Many mistaken assumptions about the 2008 financial crisis remain in circulation. As long as policymakers believe the crisis was rooted in the housing bubble rather than human psychology, another crisis will be inevitable... Recall that by mid-2008, home prices had returned to, or even fallen below, levels supported by their underlying fundamentals, and employment and production in the residential construction industry had declined to levels far below trend. The work of rebalancing asset valuations and reallocating economic resources across sectors had already been accomplished... To be sure, there still would have been around $750 billion worth of financial-asset losses in the form of defaults on subprime mortgages and home-equity loans. But that is only one-quarter of what global equity markets lost in seven hours on October 19, 1987. In other words, it would not have been enough to sink the global financial system... Ben Bernanke, then Chair of the US Federal Reserve, seemed confident in the summer of 2008 that the correction in housing prices had not triggered any unmanageable financial crisis. At the time, he was mainly focused on the dangers of rising inflation... And then the bottom fell out. The reason, Gennaioli and Shleifer show, is that beliefs changed.
- Investors came to believe that financial markets were saddled with highly elevated risk, owing to a number of factors.
- The interbank market had seized up,
- homeowners were defaulting on their mortgages,
- Bear Stearns had collapsed,
- the US Treasury had intervened to rein in Freddie Mac and Fannie Mae, and, above all,
- Lehman Brothers had declared bankruptcy... All of this led to the sudden run on both the shadow and non-shadow banking systems, as investors scrambled to dump assets. The increased risk that they had imputed to the system became a reality... And yet nothing about the fallout from the crisis was inevitable. Had the Fed been in possession of contingency plans for putting too-big-to-fail institutions into receivership and becoming the risk-bearer of last resort, we would probably be living in a very different world today... Gennaioli and Shleifer’s second important contribution is to show that “crises of beliefs” like the one that precipitated the disaster of 2008-2009 are deeply rooted in human psychology, so much so that we will never be free of them... Crises of belief are manifestations of a chronic condition that must be managed... When fundamental beliefs have shifted permanently, one should not expect the same policy mix that supported full employment, low inflation, and balanced growth before the crisis to do so afterwards... For a decade now, people have been looking for a silver lining to the disasters of 2008-2018, hoping that this period will bring about a more productive integration of finance, behavioral economics, and macroeconomic orthodoxy. So far, they have been searching in vain. But with the publication of A Crisis of Beliefs, there is hope yet.