Future Now
The IFTF Blog
Richard Posner on preconceptions and anticipating disasters
Richard Posner writes in this week's Chronicle of Higher Education about the current financial crisis, and why experts didn't take early warnings about it seriously.
The financial crisis, when it finally struck the nation full-blown in September 2008, caught the government, the financial community, and the economics profession unawares.
We can get help in understanding the blindness of experts to warning signs from the literature on surprise attacks. Before the Japanese attack on Pearl Harbor, there were many warnings that Japan planned to attack Western possessions in Southeast Asia, and an attack on the U.S. fleet in Hawaii, known to be within range of Japan's large carrier fleet, was a logical measure, on Japan's part, for protecting the eastern flank of its attack on the Dutch East Indies, Burma, and Malaya. The warnings were disregarded because of preconceptions (including the belief that Japan would not attack the United States because it was too weak to have a reasonable chance of prevailing), the cost and difficulty of taking effective defensive measures against an uncertain danger, and the absence of a mechanism for aggregating, sifting, and analyzing warning information flowing in from many sources and for pushing it up to the decision-making level of government.
Similar factors made it difficult to heed the warning signs of the 2008 financial crisis. Preconceptions played an especially large role. It is tempting, indeed irresistible under conditions of uncertainty, to base policy to a degree on theoretical preconceptions, on a worldview, an ideology. But shaped as they are by past experiences, preconceptions can impede reactions to novel challenges. Most economists, and the kind of officials who tend to be appointed by Republican presidents, are heavily invested in the ideology of free markets, which teaches that competitive markets are, on the whole, self-correcting. Those officials and the economists to whom they turn for advice don't like to think of the economy as a kind of epileptic, subject to unpredictable, strange seizures.
Posner also makes the important point that the failure to respond quickly enough to the crisis made it worse-- that the absence of effective contingency planning doesn't just weaken your response to the crisis, but it can deepen the crisis:
By September 2008, however, the probability of a very severe recession was high enough to warrant the government's undertaking costly efforts to try to prevent the risk from materializing. Yet the officials dithered. They dithered because they were surprised by the crisis and had no contingency plans for dealing with it. Dithering in response to a financial crisis is especially costly because of the adverse feedback involved in a depression. Once a spiral of falling demand, layoffs, a further fall in demand, more layoffs, and so on begins, it feeds on itself; it requires no external source of nourishment, no further shock to the economy.
So what does he propose to do?
Most people, even most experts, were especially unlikely to be persuaded by prophets of doom in the absence of a machinery for aggregating and analyzing information bearing on large-scale economic risk. Little bits of knowledge about the shakiness of the U.S. and global financial systems were widely dispersed among the staffs of banks, other financial institutions, and regulatory bodies and among academic economists, financial consultants, accountants, actuaries, rating agencies, mortgage brokers, real-estate agents, and business journalists. There was no financial counterpart to the CIA to assemble an intelligible mosaic from the scattered pieces. Much of the relevant information was proprietary; investment banks, hedge funds, and other financial firms conceal information about business strategies that might help competitors, and they soft-pedal adverse information about the firm's prospects. Even the regulatory agencies lacked access to much crucial information about the financial system, because of limitations on their authority that were thought appropriate in an era of deregulation. Lacking authority to regulate new derivative securities such as credit-default swaps, financial regulators could not force disclosure of information that might have revealed how risky the financial system had become.
A focus of reform, therefore, should be the creation of a centralized, unitary financial-intelligence apparatus in government that would have complete and continuous access to the books of all financial institutions. This sounds simple but the details would be complex, and in my view consideration of all nonemergency reform measures should be deferred until the current economic emergency ends, or at least until the recovery has begun. Until then, it is important that the financial sector be spared additional uncertainty concerning its regulatory environment — uncertainty that would exacerbate the tendency of the banks and other financial intermediaries to freeze and hoard in the present unsettled economic conditions — and that the designers of reform not be distracted by the urgencies of responding to the current crisis.