"Shared delusions" run deep with risks
Letter to the Editor

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Article Highlights

  • Assets that are perceived as safe become #risky and consequently cause crises

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  • Intelligent people rationalize asset expansion, but these are usually self-falsifying ideas #itsbeendone

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  • Emotional performances lead the #US into risky situations #sappy #debt

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Andrew Kahr's excellent discussion of how "Systemic Risk Is About Assets, Not Size" rightly focuses on bubble-inflating movements in the aggregate balance sheet of the financial sector. We should expand on three of his insightful points:

1. "When the industry as a whole gorges itself on a new class of assets," it is likely to be assets previously well behaved with attractive credit experience. As Richard Milne wrote recently in the Financial Times, "Risky assets do not cause crises. It is those perceived as being safe that do." Precisely because they are perceived as safe, they become risky.

Perceptions of uncertain future events like credit safety or credit risk are inherently subjective and highly influenced by the views of all the others who are doing what you are doing. That is why (in my paraphrase of a famous thought of J.M. Keynes) a prudent banker is one who goes broke when everybody else goes broke!

2. "Banks' shared delusions generate systemic risk"--yes indeed, but bankers are far from alone in sharing the delusions. The cognitive herding also includes regulators, consultants, central bankers, investment bankers, investment managers, entrepreneurs, brokers, accountants, academics, rating agencies, borrowers, speculators, and in a leading role, politicians. Plausible and clever rationalizations for why the systemic risk-generating asset expansion is a good idea are always produced by very intelligent people, going back at least to John Law in 1717, whose ideas turn out to be self-falsifying.

3. "A sappy emotional preference for promoting further European integration" led the march into the European sovereign debt debacle. Yes: and a sappy emotional preference for promoting housing led our own mass march into the debt quagmire. O Tempora, O Mores!

Alex Pollack is a resident fellow at AEI.

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About the Author

 

Alex J.
Pollock
  • Alex J. Pollock is a resident fellow at the American Enterprise Institute (AEI), where he studies and writes about housing finance; government-sponsored enterprises, including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks; retirement finance; and banking and central banks. He also works on corporate governance and accounting standards issues.


    Pollock has had a 35-year career in banking and was president and CEO of the Federal Home Loan Bank of Chicago for more than 12 years immediately before joining AEI. A prolific writer, he has written numerous articles on financial systems and is the author of the book “Boom and Bust: Financial Cycles and Human Prosperity” (AEI Press, 2011). He has also created a one-page mortgage form to help borrowers understand their mortgage obligations.


    The lead director of CME Group, Pollock is also a director of the Great Lakes Higher Education Corporation and the chairman of the board of the Great Books Foundation. He is a past president of the International Union for Housing Finance.


    He has an M.P.A. in international relations from Princeton University, an M.A. in philosophy from the University of Chicago, and a B.A. from Williams College.


  • Phone: 202.862.7190
    Email: apollock@aei.org
  • Assistant Info

    Name: Emily Rapp
    Phone: (202) 419-5212
    Email: emily.rapp@aei.org

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