Won’t Be Fooled Again?

January 06, 2010

The New York Times’ David Leonhardt has a trenchant piece published in its January 5, 2010 edition that highlights a critical lesson of the financial crisis.  Summarizing Bernanke’s recent speech before the American Economic Association in which he blamed lax regulation rather than interest rate decisions for the mortgage and finance crisis, Leonhardt notes that while asset bubbles of any kind are hard to call, the Fed and other regulators had plenty of warning.  Experts within and outside of the government amassed and arrayed all kinds of data pointing to unsustainable housing price growth.  And consumer advocates and others were clamoring for the Fed and other regulators to spike the dangerous mortgages that helped fuel the bubble using regulatory authorities they already had.  Leonhardt asks, 

So why did Mr. Greenspan and Mr. Bernanke get it wrong?

The answer seems to be more psychological than economic. They got trapped in an echo chamber of conventional wisdom. Real estate agents, home builders, Wall Street executives, many economists and millions of homeowners were all saying that home prices would not drop, and the typically sober-minded officials at the Fed persuaded themselves that it was true. “We’ve never had a decline in house prices on a nationwide basis,” Mr. Bernanke said on CNBC in 2005.

He and his colleagues fell victim to the same weakness that bedeviled the engineers of the Challenger space shuttle, the planners of the Vietnam and Iraq Wars, and the airline pilots who have made tragic cockpit errors. They didn’t adequately question their own assumptions. It’s an entirely human mistake.

Which is why it is likely to happen again.

He might have added CIA officials who invited last week’s suicide bomber/triple agent onto their base where he blew up himself and seven officers, or all of the intelligence agency employees who handled intelligence about the Under-Bomber but were unable to put the puzzle pieces together and stop him.  

Human frailty and the reluctance of large organizations to change course when confronted with complex datasets and decisions that challenge orthodoxy are constants.  This is especially true when entrenched interests—both inside and outside organizations  — stand to lose if policies are changed.  As Leonhardt points out, acknowledging failure and analyzing its roots is the first step in reducing the chances of it happening again.  Organizational cultures have to support contrary views and reward decision making that forces people outside of the comfortable boxes in which they live day to day.  Breeding a culture of curiousity and challenge makes big shots uncomfortable.  But it can also spark unconventional thinking that puts old “certainties” under pressure and forces recognition—or at least preparation for—events that rock the boat and shift key assumptions.  

This is one reason that the proposals to create a Consumer Financial Protection Agency make so much sense to me.  Opponents, including Bernanke, argue that a separate agency will separate prudential from consumer oversight and regulation.  This disconnect will weaken regulators’ ability to see the “big picture,” and potentially put the two at odds.  Bankers argue that this potential tension will put them in an untenable position and at a minimum greatly increase their regulatory burdens. 

But the prudential agencies subordinated consumer interests consistently to those of the companies they were regulating.  The Fed and other prudential regulators had all the regulatory tools they needed to spike the excesses of the mortgage industry that led to the crisis.  Indeed, consumer advocates and others implored them to do so.  They did not.  An agency tasked with examining these issues from a consumer protection point of view is likely to see things differently and challenge the orthodox views of a regulator tuned to a safety and soundness frequency.  

When something ain’t broke, it’s reasonable to argue against fixing it. But broken systems that fail to work as designed should be fixed.  A total shift of responsibility that puts consumer protection first is one way to do it.