This is a paper I just wrote for the International Financial Crisis class. Much of it is based on the book Fault Lines, but some of it is also my own analysis.
The incentives of US financial firms and political pressures on the US government were based on expectations for the US economy that may be outdated. These expectations about the American dream have led to a smaller safety net compared to European countries and also resistance against redistributive taxes. In response to jobless recoveries, Americans came to favor expanding credit over strengthening the safety net. At the same time, high expectations for the digital information age have led to a false sense of security while competition for growth intensified in the financial industry. Popular unrest in the form of the Tea Party and the Occupy movements show that Americans are reevaluating their expectations as the recovery inches along.
The US economy developed over years of slow growth with relatively low amounts of government intervention. Because of this, there is a strong faith in the efficiency of markets, individual incentive, and competition. A small safety net for the unemployed is appropriate for a competitive economy that quickly reallocates labor to more productive uses. At the same time, Americans began to take this to an extreme, recategorizing public education and progressive taxes (such as the estate tax) as welfare services. They became reluctant to properly fund schools or redistribute wealth, leading to growing wealth inequality and skills disparity among the labor force.
Until 1991, post-war recessions were short and jobs were quickly recovered since workers were strongly motivated to find work to regain health insurance and other benefits. However, the recession in 1991, 2001, and 2008 have been increasingly jobless. This could possibly be because of structural changes in the economy, but may also be because underfunding education is finally impacting the labor market. To adjust to this development, it has been more political feasible to lower interest rates to stimulate investment and expand Americans’ access to credit rather than enlarge the safety net.
Meanwhile, as information became digitized, it became easier and quicker to access and analyze information. It is possible that financial firms and the public overestimated the quality of this information. The trustworthiness of a broker is masked by the professional detachment of a database. The digital age gave financial firms the ability to create and distribute more complicated instruments more quickly. Risk models are more sophisticated and complex, but complexity also makes models and underlying data more difficult to scrutinize. Furthermore, these models were proprietary and thus although there is more data available, many institutions including the regulatory agencies do not yet have the capacity or tools to analyze them. Data itself cannot be equated with transparency.
The focus on performance in financial firms and confidence in digital information caused bankers to take on tail-risk to increase returns or be replaced. Tail-risk is a low probability but extremely high cost risk. When tail-risk is systematically ignored, the probability increases significantly. This isn’t exactly because the risk models are wrong, but because the operating point of the risk model has moved to where actions of bankers and investors are correlated rather than independent. The public became accustomed to high levels of growth of their investments without considering whether the disproportionate growth of the financial sector was consistent with the amount of value added.
High expectations for the efficiency of markets leading to expanding credit, high expectations for the quality of information in the digital age, and high expectations for the performance of the financial sector set the stage for the financial crisis. When the crisis hit, almost everyone was extremely surprised. The large disconnect between the public’s view of the economy and the reality is evident in the outcry when the government bailed out Wall Street to prevent a crash on Main Street. At the same time, the American public may be adjusting their expectations. Healthcare reform was signed into law in 2010 and the financial industry is in the process of downsizing. It remains to be seen whether the adjustment will be enough to avoid old patterns of behavior and additional economic strife.