subprime mortgage crisis was another singular and unexpected event, but not one that came without warning. As early as 2002, some commentators, myself included, were saying that in many parts of the country real estate values were losing touch with incomes. In the fall of that year, I visited the prototypical middle-class town of Levittown, on Long Island, where, in the aftermath of World War II, the developer Levitt and Sons offered for sale eight-hundred-square-foot ranch houses, complete with refrigerator, range, washing machine, oil burners, and Venetian blinds, for $7,990. When I arrived, those very same homes, with limited updating, were selling for roughly $300,000, an increase of about 50 percent on what they had been fetching two years earlier. Richard Dallow, a Realtor whose family has been selling property there since 1951, showed me around town. He expressed surprise that home prices had defied the NASDAQ crash of 2000, the economic recession of 2001, and the aftermath of 9/11. "It has to impact at some point," he said. "But, then again, in the summer of 2000, I thought it was impacting, and then things came back."
By and large, the kinds of people buying houses in Levittown were the same as they had always been: cops, fi refighters, janitors, and construction workers who had been priced out of neighboring towns. The inflation in home prices was making it difficult for these buyers even to afford Levittown. This "has always been a low-down-payment area," Dallow said. "If the price is three hundred and thirty thousand, and you put down five percent, that's a mortgage of three hundred and thirteen thousand five hundred. You need a jumbo mortgage. For Levittown." When I got back to my office in Times Square, I wrote a story for The New Yorker entitled "The Next Crash," in which I quoted Dal-low and some financial analysts who were concerned about the real estate market. "Valuation looks quite extreme, and not just at the top end," Ian Morris, chief U.S. economist of HSBC Bank, said. "Even normal mom-and-pop homes are now very expensive relative to income." Christopher Wood, an investment strategist at CLSA Emerg
WARNINGS IGNORED • 19
ing Markets, was even more bearish: "The American housing market is the last big bubble," he said. "When it bursts, it will be very ugly."
Between 2003 and 2006, as the rise in house prices accelerated, many expressions of concern appeared in the media. In June 2005, The Economist said, "The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops." In the United States, the ratio of home prices to rents was at a historic high, the newsweekly noted, with prices rising at an annual rate of more than 20 percent in some parts of the country. The same month, Robert Shiller, a well-known Yale economist who wrote the 2000 bestseller Irrational Exuberance, told Barron's, "The home-price bubble feels like the stock-market mania in the fall of 1999."
One reason these warnings went unheeded was denial. When the price of an asset is going up by 20 or 30 percent a year, nobody who owns it, or trades it, likes to be told their newfound wealth is illusory. But it wasn't just real estate agents and condo flippers who were insisting that the rise in prices wouldn't be reversed: many economists who specialized in real estate agreed with them. Karl Case, an economist at Wellesley, reminded me that the average price of American homes had risen in every single year since 1945. Frank Nothaft, the chief economist at Freddie Mac, ran through a list of "economic fundamentals" that he said justified high and rising home prices: low mortgage rates, large-scale immigration, and a modest inventory of new homes. "We are not going to see the price of single-family homes fall," he said bluntly. "It ain't going to happen."
As the housing boom continued, Nothaft's suggestion that nationwide house prices were unidirectional acquired the offi cial impri matur of the U.S. government. In April 2003, at the Ronald Reagan Presidential Library and Museum, in Simi Valley, California, Alan Greenspan insisted that the United States wasn't suffering from a real estate bubble. In October 2004, he argued that real estate doesn't lend itself to speculation, noting that "upon sale of a house, homeowners must move and live elsewhere." In June 2005, testifying on Capitol Hill, he acknowledged the presence of "froth" in some areas, but ruled out the possibility of a nationwide bubble, saying housing markets were local. Although price declines couldn't be ruled out in some areas, Greenspan concluded, "[T]hese declines, were they to occur, likely would not have substantial macroeconomic implications."
