ABSTRACT The illusion of explanatory depth, which has been identified by cognitive psychologists, may play a prominent role in encouraging regulatory action. This special type of overconfidence would logically lead regulators to believe that they are aware of the relevant causes and consequences of the activities they might regulate, and of the unintended side effects of the regulatory actions they are contemplating. So, as with other cognitive biases, the illusion of explanatory depth is likely to lead to mistakes. And unlike (...) the biases that have been the focus of so much behavioral economics, the illusion of explanatory depth is uniquely resistant to correction by those who are aware of it as a general problem and rigorously attempt to keep it under control. (shrink)

Over recent years support for deliberative democracy as a regulative ideal against which political and economic institutions should be judged has become the dominant tradition within political theory. Deliberative democrats such as Amy Guttman and Dennis Thompson argue that deliberative public decision making would bring with it important epistemological and ethical gains. Closer inspection of these claims, however, suggests that deliberative democratic arrangements are not only impractical but are fundamentally at odds with the epistemic and ethical goals that their supporters (...) seek to advance. Arrangements based on ?exit? rather than ?voice? may be better placed to meet these challenges in a world characterized by complexity and conflicting moral values. (shrink)

Over recent years support for deliberative democracy as a regulative ideal against which political and economic institutions should be judged has become the dominant tradition within political theory. Deliberative democrats such as Amy Guttman and Dennis Thompson argue that deliberative public decision making would bring with it important epistemological and ethical gains. Closer inspection of these claims, however, suggests that deliberative democratic arrangements are not only impractical but are fundamentally at odds with the epistemic and ethical goals that their supporters (...) seek to advance. Arrangements based on “exit” rather than “voice” may be better placed to meet these challenges in a world characterized by complexity and conflicting moral values. (shrink)

ABSTRACT Capital regulations stemming from the Basel accords created incentives for banks to securitize mortgages, even risky ones; hold them at a correspondingly low Basel risk weight; or shift them off of banks' balance sheets to obtain even greater leverage. Securitization was praised by economists and regulators for dispersing risks to investors across the world, providing greater resilience to the financial system. However, since in reality banks tended to hold onto securitized assets—either on their balance sheets or off of them, (...) in off‐balance‐sheet entities—the accumulated credit risk remained with the banks, especially in the “shadow banking sector.” This explains the heightened vulnerability of the financial system to a sudden collapse. (shrink)

ABSTRACTThe inherent complexity of modern financial systems, and their basis in human behavior, make it hard to establish unequivocally the “who, what, where, when, and why” of the global financial crisis. However, after almost a decade, we know enough to discard much of what has, in the meantime, become folk wisdom about the causes of the debacle, including Wall Street bonus culture, bankers’ greed, the moral hazard of “too big to fail,” government intervention and deregulation. While each of these factors (...) may have played some role, the crisis can be much more accurately described as one of ignorance than malevolence. The common thread tying the emergence of the bubble to the disastrous consequences of its bursting is the misunderstanding of correlation and causation links in three key domains: economic policy, financial modeling, and the regulatory framework. These misunderstandings helped fuel the housing bubble and introduced fragility into the system, making it vulnerable to the bubble’s subsequent, unavoidable burst. (shrink)

ABSTRACT Asset‐market bubbles occur dependably in laboratory experiments and almost as reliably throughout economic history—yet they do not usually bring the global economy to its knees. The Crash of 2008 was caused by the bursting of a housing bubble of unusual size that was fed by a massive expansion of mortgage credit—facilitated, in turn, by the longest sustained expansionary monetary policy of the past half century. Much of this mortgage credit was extended to people with little net wealth who made (...) slender down payments, so that when the bubble burst and housing prices declined, their losses quickly exceeded their equity. These losses were transmitted to the financial system—including banks, investment banks, insurance companies, and the institutional and private investors who provided liquidity to the mortgage market through structured securities. It seems that many of these institutions became insolvent; it is certain that they became illiquid. Liquidity loss and solvency fears created a feedback cycle of diminished financing, reduced housing demand, falling housing prices, more borrower losses, and further damage to the financial system and eventually the stock market and the real economy. There are important parallels with the housing and financial‐market booms that led up to the Crash of 1929 and the Great Depression. (shrink)

ABSTRACT The financial crisis was caused by the complex, constantly growing web of regulations designed to constrain and redirect modern capitalism. This complexity made investors, bankers, and perhaps regulators themselves ignorant of regulations promulgated across decades and in different “fields” of regulation. These regulations interacted with each other to foster the issuance and securitization of subprime mortgages; their rating as AA or AAA; and previously their concentration on the balance sheets (and off the balance sheets) of many commercial and investment (...) banks. As a practical matter, it was impossible to predict the disastrous outcome of these interacting regulations. This fact calls into question the feasibility of the century‐old attempt to create a hybrid capitalism in which regulations are supposed to remedy economic problems as they arise. (shrink)