People didn’t drown the markets; a bad system did

June 29, 2010

This piece first appeared in the July/August edition of Foreign Policy. The following opinions expressed are the author’s own.

The temptation is to see the 2008 Wall Street implosion that helped trigger the broader economic crisis as the consequence of individual idiocy and avarice. That thesis is emotionally appealing — nowadays everyone loves to hate and, better still, feel superior to wealthy Masters of the Universe. It is intellectually appealing, too. Blaming the crisis on human error is a lot easier than trying to work out the systemic problems it laid bare.

But just because something is easy doesn’t make it accurate. Call it the Michael Lewis fallacy. His book The Big Short deserves its place on the best-seller lists; it offers the best insight yet into the lunacy of subprime borrowing and the intricate world of structured financial products used to bet on those dreadful home loans. But the fabulous human stories of greed and stupidity Lewis tells are a seductively dangerous basis for understanding the global economic meltdown.

Start with the hedge-fund crowd Lewis introduces us to. It is easy to cheer for the smart outsiders who bet against those risky subprime mortgages, and to think that if only everyone else had been as sharp and as contrarian, the system wouldn’t have imploded. But both academic research and real-life market experience show that buying into a bubble — rather than betting against it — is often the wiser, safer, and more lucrative approach.

It is this perverse logic that Chuck Prince, then CEO of Citigroup, had in mind in July 2007, when he explained that “as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” That remark, made just a few weeks before the credit crunch really began to bite, is ritually cited as evidence of the blinkered Wall Street groupthink that nearly detonated the world financial system.

Yet what’s really unsettling about Prince’s observation is not that he was wrong, but that he was right. Betting against an overheated market seems like common sense in hindsight. In real time, though, fighting a bubble is a lot more complicated than simply recognizing that certain assets are overpriced.

“I’ve been through probably six crises now in my 30 years in the business, and it’s the pendulum of capitalism,” Peter Weinberg, co-founder of boutique investment firm Perella Weinberg and the former CEO of Goldman Sachs International, told me. “It’s very, very hard to lean against the wind in a bubble. … If one of the heads of the large Wall Street firms stood up and said, ‘You know what, we’re going to cut down our leverage from 30 to one to 15 to one, and we’re not going to participate in a lot of the opportunities in the market’ — I’m not sure that chief executive would have kept his job.”

“Whenever I read about people not seeing it coming, I get a kick out of it,” a top (and publicity-shy) New York hedge-fund manager told me. “Most every intelligent person … knew that there was a housing bubble.” The trick was figuring out when that bubble would burst.

Indeed, markets aren’t like math quizzes — you can be right and still go broke. That’s essentially what happened to Julian Robertson, one of the world’s greatest fund managers, who was presciently skeptical of the dot-com boom. But his caution deprived him of so many gains as the bubble was growing that his investors began to pull out. A disenchanted Robertson closed his fund on March 30, 2000 — ironically, just as his prediction was beginning to come true.

No less an authority than John Maynard Keynes summarized this dilemma with typical elegance: He is commonly credited with the line that the market can stay irrational longer than you can stay solvent. A more recent generation of scholars has borne out that observation. The most famous such work is “The Limits of Arbitrage,” a 1997 article in The Journal of Finance in which economists Andrei Shleifer and Robert Vishny argue, “When arbitrage requires capital, arbitrageurs can become most constrained when they have the best opportunities, i.e., when the mispricing they have bet against gets even worse.” Just ask Julian Robertson.

If anything, the truth turns out to be even more unpalatable. Not only is betting against an asset bubble dangerous — buying into it can be smart. That’s what economists Markus Brunnermeier and Dilip Abreu showed in a 2003 Econometrica article: “Rational arbitrageurs understand that the market will eventually collapse but meanwhile would like to ride the bubble as it continues to grow and generate high returns.” If you were on Wall Street while the music was playing, you really did have to keep on dancing.

That market imperative is important because it is a central reason why the efficient-markets hypothesis — the view that the actions of rational, self-interested market participants will keep markets in equilibrium — didn’t work in practice. Even Alan Greenspan, who had been the most powerful real-world practitioner of that view, has admitted intellectual defeat. As he told the House Oversight and Government Reform Committee in October 2008: “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”

In hindsight, it is easy to attack what billionaire financier George Soros calls “market fundamentalism.” What is tougher is to develop a new, more robust intellectual framework.

Nouriel Roubini, one of the few economists who predicted the financial meltdown, argues that jolts like the one the world experienced in 2008 aren’t freak events, caused by stupid and greedy bankers; they are a natural and inevitable feature of capitalism. “In the history of modern capitalism, crises are the norm, not the exception,” Roubini and Stephen Mihm, co-authors of the new book “Crisis Economics,” write. “Contrary to conventional wisdom, crises are not black swans, but white swans: the elements of boom and bust are remarkably predictable.”

