Understanding the 2008

Financial Crisis
3. Economic theories and the
crisis
Nicoli Nattrass
Centre for Social Science Research
University of Cape Town
January 2015

Generating the wrong incentives

Bonuses and executive pay generated
incentives to increase leverage and take on
more risk (Raghuram Rajan). He proposed that
executive pay should be managed.
But this flew against the conventional
wisdom of free-market ideology (and neoclassical economics).
See How Markets Fail, pages 21-24 (on the 2005 Rajan paper)
and chapters 2-8 for a history of free-market economics)

Some economists like

Nouriel Roubini and
Paul Krugman had
warned about the
bubble but had
been ignored by
those believing in the
invisible hand of the
free market.

Alan Greenspan
Chair of the US Federal Reserve
from 1987-2006 (previously served as a director of JP
Morgan)
Had great faith in the ability of markets to regulate
themselves. After the 2008 crisis he admitted in a
televised congressional hearing (chaired by Henry
Waxman) that he had found a flaw in his ideology and
had made a mistake in presuming that the selfinterests of organizations, especially banks and others,
were such that they were best capable of protecting
their own shareholders and their equity in the firm
(See Cassidy, How Markets Fail, Introduction)

Mistaking beauty for truth (Krugman)

Assumption of free-market theory (perfect
information, perfect competition) results in
socially optimal outcomes (what Cassidy calls the
illusion of harmony).
The idea that financial markets were so efficient
that stock prices displayed a random walk,
(Cassidy calls this the illusion of stability and the
illusion of predictability). This approach
(pioneered by Eugene Fama) implies that looking
at the fundamentals of stocks is unnecessary
rather just invest in unit trusts.

In 1975 Stiglitz and Grossman critiqued the efficient market

hypothesis on the grounds that it was based on a logical
inconsistency:
If stock prices at every moment reflected all of the available
information about the economic outlook and other factors
pertinent to individual companies, investors wouldnt have any
incentive to search out information and process it. But if nobody
finds and processes information, stock prices wont reflect that
information and the market wont be efficient. For the market to
work at all there must be some level of inefficiency. Grossman
and Stiglitz entitled their paper On the impossibility of
Informationally efficient markets. Other economic theorists
admired its terse logic, but it didnt have much immediate impact
on Wall Street (How Markets Fail, page 94).

Cassidy: How Markets Fail, page 91-2 on the mean variance approach
(assuming a bell curve) and page 93.

Consider the following option: A December 2015 put on IBM

with a strike of $150 gives you the right to sell a share in IBM
for $150 in December 2015. If you write (i.e. sell) a put, you are
insuring the buyer against the possibility that the value of the
stock will fall below the strike price. How much do you charge?
To compute the value of an option using the BlackScholes formula, all you needed, in addition to the strike
price, the current price, and the duration of the option,
was the interest rate on government bonds, the standard
deviation of the stock, and a table of the normal
distribution. By the end of 1973, you did not even need a
pen and paper to do the calculation: Texas Instruments
had introduced a calculator to do it for you (How Markets
Fail, page 93)
A huge risk management industry was thus born assuming they
now understood risk

 Myron Scholes got a Nobel

prize in 1997 the year
before his own firm, Long
Term Capital Management
collapsed due to bad
derivative bets..
The collapse resulted in a
$3.6 billion recapitalization
bailout by a group of 16
banks under the
supervision of the Fed.
It was liquidated and
dissolved in early 2000
Why did this lesson not get
learned?

Collateralised debt obligation (CDOs) rated AAA

BBB rated tranches

Mortgage bonds
made up of pools
of home loans

Mortgage bonds
made up of pools
of home loans

NB: CDOs
made up of
BBB tranches
were still
rated AAA
because the
model saw
them as
diversified
CDSs were
priced low
according to
Black Scholes

The market seemed to believe its own

lie (The Big Short page 129)
The genius of Cornwall Capitals bet: To pay 0.5%
a year on a bet against the AAA rated CDOs
because they were made up of BBB-rated
underlying mortgage bonds (which had cost
Michael Burry 2% to bet against). The Big Short
page 129.
But this still begs the question why anyone
trusted the rating agencies, especially given their
reputation on Wall Street (Big Short, pages 1539)..

