What Caused the Financial Crisis

11. The Crisis of 2008: Lessons for and from Economics

Chapter 11 The Crisis of 2008: Lessons for and from Economics DARON ACEMOGLU We do not yet know whether the global financial and economic crisis of 2008 will go down in history as a momentous or even a uniquely catastrophic event. Unwritten history is full of events that contemporaries thought were epochal but are today long forgotten. Conversely, much of what we think of as critical was, at the time, considered insignificant; in the early stages of the Great Depression, for instance, many people belittled its import. Regardless whether the second half of 2008 will be featured in history books, however, it is a critical opportunity for many in the economics profession—unfortunately, myself included—to be disabused of certain notions that we should not have accepted in the first place. It is an opportunity for us to step back and consider which, among the conclusions to our theoretical and empirical investigations led us, remain untarnished by recent events—and to figure out what intellectual errors we have made, and what lessons these errors offer. Whatever the intellectual currents of the past, however, economic theory still has a lot to teach us as we make our way through the crisis. Several economic principles related to the most important aspect of economic performance—the long-run growth potential of nations— are still valid and hold important lessons in our intellectual and practical deliberations. But, curiously, these principles have played little role in recent academic debates and have been entirely absent in pol- 252 Daron Acemoglu icy debates. Academic economists should not let these principles be forgotten, even as we acknowledge our mistakes. There remains much uncertainty about what happened in the financial markets and inside many corporations. We will know more in the years to come. From what we know today, many of the roots of our current problems are apparent; but most of us did not recognize them before the crisis. Three inaccurate notions impelled us to ignore these impeding problems and their causes. The Unconquered Business Cycle The first notion to be discarded is that the era of aggregate volatility has come to an end. We believed that, through astute policy or new technology (including better methods of communication and inventory control), the business cycle had been conquered. Our belief in a more benign economy made us more optimistic about the stock market and the housing market. If all economic contractions must be soft and short lived, then it becomes easier to believe that financial intermediaries, firms, and consumers should not worry about large drops in asset values. Even though the data robustly show a negative relationship between an economy’s income per capita and its volatility, and many measures did show a marked decline in aggregate volatility since the 1950s and certainly since the prewar era, these empirical patterns neither mean that business cycles have disappeared nor that catastrophic economic events are impossible. The same economic and financial changes that have made our economy more diversified and individuals and firms better insured have also increased the interconnections among them. The diversification of idiosyncratic risks shares them among many companies and individuals, creating a multitude of counterparty relationships . Such interconnections make the economic system more robust against small shocks, but they also make the economy more vulnerable to certain low-probability, ‘‘fat tail’’ events because of potential domino effects among financial institutions, companies, and households. In this light, perhaps we should not find it surprising that The Crisis of 2008: Lessons for and from Economics 253 years of economic calm can be followed by tumultuous times and notable volatility. There is another sense in which the myth of the end of the business cycle is at odds with fundamental properties of the capitalist system. As Joseph Schumpeter argued long ago, the market depends on innovation, which involves a heavy dose of creative destruction— where new firms, procedures, and products replace old ones. Much of the market system’s creative destruction takes place at the micro level. But not all of it. Many companies are so large that their replacement by new firms and products will have aggregate effects. Moreover, many general-purpose technologies are shared by diverse companies in different lines of business, so their failure and potential replacement by new processes will also have aggregate effects. Equally important, businesses and individuals make decisions under imperfect information, and they may learn from each other...