But we do not yet know how to get investors out of T-bills and back into riskier assets.

TO BE NOTED:

"©2009 CFA Institute www.cfapubs.org 17
A Simple Theory of the Financial Crisis;
or, Why Fischer Black Still Matters
Tyler Cowen
“ Black’s
revolutionary
idea was simply
that we are not as
shielded from a
sudden dose of bad
luck as we would
”
like to think.
ouriel Roubini (“Dr. Doom”) and the late Hyman Minsky are
often heralded as the economic prophets of the current financial
crisis. But there are also connections between recent
events and the work of Fischer Black (19381995). Best
known for his seminal work in option-pricing theory, Black also wrote
extensively on monetary economics and business cycles.
An enigmatic thinker, Black sometimes wrote in epigrams or
brief sentences and did not present his macroeconomic views in terms
of a formal model. For that reason, interpreting Black is not always
easy. Nonetheless, Black’s writings offer ideas for explaining the
current crisis, most notably the idea that a general risk–return tradeoff
governs business cycles. Black also stressed “noise traders,” T-bills
as the new form of cash, the inability of monetary policy to address
many downturns, and the notion that a business cycle is characterized
by significant sectoral shifts.
Published in 1995, Black’s Exploring General Equilibrium starts
with the idea that entrepreneurs choose a preferred level of risk. Of
course, choosing a higher level of risk involves higher expected
returns but also a correspondingly greater risk of collapse. That is a
common assumption about individual entrepreneurs, but Black’s
innovation was to insist that such reasoning could be applied to the
economy as a whole.
Black’s account of the business cycle downturn required many
different economic sectors to go wrong all at once, through widely
held but incorrect assumptions about the real world. At the time, this
approach was out of sync with “rational expectations” theories. In
favored approaches of the 1980s and 1990s, it was common to admit
that individual mistakes were possible but that such mistakes would
be governed by the “law of large numbers.” (This view was prevalent
before the rise of behavioral economics to its current popularity.)
Mistakes could occur in many different and scattered directions, and
so mistakes did not suffice to drive the co-movement of many different
economic sectors. Although forecasting mistakes would cause some
sectors to do worse than average, other sectors would do better than
average because of forecasting errors in the opposite direction. Black,
however, never accepted this perspective, and he continued to insist
that the law of large numbers did not necessarily apply to a business
cycle setting. As I will show, some plausible expectational errors are
magnified in the aggregate and do not cancel one another out.
Most business cycle analysts offer detailed scenarios for how
things go wrong, but Black’s revolutionary idea was simply that we
are not as shielded from a sudden dose of bad luck as we would like
to think. With that in mind, I would like to consider how we might
make sense of the current financial crisis and recession by drawing
broadly upon some of Black’s ideas.
Tyler Cowen is professor of economics at George Mason University,
Fairfax, Virginia.
N
18 www.cfapubs.org ©2009 CFA Institute
The Financial Crisis: One Possible
Scenario
Fundamentally, the current financial crisis is not
about the bursting of a real estate bubble. Although
housing and subprime loans were the proverbial
canary in the coal mine, the real problem was that
investors chose too many risky assets of many
different kinds. Nor is the financial crisis about
mistakes in the banking sector, although many
such mistakes were made. At bottom, the financial
crisis has been a story of how poorly suited we are
at handling unexpected systemic risks, especially
those that stem from the so-called real economy. In
essence, the story of the current financial crisis can
be told in three broad chapters: (1) the growth of
wealth, (2) the decision to opt for risky investments,
and (3) the underestimation of a new source
of systemic risk.
First, starting in the 1990s, global wealth grew
enormously. Communism fell, world trade expanded,
China grew at about 10 percent a year, and
the investing class experienced unprecedented
gains in income and wealth. Strong demand to
invest the new wealth existed. Before Ben Bernanke
became Fed chairman, he coined the phrase “global
savings glut” to describe this new state of affairs.
More and more wealth was released into
financial markets as many countries—including
Spain, Iceland, Ireland, and the United Kingdom—
modernized their financial systems. China channeled
its new wealth into U.S. credit markets by
buying T-bills and mortgage agency securities.
These purchases freed up other funds for the
pursuit of riskier investments.
The second basic trend was the increased willingness
of both individuals and financial institutions
to make risky investments, including the
purchase of overvalued equities, risky derivatives
positions, loans to such highly leveraged companies
as AIG, and real estate loans (especially subprime
loans). Many of these risks were not based in
the financial sector but, rather, involved unduly
optimistic revenue models, as we have seen in the
automotive industry, state and local governments,
and such “Web 2.0” companies as Facebook. Some
of the risky investments included speculation in
volatile commodity prices, which spread the
boom–bust cycle to such commodity exporters as
the oil-exporting countries.
