Reviewing 21 books on the 2007 crisis: Facts vs Fantasies

Andrew Lo of MIT’s this paper  really helps as it reviews 21 books on the crisis (HT: Cowen).

Though  Lo just gives a very brief overview of the books, atleast now you know what each one is talking about. I have not read any of these books fully (as most get repetitive after a while, papers are so much better) so is really helpful.

He says sch an exercise it is much like Kurosawa’s film Roshomon:

In Akira Kurosawa’s classic 1950 film Rashomon, an alleged rape and a murder are described in contradictory ways by four individuals who participated in various aspects of the crime. Despite the relatively clear set of facts presented by the different narrators—a woman’s loss of honor and her husband’s death—there is nothing clear about the interpretation of those facts. At the end of the film, we’re left with several mutually inconsistent narratives, none of which completely satisfies our need for redemption and closure. Although the movie won many awards, including an Academy Award for Best Foreign Language Film in 1952, it was hardly a commercial success in the United States, with total U.S. earnings of $96,568 as of April 2010.1 This is no surprise; who wants to sit through 88 minutes of vivid story-telling only to be left wondering whodunit and why?

Six decades later, Kurosawa’s message of multiple truths couldn’t be more relevant as we sift through the wreckage of the worst financial crisis since the Great Depression. Even the Financial Crisis Inquiry Commission—a prestigious bipartisan committee of  0 experts with subpoena power who deliberated for 18 months, interviewed over 700 witnesses, and held 19 days of public hearings—presented three different conclusions in its final report. Apparently, it’s complicated.

He looks at some initial papers on the crisis and says one can argue both for and against the causes pointed by authors. If one paper says high leverage was the reason, other says leverage was even higher earlier.

However, if Kuroshawa was alive and was to write an op-ed he would have written to continue writing:

it may seem like sheer folly to choose a subset of books that economists might want to read to learn more about the crisis. After all, new books are still being published today about the Great Depression, and that was eight decades ago! But if Kurosawa were alive today and inclined to write an op-ed piece on the crisis, he might propose Rashomon as a practical guide to making sense of the past several years. Only by collecting a diverse and often mutually contradictory set of narratives can we eventually develop a more complete understanding of the crisis. While facts can be verified or refuted—and we should do so expeditiously and relentlessly—we must also recognize the possibility that more complex truths are often in the eyes of the beholder.

This fact of human cognition doesn’t necessarily imply that relativism is correct or desirable; not all truths are equally valid. But because the particular narrative that one adopts can color and influence the subsequent course of inquiry and debate, we should strive at the outset to entertain as many interpretations of the same set of objective facts as we can, and hope that a more nuanced and internally consistent understanding of the crisis emerges in the fullness of time.

His list of 21 books includes 11 by  economists and 10 by journalists.   The difference between acads and journos is that latter relies more on anecdotes, connections, media reporting etc. Acad books are more researched and empirical with close examination of their and other theories

I am not looking at all of the books but just mention one from each which tops Lo’s list (he does not rank them but praise for the books does indicate).

Amidst the econ books he seems to prefer This time is different by Rogoff- Reinhart:

By the fall of 2009, the outlines of the early stages of the financial crisis were clear, although the exact causation (or the blame) remained a point of vigorous contention. With the September publication of This Time Is Different: Eight Centuries of Financial Folly, Carmen M. Reinhart and Kenneth Rogoff provided invaluable historical data and context for understanding the crisis. Among all the books reviewed in this article, theirs is the most richly researched and empirically based, with almost 100 pages of data appendices. If all authors of crisis books were required to support their claims with hard data, as Reinhart and Rogoff do most of the time, readers would be considerably better off and our collective intelligence would be far greater.

This vast compendium of financial crises showed that the 2007 subprime meltdown was neither unprecedented nor extraordinary when compared to the historical record. Reinhart and Rogoff briefly document the “this time is different” thinking among investors, academics, and policymakers.

RR link the housing bubble to capital inflows to US which just made the whole thing unsustainable after a point. Hence the crash. And as Rogoff has said in multiple forums that debt financed housing bubbles and financial crisis plus recessions take a while to resolve. What is RR solution? One, to have early warning systems (not sure whether they can work) and more detailed monitoring of national financial data preferably via new international financial institution.

