Financial History’s False Lessons

TOULOUSE – If history punishes those who fail to learn from it, financial history does its punishing with a sadistic twist – it also punishes those who learn from it too enthusiastically. Time and again, financial crises have reflected the weaknesses of regulatory systems founded on the lessons learned from previous crises. Today’s crisis is no exception; nor will the next one be.

The post-war system of financial regulation was founded on three supposed lessons from the 1930’s. First, we thought that the main reason why banks fail is that depositors panic, not that the main reason depositors panic is that banks are in danger of failing.

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Like the view that running away from lions provokes them to eat you, there is a grain of truth in the view that banks fail because depositors panic. But it is a small grain, and one on which the average uninsured depositor, like the average tourist in a game park, would be ill-advised to rely. In fact, many panics happen for a good reason. Even in the 1930’s, most banks failed as a result of bad management and illegal activity, as is true today.

Second, we thought that the depositors prone to panic would always be small depositors – households and small firms – rather than corporations or professional investors. We now know that this is wrong, but there was never any serious reason to believe it.

If large corporations (and other banks) have deposits that they expect to be able to claim on short notice, and if they know that not all such deposits can be withdrawn at the same time, then suspicion that a bank might fail gives them as much reason to rush to the exit as households have. If bank failures typically reflect real underlying problems, sensitive professional investors can be expected to react quickly when any whiff of panic is in the air.

Lending between banks, as well as deposits placed by large corporations, increased spectacularly in the years leading up to the crisis. This is particularly true of the repo markets, which provide the equivalent services for professional investors – banks and large corporations – that ordinary bank deposits provide for individuals and small firms.

Until the financial reforms adopted since the crisis, this “shadow” banking system operated outside the regulatory regime that applied to traditional deposit-taking banks. Indeed, shadow banking would not have grown so fast had that regime not been devised with the apparent lessons of the 1930’s in mind. But the shadow system’s failure after the collapse of Lehman Brothers was no less a bank run just because professional investors were involved. In this case, unlike in the 1930’s, banks stopped trusting each other before the rest of us realized that it was time to stop trusting banks.

The third false lesson is that if we could only maintain confidence in the financial system (and by extension the wider economic system), the system itself could be trusted to survive and prosper. This led to real alarm among policymakers whenever a threat to confidence appeared (as when the dot-com bubble burst at the end of the 1990’s). The dot-com bubble wasn't a threat to the banking system as such, but rather a threat to aggregate demand. But few people dared ask tough questions when confidence picked up again, as when a housing bubble was inflated on the rubble of collapsed technology stocks.

The idea that something that was good for confidence might lead to danger for the banking system was too strange to be believable. The lesson that confidence-building measures averted a crash in 2000 was precisely the lesson that the financial system did not need to learn.

Why were we all taken in by the idea that we could make ourselves collectively richer by selling each other overpriced equities and houses? We were collectively irrational, but that is no explanation. We need to know why some forms of collective irrationality gain a stronger grip on us than others.

An intriguing clue comes from research in neuroscience that explains why it is impossible to tickle yourself. Tickling appears to be caused by unexpected sensations on certain areas of the skin. Because the brain of a person trying to tickle herself anticipates the sensations that will be caused by her fingers – a process performed within the cerebellum – the sensation no longer tickles.

You can, however, succeed in tickling yourself through an intermediary – a machine, for instance, that translates the movements of your fingers into sensations on the skin by a method indirect enough for the cerebellum to be unable to anticipate them. Although the conscious part of your brain knows that the tickling sensation comes from you and isn’t “really” unexpected, the cerebellum doesn’t get it, and the tickling works.

Tickling yourself is as futile as trying to make yourself richer by writing yourself a check – or selling yourself your house for twice its current market price. It isn’t much better if you and a friend write each other checks, or sell each other houses.

For a few years we managed to circumvent that part of our brains that told us we couldn’t tickle ourselves to greater wealth. Perhaps ordinary citizens always knew that when they sold houses for real gains, ultimately they were profiting at someone else’s expense. It was only economists, who studied the lessons of previous crises, who fell for the idea that no one would lose out.

Today’s policymakers, reasoning from the 1930’s, appear to believe that creating confidence is somehow different from creating good reasons to be confident. The recent “stress tests” of European banks were blatantly designed as a confidence-building measure rather than a genuine exploration of possible systemic weaknesses – failing, for instance, to include the possibility of default on Greek sovereign debt.

That, of course, is like testing your home’s fire extinguishers against burglars. Positive results will persuade only those who have learned well the lessons of the 1930’s – and then failed to forget them.