The risks of many investments were aggravated
by increases in leverage. Many U.S. investment
banks moved from leverage ratios of about 12
to 1 to ratios of about 30 to 1 and expanded their
investments in risky assets in the process. The
result was a lower margin of error for profit-andloss
calculations, and thus, these high leverage
ratios were not validated.
Many believe the Fed is largely responsible for
the crisis. From 2001 to 2003, Alan Greenspan, the
former Fed chairman, kept the federal funds rate at
1 percent, but monetary policy was not fundamentally
at fault for the resulting overreach. If monetary
policy had been the primary driver of the credit
boom, investment would have gone up and consumption
would have fallen. After all, without an
increase in real resources (the global savings glut),
an economy cannot expand on all fronts at the same
time. But consumption was highly robust during
the boom, especially in the United States. This fact
implies that the resources behind the real estate and
financial asset boom came from the real economy
and that the Fed is largely not to blame for the
current crisis. The presence of major financial problems
in “tight money” Europe is consistent with
this interpretation.
How Were All These Systematic
Errors Possible?
The obvious question is, How were so many unsound
decisions in so many countries made? A number of
specific answers can be given, ranging among
hypotheses about home prices, the weak transparency
of mortgage securities, corporate malgovernance,
excess subsidies to housing, and excessively
loose monetary policy. Although these answers may
have merit in explaining particular aspects of the
crisis—given that bubbles have burst in just about
every asset market and in many countries—they do
not seem sufficiently fundamental.
Once we liberate ourselves from applying the
law of large numbers to entrepreneurial error, as
Black urged us, another answer suggests itself.
Investors systematically overestimated how much
they could trust the judgment of other investors.
Investment banks overestimated how much they
could trust the judgment of other investment
banks. Purchasers of mortgage-backed securities
overestimated how much they could trust the judgment
of both the market and the rating agencies as
to the securities’ values. A commonly held view
was that although financial institutions had made
May/June 2009 www.cfapubs.org 19
large bets, key decision makers had their own
money on the line and thus things could not be all
that bad. Proceeding on some version of that
assumption, most market participants (and regulators)
held positions that were increasingly vulnerable
to systemic financial risk.
In this regard, an indirect link exists between
the current crisis and the massive investment fraud
perpetrated by Bernie Madoff. The point is not that
all banking is a fraud but, rather, that we rely on
the judgments of others when we make our investment
decisions. For years, Madoff had been a wellrespected
figure in the investment community. His
fraud was possible, in large part, because he was
trusted by so many people. The more people
trusted Madoff, the easier it was for him to gain the
trust of others. A small amount of initial trust snowballed
into a large amount of trust, yet most of that
trust was based on very little firsthand information.
Rather than scrutinize the primary source materials
behind Madoff’s venture, investors tended to rely
on the identities and reputations of those who
already trusted Madoff. In the run-up to the current
crisis, a similar process of informational “cascades”
led a great many investors to put excessive trust in
highly leveraged banks and other business plans.
In a strict rational expectations model, we
might expect some people to overtrust others and
other people to undertrust others. Yet, when it
comes to the cumulative and reinforcing nature of
social trust, this averaging-out mechanism can fail
for at least four reasons.
First and most important, a small amount of
information can lie behind a significant social
trend, as previously explained. One of the most
striking features of the current crisis is how many
countries it hit at roughly the same time, which
suggests some kind of international peer effect.
Second, market participation involves a selection
bias in favor of the overconfident. No one
aspires to become a CEO for the purpose of parking
the company assets in T-bills.
Third, incentives were pushing in the wrong
direction. The individuals who were running
large financial institutions had an opportunity to
pursue strategies that resembled, in terms of their
reward structures, going short on extreme market
volatility. Those strategies paid off for years but
ended in disaster. Until the volatility actually
arrives, this trading position will appear to yield
supernormal profits, and indeed, the financial
sector was enormously profitable until the assetpricing
bubbles burst.
Fourth, the course of history cemented this bias
toward excessive trust. As the world became more
prosperous, to rely on the optimistic expectations
of others seemed to be increasingly justified.
The notion that the United States was experiencing
a real estate bubble was a staple observation
among financial commentators at the time. A real
estate bubble had formed and burst before—in the
late 1980s—and the United States had survived that
event with little calamity and only a mild recession.
But most people failed to see the new and increased
financial risk associated with the bursting of the
more recent bubbles.
