Never Saw It Coming - Why the Financial Crisis Took Economists By Surprise

(Yuriko Nakao / Courtesy Reuters)

It was a call I never expected to receive. I had just returned home from playing indoor tennis on the chilly, windy Sunday afternoon of March 16, 2008. A senior official of the U.S. Federal Reserve Board of Governors was on the phone to discuss the board’s recent invocation, for the first time in decades, of the obscure but explosive Section 13(3) of the Federal Reserve Act. Broadly interpreted, that section empowered the Federal Reserve to lend nearly unlimited cash to virtually anybody: in this case, the Fed planned to loan nearly $29 billion to J.P. Morgan to facilitate the bank’s acquisition of the investment firm Bear Stearns, which was on the edge of bankruptcy, having run through nearly $20 billion of cash in the previous week.

The demise of Bear Stearns was the beginning of a six-month erosion in global financial stability that would culminate with the failure of Lehman Brothers on September 15, 2008, triggering possibly the greatest financial crisis in history. To be sure, the Great Depression of the 1930s involved a far greater collapse in economic activity. But never before had short-term financial markets, the facilitators of everyday commerce, shut down on a global scale. As investors swung from euphoria to fear, deeply liquid markets dried up overnight, leading to a worldwide contraction in economic activity.

The financial crisis that ensued represented an existential crisis for economic forecasting. The conventional method of predicting macroeconomic developments -- econometric modeling, the roots of which lie in the work of John Maynard Keynes -- had failed when it was needed most, much to the chagrin of economists. In the run-up to the crisis, the Federal Reserve Board’s sophisticated forecasting system did not foresee the major risks to the global economy. Nor did the model developed by the International Monetary Fund, which concluded as late as the spring of 2007 that “global economic risks [had] declined” since September 2006 and that “the overall U.S. economy is holding up well . . . [and] the signs elsewhere are very encouraging.” On September 12, 2008, just three days before the crisis began, J.P. Morgan, arguably the United States’ premier financial institution, projected that the U.S. GDP growth rate would accelerate during the first half of 2009. The pre-crisis view of most professional analysts and forecasters was perhaps best summed up in December 2006 by The Economist: “Market capitalism, the engine that runs most of the world economy, seems to be doing its job well.”

What went wrong? Why was virtually every economist and policymaker of note so blind to the coming calamity? How did so many experts, including me, fail to see it approaching? I have come to see that an important part of the answers to those questions is a very old idea: “animal spirits,” the term Keynes famously coined in 1936 to refer to “a spontaneous urge to action rather than inaction.” Keynes was talking about an impulse that compels economic activity, but economists now use the term “animal spirits” to also refer to fears that stifle action. Keynes was hardly the first person to note the importance of irrational factors in economic decision-making, and economists surely did not lose sight of their significance in the decades that followed. The trouble is that such behavior is hard to measure and stubbornly resistant to any systematic analysis. For decades, most economists, including me, had concluded that irrational factors could not fit into any reliable method of forecasting.

Financial firms believed that if a crisis developed, the insatiable demand for exotic products would dissipate only slowly. They were mistaken.

But after several years of closely studying the manifestations of animal spirits during times of severe crisis, I have come to believe that people, especially during periods of extreme economic stress, act in ways that are more predictable than economists have traditionally understood. More important, such behavior can be measured and should be made an integral part of economic forecasting and economic policymaking. Spirits, it turns out, display consistencies that can help economists identify emerging price bubbles in equities, commodities, and exchange rates -- and can even help them anticipate the economic consequences of those assets’ ultimate collapse and recovery.


(Ib Ohhlson)



The economics of animal spirits, broadly speaking, covers a wide range of human actions and overlaps with much of the relatively new discipline of behavioral economics. The study aims to incorporate a more realistic version of behavior than the model of the wholly rational Homo economicus used for so long. Evidence indicates that this more realistic view of the way people behave in their day-by-day activities in the marketplace traces a path of economic growth that is somewhat lower than would be the case if people were truly rational economic actors. If people acted at the level of rationality presumed in standard economics textbooks, the world’s standard of living would be measurably higher.

From the perspective of a forecaster, the issue is not whether behavior is rational but whether it is sufficiently repetitive and systematic to be numerically measured and predicted. The challenge is to better understand what Daniel Kahneman, a leading behavioral economist, refers to as “fast thinking”: the quick-reaction judgments on which people tend to base much, if not all, of their day-to-day decisions about financial markets. No one is immune to the emotions of fear and euphoria, which are among the predominant drivers of speculative markets. But people respond to fear and euphoria in different ways, and those responses create specific, observable patterns of thought and behavior.

Perhaps the animal spirit most crucial to forecasting is risk aversion. The process of choosing which risks to take and which to avoid determines the relative pricing structure of markets, which in turn guides the flow of savings into investment, the critical function of finance. Risk taking is essential to living, but the question is whether more risk taking is better than less. If it were, the demand for lower-quality bonds would exceed the demand for “risk-free” bonds, such as U.S. Treasury securities, and high-quality bonds would yield more than low-quality bonds. It is not, and they do not, from which one can infer the obvious: risk taking is necessary, but it is not something the vast majority of people actively seek.


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commented 2014-01-06 18:08:43 -0500 · Flag
Delroi writes:

same as it ever was. NO STATESMEN. NO CIVIC FORETHOUGHT. NO LONG-BALL VISION. “all through the day, i, me, mine i, me, mine, i, me, mine…”
commented 2014-01-06 18:07:42 -0500 · Flag
Delroi writes:

the very reason they founded a constitutional republic, not a democracy. the founders were true students of western canon/philosophy… the knew their descartes/kant/hume/hobbes/locke/rousseau/seneca/cicero/etc… this is the essential beauty of the founding documents (declaration of independence, constitutional, bill of rights, federalist papers). for that reason, they knew an informed polity was essential for sustainability of constitutional republic… you don’t get the majority to engage in self-defeat via voting themselves cash from the trough until you have imbecilified them and rendered any civics lessons and respect for history’s lessons as quaint curios. the fabian socialist knew this, and thus infiltrated the public school system first…don’t try to fell the tree with an axe of revolt, poison the root instead.

my problem with all of this is that i see critical shortcomings — some unavoidable, some addressable — at every defining inflection point when the opportunity to introduce true governance and capitalism is at hand.

example: the founders allowed slavery to continue as the price for southern participation in a new federalized nation-state. the south’s ‘peculiar institution’ was nearly (and might end up still being) the terminal flaw in our dna. we allowed ~25% of the population to remain in quasi-human indentured servitude for another ~75 years after our official founding. and then allowed a shadow sub-human caste system to remain for another 100 years thereafter. the fruits of this error? (1) a rank mockery of the philosophy underscoring the texts of our founding documents [‘we hold these truths to be self-evident, that all men are created equal…’]; (2) ultimately gave rise to a civil war, unique in history in its motivations, which killed & maimed 1.4 million of it’s citizens, tragically to almost no avail, because for 100 years after the cessation of hostilities, the entire south was still ruled by de-facto jim crow laws that maintained a slavery caste system; (3) steeped a quarter of our population in a victimology legacy that >>to this day