Saturday, May 10, 2014

Could the Financial Crisis Have Been Prevented?

"Our task was first to determine what happened and how it happened so that we could understand why it happened."
    -- The Financial Crisis Inquiry Report

"The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done. If we accept this notion, it will happen again.... This is our collective responsibility. It falls to us to make different choices if we want different results."
    -- The Financial Crisis Inquiry Report

"... there are known knowns; there are things we know that we know. There are known unknowns; that is to say, there are things that we now know we don't know. But there are also unknown unknowns – there are things we do not know we don't know."
    -- Donald Rumsfeld

Your First Game of Fluxx

Have you ever played the card game Fluxx? It has only one rule: draw one card, play one card. This is how the game goes for new players:

New Player: Ok, then. My hand is Keeper: Love, Keeper: Cookies, and Goal: 5 Keepers. Ok, so now I know there are Keepers and Goals, and I can win if I play "Goal: 5 Keepers" and five Keepers. Looks like if I keep drawing Keepers, I can win! I play Cookies.

On my next turn, I draw "Goal: All You Need is Love. You win if your only Keeper is Love." Oh, no! If I knew this was a Goal of the game, I would have played Love first. By playing Cookies I have prevented myself from winning with this card! My friends snicker. Oh, well. Next time we play, I'll know to play Love as my first Keeper when I have a chance.

It's my third turn. My friends have played two other types of cards, Actions and New Rules. So now I know there are Keepers, Actions, New Rules, and Goals. I am informed by a verteran that those are the only card types in the game. Great. Now I am getting a sense of how this plays. I draw... "Creeper: Death. You must play this card immediately. This card prevents you from winning the game."

What? What? What? Everyone is surprised. The veteran (of version 1.0) checks the rules. Sure enough, we are playing Fluxx v 3.0. Creepers have been added as a type. What a disaster! We didn't know these kind of horrible things awaited us! What could happen in version 4.0?

The Creeper No One Saw Coming

"A risk that was little appreciated before 2007 was that JP Morgan and BNY Mellon could face large losses if a counterparty such as Bear defaulted during the day."
    -- The Financial Crisis Inquiry Report

“The Federal Reserve realized far too late the systemic danger inherent in the interconnections of the unregulated over-the-counter (OTC) derivatives market and did not have the information needed to act.”
    -- The Financial Crisis Inquiry Report

The financial crisis was the Creeper no one saw coming. It's the unknown unknown. Before that, September 11th was the Creeper no one saw coming. Before that, the tech bubble was the Creeper no one saw coming. Every crisis seems different.

In fact, if we are doing it right, EVERY crisis will be the Creeper no one saw coming because all the horrible things we saw coming were prevented! That's an encouraging thought. If each crisis was always exactly the same, I would be very concerned. If we've seen this EXACT same thing before, why aren't people doing anything differently this time around?

Sometimes there is literally nothing you can do about shocks that hit the economy. A hurricane is devastating to a city's economy. But could you have prevented it? Should you even try?

In fact, there may not be a need for government policy changes at all after a crisis. Rational actors will adjust. The unknown unknown became known. Hedge funds and banks don't WANT to lose money. They will anticipate that Creeper now. If they can do something to prevent the crisis from happening again, they will. Banks won't mismodel the probability of default on mortgages in the same way again.

Of course, sometimes, actors can't adjust, or the crisis was caused by institutional failures, or simply changes in the economy, and that's where government policy changes may help.

We could invest more in research to prevent future crisis that we don't know about yet. We can take stands on how the black box of the economy works. We can try new policies that upend entire sectors and see what happens. But that is potentially costly. How much do we trade off other stuff in order to investigate or attempt to control unknowns we can't even quantify (they are the unknown unknowns, remember, not the known unknowns).

It's a tough question.

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