Knowing Better Is Not Doing Better

The Conference Board Review^® Article

Economic crises highlight our inability to make rational decisions.

By Michael E. Raynor

Michael E. Raynor is with Deloitte Consulting LLP. In addition to consuming theory, he occasionally tries to create some; BusinessWeek named his most recent book, The Strategy Paradox, one of the top 10 books of 2007. He can be reached via www.michaelraynor.com.

The credit crunch that began about a year ago has yet to be named for posterity. I fear that if we're not careful, we'll end up with "The Subprime Crisis," which doesn't have nearly the poetry of something like "Black Thursday." But whatever we end up calling it, we seem to have gone through at least four, and perhaps all five, of Kübler-Ross's stages of grief (anger, denial, bargaining, depression, acceptance). And now general sentiment has turned to dealing with the fallout.

This is déjà vu all over again. We went through a financial near-meltdown a decade ago with Long-Term Capital Management and the Asian Contagion (another great name, by the way). A decade before that, we were still mopping up the savings-and-loan collapse of the early 1980s. And before that it was sovereign-debt defaults in the 1970s. Sadly, it's a long list: Jean-Charles Rochet, in his new book Why Are There So Many Banking Crises?, cites an IMF study identifying 112 systemic banking crises in ninety-three countries and fifty-one borderline crises in forty-six countries between 1975 and 1995.

What's going on? Why so much instability?

An all-encompassing generalization might seem difficult to develop, for we seem constantly to be finding new ways to walk into sharp objects. I think the reason we repeatedly succumb to a pathological cycle of overreach and hangover-induced contrition when going through these crises is that, in financial markets in particular, we tend to work on the assumption that market participants are rational and that they respond in predictable ways to financial incentives. It turns out that only half of that equation is true.

At the risk of oversimplifying a complex reality, let me suggest (and I'm not alone in so doing) that the root of today's troubles lies in the repeal of the Depression-era Glass-Steagall Act. Glass-Steagall separated commercial and investment banks in order to keep debt and equity markets separate. The concern then was that banks had extended loans to otherwise insolvent companies in order to prop up the value of the equity they had underwritten. When the companies finally went bust, the resulting collapse was far more severe than it otherwise would have been, dragging down entire banking systems.

David Dodge, former governor of the Bank of Canada, said in a January speech that to avoid similar debacles in the future, securities holders should do more of their own due diligence rather than outsource the assessment of financial risk to ratings agencies with so little skin in the game. In addition, originators of securities should be forced to hold some portion of what they issue to ensure that they are properly incented to represent accurately the reliability of the underlying assets and cash flows.

There's considerable merit in these suggestions, for they are based on valid economic theory. The problem, or at least the limitation, of such solutions is that they trade exclusively on incentives — and incentives function only when people are able to assess accurately the benefits and costs associated with specific courses of action. In truth, we're simply terrible at making decisions. Although why we're so bad remains a subject of debate, that we're no good is about as robust a finding as there is in psychology.

Pages: [1] 2 3

Comments? Write a letter to the editor.

Return to the July/August 2008 The Conference Board Review® issue.