Where was I in 2005?

by Russ Roberts on November 17, 2008

in Financial Markets, Government Intervention

Reader Tim Allen asks a very good question. I’m going to quote his entire email and then try to answer his question:

I am a frequent visitor of your blog, Cafe Hayek. I saw your post
about the new collection of essays about the financial meltdown. I feel
compelled to write to you and Don although up to this point I have
restrained myself. I have to admit that I have this unfocused anger
about the financial meltdown and I confess has presently coalesced
around you. Much like when I am aggravated at a product or service from
some random company, I know better than to unload on the customer
service person whose only fault is being the next in the queue to
answer my phone call.
With that in mind, I need to ask of a person with a publication, a
popular blog and such access to media outlets like NPR, (not to mention
a PhD in economics) how is it that this financial meltdown only gets
analyzed by you and your profession ex post facto?
I promised myself that I wouldn’t bore you with how well I
followed this financial crisis between 2003 and now. The no name blogs
by averages Joes that I read… How hard it was from 2003 to 2006 to
find anyone other than the regular people with no economics PhD that
were writing about the housing bubble. And then, when in late 2006 when
the housing bubble was self evident, how hard it was to find anyone
talking about what the ramifications would be for the banks and
financial structure of the world.
What really really bugs me is that I was drinking beers with my
brother telling him how I didn’t think that capitalism, which I truly
love, would survive this pending financial imploding back in 2005. So I
guess, what I really want to know, is where were you in 2005 and where
was everyone in your profession?

You’re right, Tim. I didn’t see this coming. And I wasn’t alone. People a lot smarter than I am didn’t see it coming either. So what happened?

I should mention first that the few people who did see it coming were not necessarily any wiser than anyone else. Some of them had predicted nine of the last five recessions. A stopped clock is right twice a day. Even those who claim to have foreseen this mess couldn’t make the case well enough to alarm very many other people. And if you want to know if they were really wise or just selling a different story because the market was less crowded on the pessimistic side, you’d have to look at their bank accounts. Did they put their money where their mouth was?

But back to the rest of us. Why were so many people blind about what was going on until it was too late? I’ll talk about myself. First, this problem began in the housing sector. I knew very little about housing. I don’t know a single economist who specializes in housing the way I know people who specialize in trade or labor economics or health care issues. More importantly, I was oblivious to government’s role in housing markets.

Oh, I knew about the deductibility of mortgage interest. I knew there was something called the FHA that helped poor people buy houses. But I knew nothing about Fannie Mae or Freddie Mac. I’d heard of them, but I didn’t know what they really did. I didn’t know anything about their quasi-public status. I didn’t know how HUD leaned on them to get more involved in "affordable housing." I had no idea of the magnitude of Fannie and Freddie’s involvement in the mortgage market, generally. I didn’t pay close attention to the Taxpayer Relief Act of 1997 that changed the tax treatment of housing. And that’s just the beginning.

More disturbing perhaps, is that there is no public record of Fannie and Freddie’s involvement in the subprime market. I’ve seen claims in the New York Times and the Washington Post but they are extremely difficult to verify.

Having said all that, when home ownership went from 64% to an all time high of 69%, I foolishly attributed it to our growing standard of living and Wall St. innovation. I was right about part of it. We do have a growing standard of living (contrary to the claims that the average American isn’t sharing in the economy’s expansion) and Wall St. innovation did reduce the risk of lending to people who otherwise wouldn’t have gotten a loan. But I, like others, didn’t see the unsustainability of that rise. And most people thought that if the rise slowed or fell, then some people would lose their houses and others who invested in those mortgages would lose their money. We didn’t see the systemic risk.  We didn’t pay enough attention to the magnitudes. Prices are unlikely to double in ten years solely because of fundamentals. The explosion of subprime securitization in 2004 and 2005 should have set off alarm bells.

A deeper question that I have not seen adequately answered is why people who specialized in the housing market, people who were paying attention, people who put their life’s wealth on the line, were equally oblivious. What were they thinking? That housing prices would keep doubling? Or just keep going up? Were they comforted by the AAA rating of the CDO they had purchased? The credit default swap they had purchased? Should that have been enough? The standard answer that they were greedy is not an answer.

Which brings us to another reason I and others were silent in 2005. Financial markets are incredibly complicated. Even today, ex post, it’s hard to know what really happened that spiraled downward so dramatically. There are a lot of culprits. The ratings agencies. Fannie and Freddie. Greed. Innovative products that were too complicated to understand. Tax policy. Monetary policy. Mark-to-market accounting. How do all of these effects interact? The ex post story isn’t straightforward. Ex ante is much much harder.

The bottom line is that the ability of economics to anticipate disaster or to understand the full playing out of the complex system known as the economy is very limited. We are pretty good at microeconomics–the incentives created by a particular policy. We are not very good at macroeconomics. And we don’t have much to suggest for getting out of the mess we’re in. We know the conditions that are necessary–some optimism for the future, functioning credit markets, incentives to invest. But we don’t know much about how to create those conditions. At this point,  I think our value as economists lies in helping policy makers avoid mistakes. Not so helpful but better than nothing.

Finally, you might listen to this podcast with Robert Barro. It was taped in August when things weren’t going well but very few people thought we’d be where we are today. Barro basically argues that we have a disaster like this once every 50 to 100 years. Maybe that’s the best we can hope for. Events that occur that erratically are hard to understand in a systematic way. And maybe if we’re lucky, this will just turn out to be a bad recession and not something worse. But nobody knows. Certainly not us economists.


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