What about the journalists? It is likely to be Too big to Fail by Andrew Ross Sorkin:

During the autumn of 2009, The New York Times columnist Andrew Ross Sorkin published Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves. Its release came a little over a year after the critical events of September 2008 (speaking generally for all these books, one has to be impressed by their speed from crisis to print). Sorkin’s account is perhaps the best single descriptive narrative of the top levels of the 2008 phase of the crisis  that we have, and as memories fade, self-justifications harden, and participants leave the scene, it’s likely to remain the best anecdotal summary of these events. As one of The New York Times reporters covering the crisis, Sorkin had an unusual amount of access to participants and observers both during and after the events of 2008. Too Big to Fail must represent the distillation of hundreds, if not thousands of hours of off-the-record interviews, tapes, videos, and more conventional sources.

However, Sorkin’s wide scope and multiple viewpoints of the crisis represent a tradeoff with respect to deeper analysis. His book is probably best read in conjunction with other accounts as a reference point.

What are the lessons from his readings:

There are several observations to be made from the number and variety of narratives that the authors in this review have proffered. The most obvious is that there is still significant disagreement as to what the underlying causes of the crisis were, and even less agreement as to what to do about it. But what may be more disconcerting for most economists is the fact that we can’t even agree on all the facts. Did CEOs take too much risk, or were they acting as they were incentivized to act? Was there too much leverage in the system? Did regulators do their jobs or was forbearance a significant factor? Was the Fed’s low interest-rate policy responsible for the housing bubble, or did other factors cause housing prices to skyrocket?

Was liquidity the issue with respect to the run on the repo market, or was it more of a solvency issue among a handful of “problem” banks? For financial economists—who are used to dealing with precise concepts such as noarbitrage conditions, portfolio optimization, linear risk/reward trade-offs, and dynamic hedging strategies—this is a terribly frustrating state of affairs. Many of us like to think of financial economics as a science, but complex events like the financial crisis suggest that this conceit may be more wishful thinking than reality. John Maynard Keynes had even greater ambitions for economics when he wrote, “If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid”. Instead, we’re now more likely to be thought of as astrologers, making pronouncements and predictions without any basis in fact or empirical evidence.

He says we should approach research on financial crisis and recessions as we do for airplane crashes. National Transportation Safety Board does a real good job of understanding any plane crash. Though straight application is difficult in financial markets, some lessons could still be taken.

Given that we can’t even agree on a set of facts surrounding the financial crisis, nor do we fully understand what the “correct” operation of a financial institution ought to be in every circumstance, the challenges facing economists are far greater than those faced by the NTSB. However, the stakes are also far higher, as we’ve witnessed over the past four years. There is a great deal to be learned from the NTSB’s methods and enviable track record, as Fielding, Lo, and Yang (2011) illustrate in their case study of this remarkable organization. And one of the most basic elements of their success is starting with a single set of incontrovertible facts. In other words, we need the equivalent of the “black box” flight  data recorder for the financial industry, otherwise we may never get to the bottom of any serious financial accident.

He says there are some major myths surrounding the crisis and one of them is SEC-2004 regulation which allowed i-banks to increase leverage. He says this is just a myth as i-banks has higher leverage even earlier:

While these “facts” seemed straightforward enough, it turns out that the 2004 SEC amendment to Rule 15c3–1 did nothing to change the leverage restrictions of these financial institutions. In a speech given by the SEC’s director of the Division of Markets and Trading on April 9, 2009 (Sirri, 2009), Dr. Erik Sirri stated clearly and unequivocally that “First, and most importantly, the Commission did not undo any leverage restrictions in 2004”. He cites several documented and verifiable facts to support this surprising conclusion, and this correction was reiterated in a letter from Michael Macchiaroli, Associate Director of the SEC’s Division of Markets and Trading to the General Accountability Office (GAO) on July 17, 2009, and reproduced in the GAO Report GAO–09–739 (2009, p. 117).

He points that this story fit well with the perception that rising leverage was a problem. So no one even checked the facts and most big names actually used this to press their points. Infact the error remains uncorrected:

As of October 19, 2011, The New York Times has yet to print a correction of its original stories on the 2004 change to Rule 15c3–1, nor did the Times provide any coverage of Dr. Sirri’s April 9, 2009 speech. Correcting mistaken views and factual errors may not be news, but it does make for good economic science.


Superb effort by Dr Lo. Much appreciated..

One Response to “Reviewing 21 books on the 2007 crisis: Facts vs Fantasies”

  1. A weekend guide on the global financial crisis « Mostly Economics Says:

    […] the paper they summarise 16 other papers which touch on various aspects crisis (I just pointed to a paper which summarised books on the […]

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