Why do smart people make big financial mistakes?
Why do financial markets present us with recurring spectacles of very smart people making very big mistakes, so that something they had judged impossible or of remote probability nonetheless happens with disastrous results?

Article Highlights

  • Booms and busts populate all of financial history.

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  • The past 15 years of finance has provided us 3 huge bubbles and their subsequent collapses.

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  • In complex, densely recursive systems, uncertainty is an unavoidable fact of life.

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Booms and busts populate all of financial history. Carmen Reinhart and Kenneth Rogoff's list of banking crises around the world since 1800 is 45 pages long. They also count 250 defaults on government debt during this period. In the 20th century's 100 years, banking crises started somewhere in 54 of them. In the U.S., 2,270 regulated commercial banks and thrifts failed in 1982-1992. During this period, more than 100 per year failed for eight years in a row.

Surely, considering all this accumulated experience, human learning, judgment and ingenuity would have figured out how to prevent such unintended, unfortunate financial adventures. The regulators and legislators of two decades ago thought so. With the advice of experts, Congress enacted the Financial Institutions Reform, Recovery and Enforcement Act of 1989; the Federal Deposit Insurance Improvement Act of 1991 and the GSE Safety and Soundness Act of 1992.  The then-Secretary of the Treasury announced that all this effort meant that "never again" would we have such problems.

He was wrong, needless to say, and we know what happened afterwards. The past 15 years of finance has provided us three huge bubbles and their subsequent collapses: tech stocks, housing and now-collapsing European government debt.

Living in the wake of a bubble is no fun, and we do not even have an antonym in English to convey the experience. "Boom" and "bust" go together, but "bubble" and – what? I believe a "shrivel" has the right image and emotional tone.

The continuing bubbles and the ensuing shrivels do not mean that the people involved are stupid. Many are brilliant. But then why do they make such disastrous mistakes so often? Some of the very smartest private and governmental financial actors contributed to creating the bubbles. This includes the mathematicians, or "rocket scientists," of Wall Street who designed complex structured securities and, it has been wittily said, built a financial missile that landed on themselves.  

"No one is in a godlike position outside the interactive system. Not central bankers. Not regulators." -Alex J. Pollock

But it has equally included, among others, central bankers. Not only did Federal Reserve actions stoke the housing boom, but transcripts released by the Fed make it clear that they entirely missed the magnitude of the problem of the housing bubble and failed to anticipate the ensuing crisis. This occurred even with diligent and constant economic forecasting by scores of intelligent and well-intentioned Ph.D. economists, armed with all the computers and databases they could desire, and earnest discussions of the outlook by senior officials.

This is emphatically not because economists are not intelligent or not trying hard. It is something profound and elusive about complex interactions of human minds, expectations, theories, partial knowledge, strategies and actions, of which the theories and forecasts of the economists, the business strategies, the regulatory rulemaking, and the central bank policies, all reflecting theories and forecasts, are enmeshed in the web of interactions. No one is in a godlike position outside the interactive system. Not central bankers. Not regulators. Not committees of central bankers nor committees of regulators chaired by the secretary of the Treasury.

Europe's banks and entire monetary system are in an agonizing crisis from the sovereign debt of financially weak governments. But the capital requirement for banks to hold such debt was zero. Being considered "risk free," which it wasn't, caused the risk of this debt to increase, helped push it into a bubble, and has led to massive and ongoing financial and political pain.

What an amazing set of blunders, it now seems, both by those who bought the debt and who wrote the capital requirement – especially given the blatant historical record of defaults by governments on their debt. But the government and private actors who made what are so obviously blunders viewed after the fact were intelligent and well-educated.

In complex, densely recursive systems, uncertainty is an unavoidable fact of life. Yet those enmeshed in such systems still have to make decisions and to act. Mistakes inevitably follow, and will continue to do so.

I am often asked, "Will we learn the lessons of the financial crisis?" "Yes, we will," I answer. "We learn the lessons after every crisis. But it doesn't stop the next one from happening."

Alex J. Pollock is a resident fellow at the American Enterprise Institute in Washington. This article is adapted from his "Financial Markets and 'System Effects': Complexity, Recursiveness, Uncertainty and Mistakes in Finance" published by AEI.

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