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Why academia failed to see the financial crash coming

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Soul searching over who’s to blame for the financial-system meltdown, UC Berkeley economics professor Barry Eichengreen takes aim at his own profession.

In a highly readable piece on nationalinterest.org, Eichengreen writes:

The Great Credit Crisis has cast into doubt much of what we thought we knew about economics. . . . The question is how we could have been so misguided. One interpretation, understandably popular given our current plight, is that the basic economic theory informing the actions of central bankers and regulators was fatally flawed. But another view, considerably closer to the truth, is that the problem lay not so much with the poverty of the underlying theory as with selective reading of it . . . [which] encouraged financial decision makers to cherry-pick the theories that supported excessive risk-taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists whose scholarship provided intellectual justification for the financial institutions’ decisions. The consequence was that scholarship that warned of potential disaster was ignored.

Eichengreen goes on to look at Wall Street’s post-1987-crash concept of measuring daily ‘value at risk’ and how business-school curricula embraced the concept, feeding the beast.

Value-at-risk models in the financial business ‘should have been regarded as no more than starting points for serious thinking,’ Eichengreen writes. ‘Instead, those responsible for making key decisions, institutional investors and their regulators alike, took them literally. . . .

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‘This reflected the seductive appeal of elegant theory. Reducing risk to a single number encouraged the belief that it could be mastered. It also made it easier to leave early for that weekend in the Hamptons.’ As for why academia didn’t sound more alarm bells about the buildup of ridiculous risk-taking in the financial system, Eichengreen says:

Generous speaker’s fees were . . . available to those prepared to drink the Kool-Aid. Not everyone indulged. But there was nonetheless a subconscious tendency to embrace the arguments of one’s more ‘successful’ colleagues in a discipline where money, in this case earned through speaking engagements and consultancies, is the common denominator of success.

I urge reading his entire piece. It’s far more interesting (and honest) than any explanation Alan Greenspan has yet offered for what went wrong.

-- Tom Petruno


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