John Maynard Keynes on the stock market

Keynes argued that as financial markets
developed, the risk of speculation
predominating over enterprise rises:
Speculators may do no harm as bubbles
on a steady stream of enterprise. But the
position is serious when enterprise
becomes the bubble on a whirlpool of
speculation. When the capital
development of a country becomes the
by-product of the activities of a casino,
the job is likely to be ill-done.

 Keynes argued that in the presence of

uncertainty, people make judgements based on
current prices and what others are saying and
doing (a conventional judgement.
This, being based on so flimsy a foundation, is
subject to sudden and violent changes.... New
fears and hopes will, without warning, take
charge of human conduct.... All these pretty
polite techniques made for a well-panelled Board
Room, and a nicely regulated market are liable to
collapse.... I accuse the classical economic theory
of being one of those pretty, polite techniques
which tries to deal with the present by
abstracting from the fact that we know very little
about the future .
Keynes, J. M. 1937. The General Theory of Employment.
In Quarterly Journal of Economics, vol.51, no.2: 209-223.

Keynesians argue that

financial sector
turbulence directly
affects the real
economy through its
impact on credit and
demand.

9 million jobs were lost in the US as a result

of the 2008 financial crisis (and it took until
the end of 2014 to get them back)

In 2008 there was a

balance sheet
recession. People saved
more to reduce debt,
which in turn reduced
demand, caused
problems for
businesses, resulted in
layoffs, and even lower
demand.

Hyman Minsky
Student of Joseph Schumpeter.
Minsky argued that capitalism was
inherently unstable because of the
activities of the financial sector which
resulted in periodic processes of
increasing financial fragility. In an ironic
reference to the efficient markets
hypothesis, he called this the financial
instability hypothesis

See discussion of
Minsky in Cassidy,
How Markets Fail,
Chapter 16

Minsky argued that rising debt levels were associated with

increasingly risky lending and hence the possibility of a crash
ending up in a downward spiral as households tried to increase
their savings and reduce debt (the so-called Minsky moment)

Minsky not only took the incentives facing investment bankers

seriously, but he assumed that they would necessarily innovate
and seek ever riskier lending opportunities
In contrast to the orthodox Quantity Theory of
Money, the financial instability hypothesis takes
banking seriously as a profit-seeking activity.
Banks seek profits by financing activity and
bankers. Like all entrepreneurs in a capitalist
economy, bankers are aware that innovation assures
profits. Thus bankers (using the term generically
for all intermediaries in finance), whether they
be brokers or dealers, are merchants of debt who
strive to innovate in the assets they acquire and
the liabilities they market. http://www.levyinstitute.org/pubs/wp74.pdf

He argued that capitalism had become money manager capitalism

because most liabilities of corporations are held by financial
institutions where the money is managed by these bankers

Minsky identified three types of finance:

Hedge finance (anticipated revenues exceed running costs
and debt and interest payments);
Speculative finance (can meet their interest payments but
can only repay the principle if the asset price rises) and;
Ponzi finance (projected earnings cannot possibly meet
obligations).
If hedge financing dominates, then the economy may
well be an equilibrium seeking and containing system.
In contrast, the greater the weight of speculative and
Ponzi financing, the greater the likelihood that the
economy is a deviation amplifying system.. But he also
argued that over periods of prolonged prosperity, the
economy transits from financial relations that make for
a stable system to financial relations that make for
and unstable system.

Crashes caused by Ponzi finance are known as Minsky moments

ICELAND
Banks privatized in 2002
From 2003 to 2007 the value of the US stock market
doubled: the value of the Icelandic stock market rose 9
fold; and house prices tripled. In 2006 the average Icelandic
family was three times wealthier than it had been in 2003
and virtually all of this wealth was linked to the financial
sector.
The banks created fake capital by borrowing money from a
abroad, relending the money to themselves to by assets
(many of them inflated by the boom).
When the banks collapsed Iceland had $100 billion in
banking losses (about $330,000 for every person in
Iceland).
The bubble was obvious, had been described by Robert
Aliber in 2006 yet other economists white-washed it.
Economists as corrupt: The Inside Job (1.19.12 1.29.44)