Small World

Humans have a remarkable capacity to be surprised by the obvious. We are frequently astonished not just by events that were easily predictable, but by outcomes that were, in fact, widely predicted. The crash of 2008 had many causes. Yet one critical precondition was an error so banal, and so widespread, that it makes your head spin. People seemed to believe that American house prices literally could not fall.

In a rational world, the run-up in prices, especially pronounced after 2000, would have eventually undermined this conviction; instead, it strengthened it. Well before the peak, house prices had come untethered from more or less every known factor that anchors them in the long run; all signs pointed to a steep drop. This risk was not overlooked: analysts and journalists wrote extensively about the likelihood that house prices would fall. Yale’s Robert Shiller, whose track record commanded attention (he predicted the stock-market crash of 2000), published a much-discussed book on the subject. To be sure, not everybody reads the financial press, but had anyone failed to notice the house-price boom? Was anyone in doubt about what follows a boom—always?

Yet innumerable fools kept buying, and bidding prices higher. (Did I mention that I was among them? I bought a house in December 2005, timing the peak of the market almost perfectly.) Meanwhile, Wall Street’s financial engineers designed their models for pricing mortgage-backed securities in such a way that if you asked, “What happens if house prices fall?” the models replied, “Cannot compute.”

This propensity for self-delusion is evidently a fact of life. The modern history of finance suggests that it cannot be regulated away, partly because regulators are people too, as susceptible as anybody else to the madness of crowds. What we can hope to do is recognize the problem and then contain it—limit its scale and curb its dangerous consequences. Once the present emergency has subsided, that is what governments will try to do. Even that, however, will be much more difficult than you might think.

Financial regulators are in a perpetual state of war with financial innovators—a war they’ve been losing for decades; a war they cannot, ultimately, win. In any industry, a rule that adds to the cost of doing business or closes down an opportunity to make profits creates an incentive to get around it. But in finance, any such sliver of opportunity may yield enormous profits. The best brains in the world therefore get hired to seek these slivers out. Lately, because of advancing technology, regulators have found it impossible to keep up.

For decades, traditional banks have been subject to stringent regulations. Banks are inherently fragile yet systemically indispensable institutions. Indispensible because they reward savers for thrift, channel capital to firms that need it to grow, and provide the backbone of the payments system. Fragile because they “borrow short” from depositors (who can demand their money back virtually at any time) and “lend long” to homeowners and institutions that generally make repayments over many years. If confidence in the banks should fail, depositors will rush for their money and, as James Stewart explained in It’s a Wonderful Life, fundamentally solvent banks will be brought down by mere panic.

So governments long ago struck a bargain with traditional banks. The safety of deposits was guaranteed, alleviating the fears of depositors. In return, since depositors would no longer insist on prudent use of their funds (they’d be guaranteed to get their deposits back no matter how recklessly banks used them), governments regulated bank lending to prevent excessive risk-taking. This system hasn’t worked perfectly. (Before it was nationalized earlier this year, investors clamored to get their money out of Northern Rock, a big British bank and an early casualty of the crisis. It was Britain’s first outright bank run since the 19th century. Not coincidentally, perhaps, sales of home safes boomed throughout Europe this fall.) But it has worked well enough.

Here’s the problem, though: banks make up only part of the financial system. Over time, new technologies and new financial products have enabled their more lightly regulated non-bank cousins to take on many bank-like functions—and often have allowed such entities to profit from these functions to a degree that traditional banks could not.