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