What Could Policymakers Do Better?

The vertically integrated bank focused on mortgage origination and securitiza­tion using borrowed money is gone. It has been replaced by a small number of large conglomerate banks with their fingers in lots of pies.

But there are some generic lessons to be learned from the crisis. One reason that this crisis was so severe is that the underlying market for mortgages was so large. The mortgage market is still a $2-3 trillion market. But it was not just its size but also the nature of the connections between it and the entire financial system. In the 2000s, the mortgage securitization market integrated the produc­tion of mortgages with financial instruments that were purchased mainly with money borrowed on a relatively short-term basis. The systemic nature of these connections and their large size should have sent off signals to regulators about the potential for trouble, particularly as the crisis unfolded in slow motion from 2006 to 2008.

This means that in the future, regulators should be vigilant for such large mar­ket movements and their interdependence with other important markets.

There were other signs that should have concerned regulators. When any in­dustry corners the profits in the economy the way that finance did in 2001-2007, regulators should be wary of potential problems. Understanding the business models of the largest firms in the largest and most profitable sectors and the risks inherent in their activities should be a front-and-center concern for regulators. No sector of the economy can sustain that level of profits for very long without running out of opportunities to make that kind of money. That banks had to turn to nonconventional mortgages to keep their high profits intact should have set of red flags for regulators. The 2005 FOMC meeting on whether there was a housing price bubble never even considered the role of the banks in making the market in nonconventional mortgages.

A more difficult set of issues to understand was interpreting the role of the in­crease in foreclosures and reports of mortgage and securities fraud. This should have alerted observers to the last gasp of the largest market in the country and the biggest profit center as well. Again, because the business models of the banks were not being observed, no one had any ability to connect the evidence of mas­sive mortgage and securities fraud to the desperate attempt to keep the vertically integrated banks model going. To have done so, someone would have had to have the expertise to see the connections and enough distance to blow the whistle.

This brings me back to one of the most intractable problems in detecting the next crisis before it happens.

One candidate for the job is the Federal Reserve. It is the strongest of the reg­ulators in terms of independence from finance and has lots of expertise and au­thority to manage the banks and financial markets. In this case, as I have shown, the Federal Reserve repeatedly downplayed the seriousness of the brewing crisis. This was partly because they believed in financial innovation. But it was mostly because they failed to see the systemic threat of the vertically integrated banks. Their focus on viewing the problem from the perspective of the macroeconomy meant they never saw the links between finance and the so-called real economy. They also never thought that the spillovers from the foreclosures would have a broad effect. It is here that some changes can be made.

A report by the Independent Evaluation Office (2010) at the International Monetary Fund agreed with my analysis of the cognitive biases of not just the Federal Reserve but central banks and regulatory authorities in general. They concluded that similar kinds of cognitive biases precluded that organization from seeing the dangers of the financial crisis as well. In the view of this study, “The linking of macroeconomic and financial sector analysis remained inadequate.... This reflected the lack of a suitable conceptual framework for analyzing such linkages within the economics profession at large” (Independent Evaluation Of­fice, 2010: 18; emphasis added). The fact that the group of experts whose job it is to make sense of the direction of the economy at the Federal Reserve and at the International Monetary Fund were more or less blinded by their assumptions about how that reality worked is something to ponder.

It is useful to ask what such organizations might do to overcome the effects of culture, framing, and cognition to better identify crises. One can certainly argue that little can be done. The complexity of troubling events and the rapidity with which that complexity can produce dramatic outcomes make it especially diffi­cult to overcome the blinders of any frame. Nonetheless, in our case, by Septem­ber 2008, the FOMC did recognize that there was a crisis brewing in the housing market and that it had spilled over into a financial crisis. But as my analysis has shown, their macroeconomic perspective continued to convince them that it could be contained and that its negative effects would not spread dramatically across the economy.

This suggests that there are two important processes that would need to be counteracted. First, the existence of any frame facilitates group decision-making but also tends to push a group toward underplaying some disconcerting facts and putting a positive spin on them. Second, the cultural content of a frame plays a big role in what are considered facts and what kinds of explanations can be justified.

Organizational solutions would have to deal with both problems in order to help such decision-making groups see a crisis and its causes and consequences. One strategy is for decision-making groups to create independent work groups whose job is to study the potential pitfalls of any policy decision. These groups would need to have standard input into decision-making processes and become part of the policy discussions. Participation in these groups would have to be rewarded by ensuring that members were rotated in and out and that participa­tion would be seen as a boost to one's career. This would reduce the penalties for having dissident views and potentially legitimate the ideas coming out of these groups in the more general discussion. It might also instill skepticism into future participants of decision-making groups.