If you accept that view, you are probably a supporter of tougher financial regulation and a countercyclical approach to central banking: Because bubbles are an inherent part of capitalism, surely regulators and central bankers should try to keep them from getting too big. Even Chuck Prince is recommending it. He told the Financial Crisis Inquiry Commission this spring that he had asked regulators to impose limits on leveraged lending before the crisis. “So you wanted them to stop you from dancing?” the somewhat incredulous vice chairman asked.

That’s the right approach — but regulatory heroism isn’t a panacea either. Just as dumb bankers weren’t the root cause of the 2008 crash, genius regulators won’t guarantee that we don’t experience another meltdown; indeed, the near-religious faith in Greenspan the maestro helped the last bubble grow so devastatingly large. Yet now we seem to be searching for new figures to lionize. Time magazine recently put three of Wall Street’s sheriffs (Mary Schapiro, Sheila Bair, and Elizabeth Warren) on its cover in a similar pose to the one used to exalt the triumvirate of Greenspan, Robert Rubin, and Lawrence Summers a decade ago.

The same human instinct that prompts us to look for villains again has us looking for saviors. That’s a worrying impulse: Our problems were systemic — and our solutions must be, too.


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Some ardent British Imperialists became Commies in the thirties because they concluded Marx was right when he said a cyclical crash occurs in a capitalist system when so much money accumulates at the top that the general pulic, supposed to serve as both producers and consumers, no longer have enough money to consume what they produce, e.g. single family houses. And it is true that concentration of wealth reached extreme levels in the twenties and in the last decade.But as the public’s ability to buy gets tighter and tighter, the folks with the money keep on investing it in the old ways because, as this author says,it is true that if the music keeps playing you have to keep dancing. What else are they going to do? Concentration of wealth reduces the overall demand for consumer products, because after all how much Diet Coke can you drink just because you’re a billionaire? So they’ve got nothing to do but riskier and riskier investments in stuff for which they overestimate the demand. That’s what the dot com bubble was about and certainly what the housing bubble was about. The risky investments and the concentration of wealth are part and parcel of the same thing. That’s what caused this mess, and the borrow-and-spend-and-deregulate culture into which we lapsed beginning around 1980 allowed a recurrence of both inexcuaable concentration of wealth (Some of the wealthiest of the wealthy say its inexcusable and they should know, right?) and a din of “Take the risk and win big” music encouraging risky investments from casino gambling for the poor and McMansions for the middle class to leveraged funds for the wealthy, making us all dance in one great frenzy until nothing was left.


Posted by Nicholas C. Arguimbau | Report as abusive

So all the “intelligent” insiders, the smart money on Wall Street, the Fed, the banks and mortgage company executives, the investment banks packaging up and securitizing the loans, the people in charge of Fannie Mae, the executive and congressional oversight branches of government, the rating agencies, etc., they knew there was a gigantic bubble that would eventually burst, but they were keeping that dirty little secret to themselves.

The only people that didn’t know, were the “little” people, dumb enough to buy a home for their family at outrageously inflated prices that only the smart people knew would soon not only wreck the economy, but ruin the “little people’s” financial lives as well? The stupid little suckers with their life savings tied up in mutual funds and 401k’s? The joke’s on them, huh? It’s all just a gigantic ponzi scheme, and we should expect the entire system to blow up eventually, but in the mean time, wink and nod and play along, and dance to the music if you want to prosper and thrive, or even keep your job at the very least?

No one’s accountable, it’s just the way the game’s played suckers? I guess for the “little people”, the question becomes “what other dirty little secrets is the investment community and government oversight body’s hiding amongst themselves”?

I agree, it’s just as I thought! I applaud you for having the guts to say it.

Posted by garrisongold | Report as abusive

I think there is a significant difference between trying to time your jump out of a bubble market and being so immersed in it that the pop threatens to take down your entire company and most of the world’s economy with it and that kind of foolishness is entirely avoidable and deserves blame both before and after the fact

Posted by td | Report as abusive

People did cause it, they were Fed and took on limitless credit on non-durables.

I suppose we overplayed our hands with our warped idea of the efficiency Frontier.

Great article.

Posted by Street Dog | Report as abusive

[…] go, Chrystia Freeland is sensible, certainly more so than some of her fishy colleagues. She recently pointed out the importance of systemic weakness rather than people in the Crunch, a point I have been making […]

Posted by Deus Ex Macchiato » Freeland sensibilities | Report as abusive