At the time Greenspan made these comments, Ben Bernanke had recently left the Fed, where he had served as governor since 2002, to become chairman of the White House Council of Economic Advisers. In August 2005, Bernanke traveled to Crawford, Texas, to brief President Bush, and afterward a reporter asked him, "Did the housing bubble come up at your meeting?" Bernanke said housing had been discussed, and went on: "I think it's important to point out that house prices are being supported in very large part by very strong fundamentals . . . We have lots of jobs, employment, high incomes, very low mortgage rates, growing population, and shortages of land and housing in many areas." On October 15, 2005, in an address to the National Association for Business Economics, Bernanke used almost identical language, saying rising house prices "largely reflect strong economic fundamentals." Nine days later, President Bush selected him to succeed Greenspan.
In August 2005, a couple of weeks after Bernanke's trip to Texas, the Federal Reserve Bank of Kansas City, one of the twelve regional banks in the Fed system, devoted its annual economic policy symposium to the lessons of the Greenspan era. As usual, the conference took place at the Jackson Lake Lodge, an upscale resort in Jackson Hole, Wyoming. Greenspan, who had, by then, served eighteen years as Fed chairman, delivered the opening address. Most of the other speakers, who included Robert Rubin, the former Treasury secretary, and Jean-Claude Trichet, the head of the European Central Bank, were extremely complimentary about the Fed boss. "There is no doubt that Greenspan has been an amazingly successful chairman of the Federal Reserve System," Alan Blinder, a Princeton economist and former Fed governor, opined. Raghuram G. Rajan, an economist at the University of Chicago Booth School of Business, who was then the chief economist at the International Monetary Fund, took a more critical line, examining the consequences of two decades of fi nancial deregulation.
Rajan, who was born in Bhopal, in central India, in 1963, obtained his Ph.D. at MIT, in 1991, and then moved to the University of Chicago Business School, where he established himself as something of a wunderkind. In 2003, his colleagues named him the scholar under forty who had contributed most to the field of finance. That same year, he took the top economics job at the IMF, where he stayed until 2006.
WARNINGS IGNORED • 21
He could hardly be described as a radical. One book he coauthored is entitled Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity. Bruce Bartlett, a conservative activist who served in the administrations of Ronald Reagan and George H. W. Bush, described it as "one of the most powerful defenses of the free market ever written."
Rajan began by reviewing some history. In the past couple decades, he reminded the audience, deregulation and technical progress had subjected banks to increasing competition in their core business of taking in deposits from households and lending them to other individuals and firms. In response, the banks had expanded into new fi elds, including trading securities and creating new financial products, such as mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs). Most of these securities the banks sold to investors, but some of them they held on to for investment purposes, which exposed them to potential losses should the markets concerned suffer a big fall. "While the system now exploits the risk-bearing capacity of the economy better by allocating risks more widely, it also takes on more risks than before," Rajan said. "Moreover, the linkages between markets, and between markets and institutions, are now more pronounced. While this helps the system diversify across small shocks, it also exposes the system to large systemic shocks—large shifts in asset prices or changes in aggregate liquidity."
Turning to other factors that had made the financial system more vulnerable, Rajan brought up incentive-based compensation. Almost all senior financiers now receive bonuses that are tied to the investment returns their businesses generate. Since these returns are correlated with risks, Rajan pointed out, there are "perverse incentives" for managers and firms to take on more risks, especially so-called tail risks—events that occur with a very low probabil ity but that can have disastrous consequences. The tendency for investors and traders to ape each other's strategies, a phenomenon known as herding, was another potentially destabilizing factor, Rajan said, because it led people to buy assets even if they considered them overvalued. Taken together, incentive-based compensation and herding were "a volatile combination. If herd behavior moves asset prices away from fundamentals, the likelihood of large realignments—precisely the kind that trigger tail losses—increases."
Finally, Rajan added, there is one more ingredient that can "make the cocktail particularly volatile, and that is low interest rates after a period of high rates, either because of financial liberalization or because of extremely accommodative monetary policy." Cheap money encourages banks, investment banks, and hedge funds to borrow more and place bigger bets, Rajan reminded the audience. When credit is fl owing freely, euphoria often develops, only to be followed by a "sudden stop" that can do great damage to the economy. So far, the U.S. economy had avoided such an outcome, Rajan conceded, but its rebound from the 1987 stock market crash and the 2000–2001 collapse in tech stocks "should not make us overly sanguine." After all, "a shock to the equity markets, though large, may have less effect than a shock to the credit markets."
