It’s human nature to search for a concise explanation of cause and effect. A reasonable pursuit with satisfactory results, most of the time. But untangling financial crises is different.
The new book All the Devils Are Here: The Hidden History of the Financial Crisis is a reminder that the near-implosion of the global financial system in late-2008 was the byproduct of multiple events over a period of years. Although some pundits are keen on pointing fingers at specific decisions by Congress or the Fed or certain financial institutions, there is no short list of catalysts that triggered the worst financial crisis since the Great Depression.
Journalists Bethany McLean (Vanity Fair) and Joe Nocera (New York Times) spin a tale that spans three decades and indicts a cornucopia of people, institutions, financial innovations, and legislative changes in the quest to explain the events of 2008. The subtext of the book is that while most of the smoking guns were conspicuous, they were veiled in the aggregate, hiding behind a curtain of complexity.
As the book reminds, studying any one factor in isolation tends to bring a fundamentally different perspective compared with considering the broader evolution that eventually gave use the 2008 crisis. Indeed, several of the individual factors that combined to deliver the perfect financial storm looked perfectly reasonable if not admirable as individual agents of change. The development of mortgage-backed securities from the 1970s onward, for instance, hardly look like weapons of mass financial destruction. Nor do the regulatory changes that promoted increased home ownership suggest a trend that was planting the seeds of economic destruction. And when the banking giant J.P. Morgan was developing a quantitative risk-management tool known as value-at-risk in 1990s, there was nothing patently treacherous about the effort. But when these and other trends were combined, the whole added up to more than the parts, and with devastating effects.
Even the successes of putting out various financial fires in the years leading up to 2008 now appear culpable as contributing factors to the crisis. The collapse of the hedge fund Long Term Capital Management in 1998 threatened the financial system for a brief period, thanks to its massive levering via derivatives. But the Federal Reserve and Wall Street contained the potential damage, leaving the impression that systematic risk could be successfully managed. One could make similar arguments about the relatively benign consequences of various currency crises in the 1990s, courtesy of deft interventions by the U.S. Treasury and Federal Reserve. Even the relatively mild economic pain in the wake of the 2001 recession, and the strong growth and low inflation that soon followed, can be seen as part of the web of factors that led to the 2008 collapse.
Stability is unstable, economist Hyman Minsky advised. McLean and Nocera’s book offers a detailed review of why and how that’s possible, and why it’s so difficult to see macro risks as they draw closer. Yes, there were a number of analysts warning in 2007 and early 2008 that trouble was brewing. But trouble’s always brewing, and there are always forward-looking strategists advising of the mounting risks.
The trouble is that the gathering storm can approach for years, fueled by a myriad of factors, without consequence. And the isolated product or regulatory change that looks productive on its own can secretly be adding to a larger threat.
Everyone laments the dark side of the business cycle, but nobody does anything about it. Why? Because cause and effect is complicated. History is littered with regulatory changes that were designed to prevent the next crisis. Yet the cycle prevails, in part because the details of cause and effect are continually evolving. The risk of fighting the last war is always lurking. That's understandable. It’s hard to defend against an enemy you can’t see.
What will be the triggers of the next crisis? Anything and everything is a potential catalyst for trouble. Sometimes the truth is no help at all.