Learning from Crises

PRINCETON – Crises, especially very severe ones, are often learning opportunities. Unfortunately, so far the world seems to have learned very little from the recent financial crisis. In fact, the situation today is just as dangerous as it was in 2007, with the United States now worried by its anemic economic recovery, Europe paralyzed by fears for the survival of its currency union, and emerging markets wrestling with asset-price bubbles.

Learning from crises is partly an exercise in analyzing what went wrong. But it is also about finding solutions. Collectively, we have done well on the former, and very poorly on the latter.

Most explanations of the causes of the post-2007 financial crisis point to five sources of instability. First, the crisis was precipitated by the peculiarities of the US real-estate market, by government incentives for increased homeownership, and in imprudent lending by financial institutions.

Second, perverse incentives led financial institutions to assume excessive risks. Internally, bankers had enormous potential to benefit from risky moves, but were insulated from the costs of failure. For individual institutions, this was not seen as a problem, because they were protected by the logic of being “too big to fail.” When the crisis erupted – owing to a downturn in the US housing market that was clearly foreseeable but willfully unforeseen – the public sector had to absorb the contingent liabilities built up in the financial system.