The Queen of England asked a very pertinent question as to why no one was able to predict the financial mess the world was getting embroiled in. A few economists tried to defend their profession by saying that they had predicted a problem but no one had listened to them. Even if a few of them did predict it, they were not able to stall it or reduce its impact. Going by academic record and other abilities, some of the best minds are part of the financial world. So, how did so many sharp minds fail to foresee the impending issue? In these days of sophisticated data, supercomputers and mind-boggling algorithms, why were people unable to foresee the looming disaster?
By now, we have heard a lot about the greed of investment bankers and the ineptitude of rating agencies and how that created the environment for a large-scale breakdown. But that does not fully explain the situation. There were also a very large number of shrewd investors who could not see through the smokescreen. A simple yet powerful explanation seems to be “lack of common sense”. In “statistical parlance” you would call it a “predominant factor” that helps explain the underlying reason for many attributes. I am reminded of one of our schoolteachers who used to say “common sense is very uncommon”. He had a deep insight into human nature, having spent most of his adult life managing unruly boys.
To a large extent, the housing bubble in the US started the mess. In hindsight, it appears both irrational and strange that everyone expected prices to go up continuously. The sensitivity models in most mortgage companies played around only with different levels of percentage increases. If some of these models had also taken the probability of price drops, the actions taken would have been very different. The expected return would have ranged from a positive net earning to a significant loss. After so many years of growth, common sense should have dictated that a decline was very possible. The failure to expect failure finally resulted in a fiasco of unimaginable proportions.
One wonders why loans were given to people who had no capacity to repay. It was like asking a non-swimmer to dive in at the shallow end and swim towards the deep end. To entice would-be home-owners, interest rates were kept very low. In terms of economics, demand was inflated artificially by easy credit availability at very low interest rates. The irony is that the loans that were doomed to cause the bust also inflated revenues of many lending agencies and banks, resulting in hefty bonuses based on chimerical profits.
Savvy financial investors (institutions and individuals) bought instruments that they did not understand. Maybe rigorous questions were not asked to show that they had understood the complicated probabilities on which the derivatives were based. Common sense would dictate that you don’t dabble in something you know nothing or very little about. Since everyone was happily investing, it would have been foolish to ignore the enticement of quick returns. In retrospect, appearing foolish for a while by asking more questions to fully comprehend the complicated math might have reduced the impact of the final collapse. Seriously questioning the AAA ratings for risky and dubious instruments should have caused alarm bells to ring long ago.
Even now (when sanity should have set in), the tendency is to gloss over the final cost of the meltdown. The latest International Monetary Fund estimates put the extent of worldwide wealth erosion at $4 trillion,?and so far only about one-fourth of that has been written down. At some stage, the past losses will catch up with us and recognizing them will become unavoidable. The jury is out on which approach would be better—the current one of managing the festering wound by changing the bandage periodically (in the form of deficit financing) or making a surgical cut which might cause excruciating pain to fix the issue fast. I leave it to your common sense to decide.
Vivek Bali is director of ANV Consulting Pte Ltd. Comment at firstname.lastname@example.org