While this might help undermine the effects of positive asymmetry, it would not solve the problem that all primary frameworks limit the types and forms of understanding involved in decision-making. This presents an even more difficult challenge. First, it comes into conflict with the fact that a primary frame serves a positive function for decision-making by allowing a consensus to emerge. Re- latedly, giving legitimacy to multiple primary frameworks undermines the status and privilege of those who have power based on their use of the primary frame, in this case the macroeconomists.

This suggests that if a decision-making group were serious about bringing dissident voices into the discussion, an effort would have to be made to ensure that these dissident members had a substantial presence (see the review by Wil­liams and O'Reilly [1998] for a discussion of the conditions under which such diversity can have positive or negative effects). In the case of the Federal Reserve, this would mean decreasing the presence of macroeconomists and increasing the presence of people with expertise relating to finance as a new and potentially dominant force in the economy. Members of the FOMC with a financial or bank­ing background did speak up more on financial topics and clearly saw more dan­ger in housing and finance than did the dominant macroeconomic perspective. Imagine what might have happened if the members who considered inflation to be the most serious problem in the economy in the spring and summer of 2008 had been replaced by members with significant finance and banking expertise. It is possible that the FOMC would have recommended different policies through­out the year and worked to mitigate the financial collapse.

To be clear, I am not advocating a revolving door between the FOMC and the financial industry or the “capture” of the Fed by financial interests themselves. Rather, I am arguing that the FOMC should couple the theoretical logic of its members' academic training with greater on-the-ground attention to the indus­try that the Fed actually regulates.

The financial crisis has already quietly shifted the way that regulators, partic­ularly the Federal Reserve, think about financial innovation, risk, and regulation. We no longer hear how financial innovation controls risk and is the best thing to happen to American capitalism ever. Instead, skeptics wonder about the efficacy of financial products and the problems of asymmetric information between buy­ers and sellers whereby sellers make money because buyers remain uninformed about the riskiness of products. Instead of assuming that every financial product by definition makes the system work more efficiently, regulators worry about the possibility of rent seeking and fraud on the part of banks.

Even more important, regulators have learned that the financial system is a system that implicates not just the financial sector but the rest of the economy. This, of course, has been the main message of this book. Regulators have realized that banks and many nonfinancial corporations fund their activities through the shadow banking system (i.e., the repo, ABCP, and money markets). This means that to ensure that short-term financing is available throughout the economy for all corporations who want to be borrowers, regulators must be prepared to step in to provide liquidity to financial markets by buying assets and providing cash.

This policy shift has already been put into practice. In the spring of 2020, a large swath of the economy of the United States was shut down due to the coro­navirus pandemic. As a result of the great uncertainty the pandemic presented, stock prices dropped about 30 percent in a month. Even more troubling, the repo and ABCP markets began to freeze up just as they had in the fall of 2008. Nonfinancial corporations found it difficult to borrow short term. Banks found themselves under some pressure to provide and receive credit. The Federal Re­serve acted aggressively to ensure the flow of credit in the economy and helped stabilize the ability of everyone to continue to borrow to fund their current economic activities. They bought trillions of dollars of Treasury securities and conventional MBSs to provide banks with cash. They began buying corporate debt and other securities. They provided liquidity to the repo and ABCP mar­kets. At a press conference on April 29, 2020, Jerome Powell, chair of the Federal Reserve, said,

Let me say that we're committed to using our full range of tools to support the economy in this challenging time. We're going to use them, as I men­tioned, forcefully, proactively and aggressively until we're confident that we're solidly on the road to recovery, and also to assure that that recov­ery, when it comes, will be as robust as possible. As you know, our credit policies are not subject to specific dollar limit. They can be expanded as appropriate, and we can do new ones.⁴

This worked spectacularly well, as the stock market rallied and lending resumed.

The shift in orientation toward viewing the financial system as part of the central circulation of the economy represents a break with the idea that it is just another sector. To invoke a metaphor, instead of a set of sectors that operate more or less independently of one another, the economy now looks much more like a living organism where the financial system operates as the heart, pumping blood to the rest of the system. Anything that dramatically limits that flow can bring the economy to its knees. Notice that the regulator of that heart now acts as a doctor (or maybe a brain), prepared to intervene to save the life of the patient by flooding the system with liquidity. The Federal Reserve has partially accepted that the economy is a system. But it needs to do this with greater insight on the interconnectedness of firms and markets.