The financial crisis of 2008-9, together with the deep recession and subpar growth that followed, heightened skepticism of mainstream economics as an academic endeavor and guide to public policy. Economists first failed to anticipate the crisis. As Queen Elizabeth famously put it while visiting the London School of Economics and Political Science, “Why did no one see it coming?”
Prominent economists then conspicuously disputed its causes. Some emphasized inadequate regulation, while others pointed their fingers at the U.S. Federal Reserve for its overly accommodating monetary policies. Some blamed politicians for encouraging purchases of subprime mortgages by the government-sponsored enterprises Freddie Mac and Fannie Mae. Still others blamed China for buying U.S. Treasury securities and pushing down interest rates, thereby encouraging investors to “stretch for yield” by borrowing more and making riskier investments. This inability to agree on a narrative, even after the fact, created the impression of a discipline in disarray.
Given the lack of agreement on causes of the collapse, it is perhaps unsurprising that economists were then unable to agree on an effective response. Some urged the Federal Reserve to aggressively expand its balance sheet and the federal government to implement a substantial fiscal stimulus. Others dismissed these responses as irrelevant or even counterproductive. Some recommended strengthening and centralizing financial regulation, while others dismissed post-crisis regulatory reforms as ineffective or, worse, as only substituting new weaknesses for old ones.
The crisis and the intellectual confusion it spawned prompted calls for a more interdisciplinary approach to economic analysis and public-policy making. Lawrence Summers, then President Obama’s chief economic adviser, famously remarked that in the heat of events he found nothing of practical value in the highly simplified, stylized mathematical models of academic economics but derived useful guidance from the rich accounts and analyses of earlier crises by historical economists like Charles Kindleberger and Walter Bagehot.
Relatedly, more than a few commentators concluded that the world was lucky that Ben Bernanke, chair of the Federal Reserve Board, and Christina Romer, head of the Council of Economic Advisers, were not merely accomplished economists but, exceptionally for a discipline that does not encourage historical literacy, serious scholars of the Great Depression who could look back to that episode for lessons on how to act. The surprise best seller of 2009-10 was This Time Is Different, a detailed chronology of six centuries of financial crises by Carmen M. Reinhart and Kenneth S. Rogoff, two economists otherwise very much in the mainstream. Their book’s reception was further evidence of a strong demand from the academic and policy communities for more historically and institutionally grounded scholarship on crises.
It has long been argued by students of foreign policy that historical analogies are a powerful framing device for officials making decisions under pressure. Advisers with knowledge of history and an ability to apply it have a disproportionate impact on decision making in crises, when the need for action is pressing and there is no time for building and testing a formal analytical apparatus. Think Truman’s invocation of Munich when contemplating intervention in Korea.
To be sure, reasoning by historical analogy can mislead when analysts cherry-pick their cases, neglect to test them for fitness to the situation at hand, and fail to consider the full range of historical experience. But the role of analogical reasoning, specifically between the financial crisis and economic depression of the 1930s, is indisputable.
At the same time, calls for a more interdisciplinary approach extend beyond appeals to incorporate more history into economics. Scholars of other social sciences have renewed their criticism of neoclassical economics, which takes as its point of departure rational agents, complete information, and utility maximization. These scholars argue that incorporating insights from their disciplines, which maintain more realistic assumptions about human behavior and social interaction, might have prevented the cataclysmic financial events of 2008-9 or at least allowed policy makers to respond more effectively.
Economic sociologists and political scientists emphasize that the structure of social life affects economic interactions and that collective narratives shape how individuals understand and respond to events. Members of the so-called constructivist school have applied these insights to the Federal Reserve. Neil Fligstein, Jonah Stuart Brundage, and Michael Schultz, sociologists at the University of California at Berkeley, argue that policy makers remained blissfully unaware of the financial crisis even while it was unfolding because their analytical framework focused narrowly on unemployment and inflation. The dominance of conventional macroeconomics in the discussions of the Fed’s main policy body, the Federal Open Market Committee, did not allow those aware of the complex interaction of the housing market, the subprime mortgage market, and derivative financial instruments to inject their concerns into policy discussions.
Other scholars emphasize the role of institutional structures and routines in determining which risks were perceived and influencing views of what constituted an appropriate response. The economist Stephen Golub, the political scientist Ayse Kaya, and the sociologist Michael Reay, all of Swarthmore College, argue in a recent paper that the Fed responded as it did because meetings of the Federal Open Market Committee were heavily scripted and prepared. Centering as they did on structured presentations, they provided little room for unconventional thinking. The narrow focus on interest-rate setting and inflation control that dominated the proceedings left little opportunity for serious discussion of financial stability.
