History is impossible

... and economic history is even harder.

Andy Lo (MIT) explains that economists have yet to agree on the causes and consequences of and remedies for the recent financial crisis. This is a must read. I hope to provide further comments when I have more time.

Although I covered the housing bubble (which I called a bubble as early as 2004) and ensuing financial crisis in great detail on this blog, I've spent very little time discussing books about the crisis. That's because many (most?) of the authors (who, as Lo points out, tend to disagree strongly with each other) are rehearsing their own priors rather than seeking truth. My talk on the financial crisis.

Reading About the Financial Crisis: A 21-Book Review

Andrew W. Lo

Abstract
The recent financial crisis has generated many distinct perspectives from various quarters. In this article, I review a diverse set of 21 books on the crisis, 11 written by academics, and 10 written by journalists and one former Treasury Secretary. No single narrative emerges from this broad and often contradictory collection of interpretations, but the sheer variety of conclusions is informative, and underscores the desperate need for the economics profession to establish a single set of facts from which more accurate inferences and narratives can be constructed.

From the introduction:

... Six decades later, Kurosawa’s message of multiple truths couldn’t be more relevant as we sift through the wreckage of the worst financial crisis since the Great Depression. Even the Financial Crisis Inquiry Commission—a prestigious bipartisan committee of 10 experts with subpoena power who deliberated for 18 months, interviewed over 700 witnesses, and held 19 days of public hearings—presented three different conclusions in its final report. Apparently, it’s complicated.

To illustrate just how complicated it can get, consider the following “facts” that have become part of the folk wisdom of the crisis:

1. The devotion to the Efficient Markets Hypothesis led investors astray [CERTAINLY TRUE], causing them to ignore the possibility that securitized debt was mispriced and that the real-estate bubble could burst. [TOO STRONG]

2. Wall Street compensation contracts were too focused on short-term trading profits rather than longer-term incentives. Also, there was excessive risk-taking because these CEOs were betting with other people’s money, not their own. [CEOS DID NOT KNOW WHAT WAS GOING ON -- HAVE TO LOOK AT INCENTIVES OF LOWER LEVEL PEOPLE]

3. Investment banks greatly increased their leverage in the years leading up to the crisis, thanks to a rule change by the U.S. Securities and Exchange Commission (SEC). [REPORTEDLY TRUE... BUT SEE THE PAPER FOR INTERESTING DETAILS]

While each of these claims seems perfectly plausible, especially in light of the events of 2007–2009, the empirical evidence isn’t as clear. ...

From the conclusions:

There are several observations to be made from the number and variety of narratives that the authors in this review have proffered. The most obvious is that there is still significant disagreement as to what the underlying causes of the crisis were, and even less agreement as to what to do about it. But what may be more disconcerting for most economists is the fact that we can’t even agree on all the facts. Did CEOs take too much risk, or were they acting as they were incentivized to act? [NOT CEOS, LOWER LEVEL TRADERS; YES] Was there too much leverage in the system? [YES] Did regulators do their jobs [NO] or was forbearance a significant factor? [REGULATORS DID NOT UNDERSTAND CDOS OR CDS] Was the Fed’s low interest-rate policy responsible for the housing bubble [PARTIALLY, BUT GSES LIKE FANNIE DESERVE MUCH MORE BLAME], or did other factors cause housing prices to skyrocket? [ANIMAL SPIRITS; IRRATIONAL EXUBERANCE; BOUNDED COGNITION] Was liquidity the issue with respect to the run on the repo market, or was it more of a solvency issue among a handful of “problem” banks? [IT WAS FEAR AND COMPLEXITY]

[THERE WAS REGULATORY CAPTURE TO GET THE CASINO GAMES GOING IN THE FIRST PLACE, BUT NO "TOO BIG TO FAIL" MORAL HAZARD. ONLY ACADEMICS AND JOURNALISTS COULD THINK SO. DURING THE CRISIS REAL FINANCIERS WERE SCARED OUT OF THEIR MINDS AND HAD NO FAITH IN A GOVT BAILOUT. (I WAS ON THE PHONE WITH LOTS OF THEM.) MANY PEOPLE, FROM CEOS DOWN TO MD LEVEL AND BELOW TRADERS, LOST MUCH OR MOST OF THEIR NET WORTH IN THE COLLAPSE. DOES THAT SOUND LIKE MORAL HAZARD? ACADEMIC ECONOMISTS HAVE A CUTE THEORY (OR IDEOLOGY) AND WANT TO CONFIRM IT. STUPIDITY EXPLAINS A LOT MORE THAN CONSPIRACY.]

For financial economists—who are used to dealing with precise concepts such as no-arbitrage conditions, portfolio optimization, linear risk/reward trade-offs, and dynamic hedging strategies—this is a terribly frustrating state of affairs. Many of us like to think of financial economics as a science [ONLY IN THE MOST LIMITED SENSE], but complex events like the financial crisis suggest that this conceit may be more wishful thinking than reality. John Maynard Keynes had even greater ambitions for economics when he wrote, “If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid”. Instead, we’re now more likely to be thought of as astrologers, making pronouncements and predictions without any basis in fact or empirical evidence.

To make this contrast more stark, compare the authoritative and conclusive accident reports of the National Transportation Safety Board—which investigates and documents the who-what-when-where-and-why of every single plane crash—with the 21 separate and sometimes inconsistent accounts of the financial crisis we’ve just reviewed (and more books are surely forthcoming). Why is there such a difference? The answer is simple: complexity and human behavior. ...

See also Physics Envy by Lo and Mueller.

Noted added: I think the movie Margin Call knows more than the worst 10 of these 21 books ;-)