2007 Bust: How Could They Not Have Known?

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We are still living in the wake of the great 21st century bubble. That is the dominant economic and financial fact of 2011, which applies both to the American housing and mortgage debt, and to the European sovereign debt, crises. As the massive losses keep coming, there is a lot of negotiating, suing, whining and politicking among contentious parties over who will take which losses.

Among the many losses imposed by the bubble is a well-deserved loss of credibility on the part of central bankers and economists. "Policy makers around the world didn't see the global financial crisis coming," columnist David Wessel said recently. "My own profession, economics, has not distinguished itself in recent decades," Henry Kaufman sadly wrote.

Observers at the peak of the housing bubble could count zero U.S. bank failures in 2005 and 2006, and as late as the second quarter of 2007, it seemed that bank profitability and capital were high and that the world had plenty, probably a surplus, of liquidity. Indeed, as British banking expert Charles Goodhart pointedly describes it:

"Never had the profitability and capital strength (over the last couple of decades) of the banking sector seemed higher, never had the appreciation of bank risk...seemed more sanguine than in the early summer of 2007. ... At the time neither bankers, nor regulators, nor virtually all commentators had any appreciation for the systemic risks that were being run."

Nor central bankers!

How quaint and ironic it already seems that even as the housing bubble was in the process of inflating, central bankers convinced themselves that they had discovered how to create and sustain the so-called "Great Moderation." This is reminiscent of the equally quaint, long-ago collapsed 1960s belief that economists had discovered how to "fine tune" economies.

At this point, we wonder how in the world they could not have foreseen the financial disasters which were descending on them and everybody else. This question, now often asked, has more to do with our unreasonable faith in benevolent experts and bureaucracies, than with the actual capabilities of human minds and institutions. As nicely summed up by a Barron's book review: "Even as failed forecast follows failed forecast...we humans crave future knowledge."

Here is a test. Fill in the blank in the following statement about "The Great Recession" by a prominent economist and guess the year in which it was written. "In the years ________, the world economy passed through its most dangerous adventure since the 1930s."

The correct answer to the blank is the years "1973-76." This was written by Otto Eckstein in a 1979 book entitled The Great Recession. He went on to make the following insightful comments, which are most applicable to our recent and current financial experience of three decades later:

"Historical model analysis is easier work than forecasting the future. Looking backwards, there are fewer surprises.... It is possible to construct the model so it tracks the past very well. No such assurance exists in forecasting."

Alas, how true. The lesson is not that we should stop thinking about the future, but that we should give up the faith that wise central bankers and learned economists can make the financial world safe. They can't.

We should equally not kid ourselves about the losses which must be taken and distributed, in one way or another, among the contending parties. This is the working out of Pollock's Law of Finance, which states: Loans which cannot be paid, will not be paid. So the wake of the bubble is inevitably an agonizing and extended time. Still, it will not last forever. History makes it clear that booms and busts, cycling however around a rising long-term trend, are normal. I venture to forecast that this history will continue.

Some commentators long for the financial stability of the post-World War II United States. Unfortunately for those longings, the 20 years after that horrifically destructive war was a unique and unsustainable period of international economic and financial dominance by the U.S. Its anomalous character means it cannot form our model for stability. Indeed, economic reality is never lasting stability, but constant adjustment and transition.

In considering the financial adventures of the past, present or future, in America, Europe or elsewhere, we cannot too often re-read that profound dictum of Joseph Schumpeter:

"The problem usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them."

Alex J. Pollock is a resident fellow at the American Enterprise Institute in Washington, D.C.

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