In attempting to account for the excessive risk taking that set the stage for the crisis and for the sharp collective reaction, or panic, that then amplified its effects, psychologists have moved beyond the traditional focus on rational economic behavior by emphasizing the role of cognitive, emotional, and social factors in decision making. Invoking the idea of bounded rationality, Daniel Kahneman and Amos Tversky in 1979 emphasized the practical importance of heuristics, that individuals make decisions based on rules of thumb rather than logic strictly defined, and on framing, or the use of anecdotes and stereotypes as a basis for understanding and responding to events.
In 1991, Kahneman, with the economists Jack L. Knetsch and Richard H. Thaler, showed how these behavioral tendencies help one to understand otherwise anomalous financial outcomes. Such anomalies include a tendency to excessively extrapolate the recent past into the distant future, giving rise in good times to “irrational exuberance” (to use Alan Greenspan’s phrase) like that seen before 2008, and in bad times to self-reinforcing slumps like the one that followed. Some analysts of financial markets have sought to adopt these insights and run with them, for example jettisoning the “efficient markets” paradigm for the alternative of behavioral finance. The awarding of the 2002 Nobel Memorial Prize in Economic Science to Kahneman, a psychologist by training, is evidence of the impact on the economic mainstream of this work.
The implications for regulatory reform are direct. Excessive risk taking will not be deterred simply by capping bankers’ compensation or adding provisions that claw back bonuses if profits from risks taken today result in losses and crises tomorrow. Better information (“financial transparency” in regulatory lingo) may do less to enhance stability than suggested by the conventional wisdom. Investors engage in herd behavior not simply because they lack information and therefore base their actions on the actions of others they presume to be better informed, but because the information-processing capacity of the human brain is limited, leading to reliance on emulation of peers and rules of thumb. This research points to the need for cooling-off periods, so-called circuit breakers, during which trade in assets is temporarily suspended to allow investors to gather their wits and reconsider their decisions.
Similarly, interdisciplinary scholars like Anke Muessig, now a professor of accounting and audit at the University of Luxembourg, have sought to apply “normal accident theory,” developed to understand nuclear-reactor accidents, to financial accidents. Building on the work of the sociologist Charles Perrow and others, Muessig argues that system breakdowns—in this context, financial meltdowns—are most likely when the technological system is complex, giving rise to nonlinear dynamics and producing outcomes that even close observers find difficult to anticipate and comprehend. The risk of breakdowns is further heightened when the system is, as Perrow put it in his 1984 book Normal Accidents, “tightly coupled,” that is when events follow one another in short order, so that observers have little time to process information and scant opportunity to intervene.
Again, the implications for regulation are direct. Simplify the system to limit unpredictable dynamics by requiring banks to adhere to simple leverage ratios or by banning complex derivative instruments. And loosen the system’s coupling, whether by adding circuit breakers or by requiring banks to hold large capital buffers to back potentially risky moves.
Related work on critical-incident management, like the psychologist Rhona Flin’s 1996 book Sitting in the Hot Seat, focuses on “high reliability organizations,” entities that succeed in avoiding, or at least limiting, the incidence of catastrophic system breakdowns. Such analyses point to the importance of training regulatory personnel so as to build a group spirit of vigilance while fostering diverse analytical perspectives, and to the importance of decentralizing decision making and power so that even individuals low on the regulatory totem pole can take steps when they detect risks to stability.
These insights reinforce the sense of unease many of us feel in light of recent revelations by Carmen Segarra, a former New York Fed bank examiner, of strong pressure for regulators to adhere to the institutional party line. They raise questions about recent moves to further centralize regulatory authority, by assigning it to the central bank in Britain and euro area and by reducing the number of separate bank regulators in the United States.
Incorporating insights from interdisciplinary research won’t prevent all financial and economic regulatory crises. Even high-reliability organizations experience system breakdowns, just less frequently than low-reliability organizations. Not even the highest-quality financial regulation can prevent all financial disruptions. There is a tendency to assume that if oversight is rigorous, then a more sophisticated, complex financial system can safely be allowed to develop, pushing the envelope of what is safe. Political scientists will cite regulatory capture, a regulatory agency’s becoming unduly influenced by the actors it’s supposed to monitor, as a problem for effective oversight, while cognitive scientists will point to “cognitive capture” and the influence of free-market ideology in shaping the course of regulation and public policy generally.
The implication is that, interdisciplinary approach or not, crises will always be with us. That said, systematically incorporating scholarship from disciplines beyond economics—getting their ideas inside economists’ heads if we can’t get the scholars themselves into more policy makers’ offices—might help to limit crises’ frequency and make them at least somewhat less disruptive.
Barry Eichengreen is a professor of economics and political science at the University of California at Berkeley. His new book is Hall of Mirrors: The Great Depression, the Great Recession, and the Uses—and Misuses—of History (Oxford University Press).