One view of rational expectations is that investors’
errors will cancel one another out in each market
period. Another view of rational expectations is
that investors’ errors will cancel one another out
over longer stretches of time but that the aggregate
weight of the forecasts in any particular period can
be quite biased owing to common entrepreneurial
misunderstandings of observed recent history. In
the latter case, entrepreneurial errors magnify one
another rather than cancel one another out. That is
one simple way to account for a widespread financial
crisis without doing violence to the rational
expectations assumption or denying the mathematical
elegance of the law of large numbers.
Where Did We End Up?
Subprime loans collapsed primarily because those
investments were most dependent on relatively
poor borrowers. But subprime loans are not essential
to the basic story of the current crisis. Subprime
borrowers simply ran out of money first and were
least able to cover up their mistakes. The market for
contemporary art, which depends almost exclusively
on wealthy buyers, was one of the last markets
to plummet, but we must not be misled by this
difference in timing. The collapse of both markets
stemmed from the same underlying forces, namely,
unwise investment in risky assets and an excessive
degree of trust in the judgments of others.
The net result is that both markets and governments
failed miserably—at the same time and for
the same reasons. Using hindsight, many have
argued that the regulators should have done more
to limit risk taking. But the regulators underestimated
systemic risk in exactly the same way that the
markets did. (Indeed, if regulators did not have this
problem, you would expect them, in their capacity
as private investors, to become systematically rich
20 www.cfapubs.org ©2009 CFA Institute
relative to the rest of the market; that, however, is
hardly the case.) Most national governments were
happy about rising real estate and asset prices and
did not seek to slow down those trends. In fact, the
U.S. government encouraged risk taking by overlooking
accounting scandals at mortgage agencies
and by trying to boost the rate of home ownership
(even today, the U.S. government has not given up
on that goal).
The conjunction of these expectational failures
has meant the collapse of major financial institutions.
Unlike in the Great Depression, however,
regulators have not allowed these institutions to fail
outright. As a result, we now have “zombie banks,”
which soak up taxpayer money and Fed guarantees
without performing the mix of intermediation services
that would sustain economic activity. Many
aspects of asset securitization have collapsed or are
ailing. Perceived levels of risk are high, and many
investors are running to safe assets, such as T-bills.
The more safe assets governments create, the more
investors pull out of the real economy and invest in
those safe assets. The more the real economy collapses,
the more investors move into the loweryielding
assets, which, in turn, further hurts the real
economy. This sequence of events epitomizes
Black’s risk–return trade-off, with investors choosing
much higher levels of safety.
As investors pull their resources out of risky
assets, the prices of those assets reflect less and less
market information and markets become less efficient.
The risky assets then become riskier, which
further lowers the demand for them. (If everyone
holds T-bills, how can anything else be priced accurately?)
Prices contain less information than before,
and rational economic calculation becomes increasingly
difficult, thereby making it hard to establish
a basis for economic recovery. This scramble for
individual liquidity does not always make society,
as a whole, more liquid, as John Maynard Keynes
and others (including Black) emphasized. But we
do not yet know how to get investors out of T-bills
and back into riskier assets. That is another major
problem impeding the recovery.
At the same time, the U.S. economy needs to
undergo significant sectoral shifts. Resources need
to be moved out of finance, out of construction, out
of luxury goods, out of big-box retail, out of domestic
auto production, and out of many economic
activities sustained by bubble-driven borrowing.
Arguably, large adjustments are also needed in the
energy and health care sectors. All these changes
represent an unprecedented level of required sectoral
shifts. But it is difficult for an economy to
make those adjustments when uncertainty is so
high, when finance is so dysfunctional, and when
price signals are so drained of value.
Unfortunately, there is no easy way out of our
current predicament. Fiscal stimulus will probably
not be very effective. The argument for fiscal stimulus
is that it will stop things from getting worse by
preventing further collapses in aggregate demand.
Although that argument may be true, fiscal stimulus
will not drive recovery. Recovery requires that
zombie banks behave like real banks, that risk premiums
be properly priced, and that the economy
undergo sectoral shifts toward whatever will
replace construction, finance, and debt-driven consumption.
Fiscal stimulus will not do much to
achieve those ends, and in fact, a temporarily successful
stimulus might hinder the necessary longrun
adjustments, especially for labor. Again, this
conclusion follows from Black’s insistence that a
business cycle is essentially a set of sectoral shifts,
and those shifts do not always occur easily.
This article qualifies for 0.5 CE credit.
References
Black, Fischer. 1987. Business Cycles and Equilibrium. Cambridge,
MA: Basil Blackwell.
———. 1995. Exploring General Equilibrium. Cambridge, MA:
MIT Press."