"to underestimate the amount of risk they faced and overestimate the amount of leverage they could handle"

Thomas F. Cooley gives the general consensus view of risk in Forbes:

"There is another, deeper possible link between the Great Moderation and the financial crisis that is worth thinking about, because it may help to inform the financial regulation of the future. The idea is simply that the decline in volatility led financial institutions to underestimate the amount of risk they faced and overestimate the amount of leverage they could handle, thus essentially (though unintentionally) reintroducing a large measure of volatility into the market.

Financial institutions typically manage their risk using what they call value at risk or VaR. Without getting into the technicalities of VaR (and there is a very long story to be told about the misuse of these methods), it is highly likely that the Great Moderation led many risk managers to drastically underestimate the aggregate risk in the economy. A 50% decline in aggregate risk is huge, and after 20 years, people come to count on things being the same.

Risk managers are supposed to address these problems with stress testing--computing their value at risk assuming extreme events--but they often don't. The result was that firms vastly overestimated the amount of leverage they could assume, and put themselves at great risk. Of course, the desperate search for yield had something to do with it as well, but I have a hard time believing that the managers of Lehman, Bear Stearns and others knowingly bet the firm on a systematic basis. They thought the world was less risky than it is. And so, the Great Moderation became fuel for the fire.

If there is a moral to this story it is probably to do with the filters we put on historical events. Succession and causality are often confused. As are the limits on our ability to think historically. What we see right now is only the great conflagration that consumes us, leaving us little appetite, and even less oxygen, to moderate our responses and hold onto a broad historical outlook."

I don't credit this, and now I think that I can explain why.

Many years ago, I read an essay which I've tried to find, but can't, about the modern conflict between Great Britain and the IRA. The essay started by stating that each side dated the conflict differently. For Great Britain, it began in the 20th Century, but for the IRA, it began in the 17th Century. The differences in dating led to completely opposite developments in the narrative and explanation of the problem.

So, when Cooley says this:

"Take, for example, "the Great Moderation."

The last really sharp recession in the United States was from 1981 to 1982, when real output fell by more than 4% below trend, and the unemployment rate rose to over 10%. It is often referred to as the Volcker Recession because it was triggered in part by then Fed Chairman Paul Volcker's efforts to squeeze inflation out of the U.S. economy.

Following that recession, something remarkable happened. The volatility in the U.S. economy declined sharply. Even though we have had two recessions in the ensuing years--in 1991 and 2002--both were relatively mild and short-lived.

Surprisingly, the U.S. economy remained dramatically more stable in spite of some major disruptions in financial markets in the U.S. and abroad over the same period. There was a major stock market crash in the U.S. in October 1987; the Mexican Financial Crisis in 1994; the Asian Financial Crisis in 1997 and 1998; the Russian debt crisis and the Long-Term Capital Management crisis in 1998 and the bursting of the dot-com bubble. In addition, there were the terrorist attacks of 9/11, and the U.S. got itself involved in two wars. In short, there were many dramatic events both in the U.S. and abroad--and yet the aggregate U.S. economy was relatively calm."

He leaves out the S & L Crisis. To me, the obviously most important factor. The implicit and explicit government guarantees to intervene in a crisis. So, we approach the history of this debacle from, not only philosophical differences, but historical differences. To me, the most important fact is how humans react to crises in real life, and what they are actually acting upon.

I've used this example before. Take illegal immigration. It's illegal. What do the government's actions over the last 20 years tell you about any implicit or explicit guarantees about whether the illegal immigrants will basically all allowed to remain in the end?

I don't know how to resolve this difference.