A Crisis in Rationality
I’m currently in the process of trying to better understand what exactly happened to the economy the last few years. After all, if some dude in California defaults on his mortgage and that affects my job prospects in New York, I want to know why.
From what I understand, the underlying causes of the current financial crisis are 1) very risky mortgages, 2) very risky financial products backed by and/or based on these very risky mortgages with no historical parallel but with enormous profit potential for various players 3) years of low interest rates, or “cheap credit,” which encouraged banks to over-leverage, 4) the bursting of the housing bubble, 5) a subsequent credit freeze after homeowners defaulted on the mortgages because banks, fearing potential insolvency, were too scared to lend, 6) a lack of personal savings by most Americans that would have enabled them to continue to consume once this credit market froze, 7) the resulting decrease in consumption, leading to a decrease in production and an increase in unemployment, and 8 ) an inadequate regulatory framework that enabled all of the above to transpire.
People love to cast blame in situations like this, and for good reason. But blaming these events on things like “greed” serves no useful purpose. Richard Posner writes in his recent book A Failure of Capitalism (which he continues to update from his blog) that rational decisions, in an industry where risk is rewarded, converged with an inadequate regulatory regime to create the downward spiral we’re currently in: banks stopped lending due to the existential threat of insolvency; Americans stopped consuming because they were unable to borrow and had little or no savings in which to dip; less demand for goods and services led to layoffs and rising unemployment; and a general lack of confidence infected the stock markets, causing stock prices to plummet.
But these decisions were entirely rational. And because rational actors made rational decisions in a regulatory environment that allowed such decisions, the self-interest of individual players in the crisis should not take the brunt of the blame. Rather, the lack of regulation that permitted such behavior should be the focus of the criticism. Undesirable conduct should be either illegalized or disincentivized. Criticizing rational human conduct in an environment in which such conduct is permitted is like criticizing gravity.