As a rule, central bankers don't rush stages or toss their chairs; if they did, Rajan might have been in physical danger. During a discussion period, Don Kohn, a governor of the Fed who would go on to become its vice chairman, pointed out that Rajan's presentation amounted to a direct challenge to "the Greenspan doctrine," which warmly welcomed the development of new financial products, such as securitized loans and credit default swaps. "By allowing institutions to diversify risk, to choose their risk profiles more precisely, and to improve the management of the risks they do take on, they have made institutions more robust," Kohn went on. "And by facilitating the fl ow of savings across markets and national boundaries, these developments have contributed to a better allocation of resources and promoted growth."
The Greenspan doctrine didn't imply that financial markets invariably got things right, Kohn conceded, but "the actions of private parties to protect themselves—what Chairman Greenspan has called private regulation—are generally quite effective," whereas government "risks undermining private regulation and fi nancial stability by undermining incentives." Turning to Rajan's suggestion that some sort of government fix might be needed for Wall Street compensation schemes, Kohn insisted it wasn't in the interests of senior executives at banks and other financial institutions "to reach for short-run gains at the expense of longer-term risk, to disguise the degree of risk they are taking for their customers, or otherwise to endanger their reputations. As a
WARNINGS IGNORED • 23
consequence, I did not find convincing the discussion of market failure that would require government intervention in compensation."
Lawrence Summers, who was then the president of Harvard, stood up and said he found "the basic, slightly lead-eyed premise of this paper to be largely misguided." After pausing to remark on how much he had learned from Greenspan, Summers compared the development of the financial industry to the history of commercial aviation, saying the occasional plane crash shouldn't disguise the fact that getting from A to B was now much easier and safer than it used to be, and adding, "It seems to me that the overwhelming preponderance of what has taken place is positive." While it was legitimate to point out the possibility of self-reinforcing spirals in financial markets, Summers concluded, "the tendency towards restriction that runs through the tone of the presentation seems to me to be quite problematic. It seems to me to support a wide variety of misguided policy impulses in many countries."
The reaction to Rajan's paper demonstrated just how difficult it had become to query, even on a theoretical level, the dogma of deregulation and free markets. As a longtime colleague and adviser of Greenspan's, Kohn might be forgiven for defending his amour propre. Summers, however, was in a different category. During the 1980s, as a young Harvard professor, he had advocated a tax on securities transactions, such as stock purchases, arguing that much of what took place on Wall Street was a shell game that added nothing to overall output. Subsequently, he had gone on to advise presidential candidates and serve as Treasury secretary in the Clinton administration. Along the way, he had jettisoned his earlier views and become a leading defender of the conventional wisdom, a phrase John Kenneth Galbraith coined for the unquestioned assumptions that help to frame policy debates and, for that matter, barroom debates. As Galbraith noted in his 1958 bestseller, The Affl uent Society, the conventional wisdom isn't the exclusive property of any political party or creed: Republicans and Democrats, conservatives and liberals, true believers and agnostics, all subscribe to its central tenets. "The conventional wisdom having been made more or less identical with sound scholarship, its position is virtually impregnable," Galbraith wrote. "The skeptic is disqualifi ed by his very tendency to go brashly from the old to the new. Were he a sound scholar . . . he would remain with the conventional wisdom."
But how does the conventional wisdom get established? To answer that question, we must go on an intellectual odyssey that begins in Glasgow in the eighteenth century and passes through London, Lausanne, Vienna, Chicago, New York, and Washington, D.C. Utopian economics has a long and illustrious history. Before turning to the flaws of the free market doctrine, let us trace its development and seek to understand its enduring appeal.

Excerpted from How Markets Fail by John Cassidy.
Copyright © 2009 by John Cassidy.
Published in 2009 by Farrar, Straus and Giroux, LLC.
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