Why had Nobody Noticed that the Credit Crunch Was on its Way?

A letter to the Queen attempting to explain why economists missed the financial crisis:

Her Majesty The Queen Buckingham Palace London SW1A 1AA


When Your Majesty visited the London School of Economics last November, you quite rightly asked: why had nobody noticed that the credit crunch was on its way? The British Academy convened a forum on 17 June 2009 to debate your question… This letter summarises the views of the participants … and we hope that it offers an answer to your question.

Many people did foresee the crisis. However, the exact form that it would take and the timing of its onset and ferocity were foreseen by nobody. …

There were many warnings about imbalances in financial markets… But the difficulty was seeing the risk to the system as a whole rather than to any specific financial instrument or loan. Risk calculations were most often confined to slices of financial activity, using some of the best mathematical minds in our country and abroad. But they frequently lost sight of the bigger picture.

Many were also concerned about imbalances in the global economy … known as the ‘global savings glut’. … This … fuelled the increase in house prices both here and in the USA. There were many who warned of the dangers of this.

But against those who warned, most were convinced that … the financial wizards had found new and clever ways of managing risks. Indeed, some claimed to have so dispersed them through an array of novel financial instruments that they had virtually removed them. It is difficult to recall a greater example of wishful thinking combined with hubris. There was a firm belief, too, that financial markets had changed. … A generation of bankers and financiers deceived themselves and those who thought that they were the pace-making engineers of advanced economies.

All this exposed the difficulties of slowing the progression of such developments in the presence of a general ‘feel-good’ factor. Households benefited from low unemployment, cheap consumer goods and ready credit. Businesses benefited from lower borrowing costs. Bankers were earning bumper bonuses… The government benefited from high tax revenues… This was bound to create a psychology of denial. It was a cycle fuelled, in significant measure, … by delusion.

Among the authorities charged with managing these risks, there were difficulties too. … General pressure was for more lax regulation – a light touch. …

There was a broad consensus that it was better to deal with the aftermath of bubbles … than to try to head them off in advance. Credence was given to this view by the experience, especially in the USA … when a recession was more or less avoided after the ‘dot com’ bubble burst. This fuelled the view that we could bail out the economy after the event.

Inflation remained low and created no warning sign of an economy that was overheating. … But this meant that interest rates were low by historical standards. And some said that policy was therefore not sufficiently geared towards heading off … risks. … But on the whole, the prevailing view was that monetary policy was best used to prevent inflation and not to control wider imbalances in the economy.

So where was the problem? Everyone seemed to be doing their own job properly… And according to standard measures of success, they were often doing it well. The failure was to see how collectively this added up to a series of interconnected imbalances over which no single authority had jurisdiction. This, combined with the psychology of herding and the mantra of financial and policy gurus, lead to a dangerous recipe. Individual risks may rightly have been viewed as small, but the risk to the system as a whole was vast.

So in summary, Your Majesty, the failure…, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole. …

We have the honour to remain, Madam, Your Majesty’s most humble and obedient servants

Professor Tim Besley, FBA Professor Peter Hennessy, FBA

[See also At your own risk and Economists were beholden to the long boom.]

Originally published at Economist’s View and reproduced here with the author’s permission.

5 Responses to "Why had Nobody Noticed that the Credit Crunch Was on its Way?"

  1. Martin Hopkins Guest   July 31, 2009 at 3:42 am

    A clear indication of why economists as a group together with their ratios and jargon are a useless breedTheir high and mighty approach caused them to miss this disaster when they could have used an elementry warning indicator namely DEMOGRAPHIC TRENDSIn 2005 I correctly predicted that house prices would fall and continue to fall until 2013 using the demographic fall in the numbers of 35-45 year olds within the uk population for this prediction35-45 year olds spends were driving the economy so any drop in real numbers was a clear indiction of change which economists fail to take notice of.Wake up!

  2. Bob Ritter   July 31, 2009 at 4:08 am

    He had me up to “We have the honour to remain, Madam, Your Majesty’s most humble and obedient servants.”The prof summed it up well though. The big surprise was that it should not have been a surprise, which is what made it a surprise. Hmmm … gotta love economists. Predicting the future is easy … it is predicting when it will happen that is the hard part. I prefer to let economists tell me what happened and to draw my on conclusions on what’s coming up!!

  3. S. Amend (Guest)   July 31, 2009 at 10:41 am

    This seems an example of the perils of overspecialization, compartmentalized thinking, and an overreliance on a quantitative-theoretical perspective of what “the economy” is. Stepping out of offices and looking at human behavior, as well as the “real” and qualitative world around you, did and could have provided plenty of information that “hot air” was happening which was in no way underpinned by any actual values. But as long as the delusion continues that complex systems can be “controlled” and fully explained by quantitative models, much relevant insight (dare we say wisdom?) will continue to be lacking.

  4. Manuel Sarachaga   July 31, 2009 at 11:27 am

    The real thing is what failed was the economic theory most of the economists had in mind. Only a few was aware of what was going on, thanks to the right model they had and still have. It is not a new model (for our disgrace), but an old one, made up at the end of the 19th century and the beginning of the 20th century. All those wrong famous economists of the 20th century destroyed most of that knowledge, and as I said, just a few remained right. Things related to the investment and saving relationship, the real and true meaning of inflation or interest, the basis of the economic growth… old thing we should know and have forgotten… all those things they knew and discussed about. We decided it was more important to talk about CDS, hedge funds… and this is how it ended.Good luck.

  5. K Subramanian   August 2, 2009 at 1:09 am

    It is a simple query which many ordinary citizens who were bewildered by the crisis had raised earlier. The query becomes important when it is raised by Her Majesty!It is a measure of the economists’ achievement that they took such a long time to reply to it. At the end of it, what we get is a white wash of the profession and a polite admission of the failure of its collective imagination. But, pray, why did their imagination fail? There is no answer.The brief answer is that economists had become slaves of pet market theories which were made worse by the application of algo bric-a-brac giving them an appearance of certitude – they clung to them until they blew on their face on 9th August 2007. From then on, there are more theories and more formulations.It is again a measure of their inadequacies that the profession is unable to analyse the current situation (green shoots or brown weeds!)and whether there should ‘exit’ strategies and when or how they should start.