The Last Temptation of Risk

The Last Temptation of Risk

Mini Teaser: Eichengreen explains the origins of the economic crisis.

by Author(s): Barry Eichengreen

THE GREAT Credit Crisis has cast into doubt much of what we thought we knew about economics. We thought that monetary policy had tamed the business cycle. We thought that because changes in central-bank policies had delivered low and stable inflation, the volatility of the pre-1985 years had been consigned to the dustbin of history; they had given way to the quaintly dubbed "Great Moderation." We thought that financial institutions and markets had come to be self-regulating-that investors could be left largely if not wholly to their own devices. Above all we thought that we had learned how to prevent the kind of financial calamity that struck the world in 1929.

We now know that much of what we thought was true was not. The Great Moderation was an illusion. Monetary policies focusing on low inflation to the exclusion of other considerations (not least excesses in financial markets) can allow dangerous vulnerabilities to build up. Relying on institutional investors to self-regulate is the economic equivalent of letting children decide their own diets. As a result we are now in for an economic and financial downturn that will rival the Great Depression before it is over.

The question is how we could have been so misguided. One interpretation, understandably popular given our current plight, is that the basic economic theory informing the actions of central bankers and regulators was fatally flawed. The only course left is to throw it out and start over. But another view, considerably closer to the truth, is that the problem lay not so much with the poverty of the underlying theory as with selective reading of it-a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists whose scholarship provided intellectual justification for the financial institutions' decisions. The consequence was that scholarship that warned of potential disaster was ignored. And the result was global economic calamity on a scale not seen for four generations.


SO WHERE were the intellectual agenda setters when the crisis was building? Why did they fail to see this train wreck coming? More than that, why did they consort actively with the financial sector in setting the stage for the collapse?

For economists in business schools the answer is straightforward. Business schools see themselves as suppliers of inputs to business. Just as General Motors provides its suppliers with specifications for the cold-rolled sheet it needs for fabricating auto bodies, J. P. Morgan makes clear the kind of financial engineers it requires, and business schools deem to provide. In the wake of the 1987 stock-market crash, Morgan's chairman, Dennis Weatherstone, started calling for a daily "4:15 Report" summarizing how much his firm would lose if tomorrow turned out to be a bad day. His counterparts at other firms then adopted the practice. Soon after, business schools jumped to supply graduates to write those reports. Value at Risk, as that number and the process for calculating it came to be known, quickly gained a place in the business-school curriculum.

The desire for up-to-date information on the risks of doing business was admirable. Less admirable was the belief that those risks could be reduced to a single number which could then be estimated on the basis of a set of mathematical equations fitted to a few data points. Much as former-GM CEO Alfred Sloan once sought to transform automobile production from a craft to an engineering problem, Weatherstone and his colleagues encouraged the belief that risk and return could be reduced to a set of equations specified by an MBA and solved by a machine.

Getting the machine to spit out a headline number for Value at Risk was straightforward. But deciding what to put into the model was another matter. The art of gauging Value at Risk required imagining the severity of the shocks to which the portfolio might be subjected. It required knowing what new variables to add in response to financial innovation and unfolding events. Doing this right required a thoughtful and creative practitioner. Value at Risk, like dynamite, can be a powerful tool when in the right hands. Placed in the wrong hands-well, you know.

These simple models should have been regarded as no more than starting points for serious thinking. Instead, those responsible for making key decisions, institutional investors and their regulators alike, took them literally. This reflected the seductive appeal of elegant theory. Reducing risk to a single number encouraged the belief that it could be mastered. It also made it easier to leave early for that weekend in the Hamptons.

Now, of course, we know that the gulf between assumption and reality was too wide to be bridged. These models were worse than unrealistic. They were weapons of economic mass destruction.

For some years those who relied on these artificial constructs were not caught out. Episodes of high volatility, like the 1987 stock-market crash, still loomed large in the data set to which the model was fit. They served to highlight the potential for big shocks and cautioned against aggressive investment strategies. Since financial innovation was gradual, models estimated on historical data remained reasonable representations of the balance of risks.


WITH TIME, however, memories of the 1987 crash faded. In the data used by the financial engineers, the crash became only one observation among many generated in the course of the Great Moderation. There were echoes, like the all-but-failure of the hedge fund Long-Term Capital Management in 1998. (Over four months the company lost $4.6 billion and had to be saved through a bailout orchestrated by the Federal Reserve Bank of New York.) But these warning signs were muffled by comparison. This encouraged the misplaced belief that the same central-bank policies that had reduced the volatility of inflation had magically, perhaps through transference, also reduced the volatility of financial markets. It encouraged the belief that mastery of the remaining risk made more aggressive investment strategies permissible. It made it possible, for example, to employ more leverage-to make use of more borrowed money-without putting more value at risk.

Meanwhile, deregulation was on the march. Memories of the 1930s disaster that had prompted the adoption of restrictions like the Glass-Steagall Act, which separated commercial and investment banking, faded with the passage of time. This tilted the political balance toward those who, for ideological reasons, favored permissive regulation. Meanwhile, financial institutions, in principle prohibited from pursuing certain lines of business, found ways around those restrictions, encouraging the view that strict regulation was futile. With the elimination of regulatory ceilings on the interest rates that could be paid to depositors, commercial banks had to compete for funding by offering higher rates, which in turn pressured them to adopt riskier lending and investment policies in order to pay the bill. With the entry of low-cost brokerages and the elimination of fixed commissions on stock trades, broker-dealers like Bear Stearns, which had previously earned a comfy living off of such commissions, now felt compelled to enter riskier lines of business.

But where the accelerating pace of change should have prompted more caution, the routinization of risk management encouraged precisely the opposite. The idea that risk management had been reduced to a mere engineering problem seduced business in general, and financial businesses in particular, into believing that it was safe to use more leverage and to invest in more volatile assets.

Of course, risk officers could have pointed out that the models had been fit to data for a period of unprecedented low volatility. They could have pointed out that models designed to predict losses on securities backed by residential mortgages were estimated on data only for years when housing prices were rising and foreclosures were essentially unknown. They could have emphasized the high degree of uncertainty surrounding their estimates. But they knew on which side their bread was buttered. Senior management strongly preferred to take on additional risk, since if the dice came up seven they stood to receive megabonuses, whereas if they rolled snake eyes the worst they could expect was a golden parachute. If an investment strategy that promised high returns today threatened to jeopardize the viability of the enterprise tomorrow, then this was someone else's problem. For a junior risk officer to warn the members of the investment committee that they were taking undue risk would have dimmed his chances of promotion. And so on up the ladder.


WHY CORPORATE risk officers did not sound the alarm bells is thus clear enough. But where were the business-school professors while these events were unfolding? Answer: they were writing textbooks about Value at Risk. (Truth in advertising requires me to acknowledge that the leading such book is by a professor at the University of California.) Business schools are rated by business publications and compete for students on the basis of their record of placing graduates. With banks hiring graduates educated in Value at Risk, business schools had an obvious incentive to supply the same.

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