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Andrew Lo and the wisdom of reading 21 crisis books

by Robert Teitelman | Published February 3, 2012 at 3:18 PM

Playing catch-up here. MIT economics professor Andrew Lo has written a paper for the "Journal of Economic Literature" summarizing, with a few general points, some 21 books on the financial crisis. This is a task I, a certified lunatic, also tackled several years ago; at last count I've managed somewhere past 25 of them (there are links to them on The Deal Economy blog), although toward the end the subjects of the books grew broader and deeper, leaving the facts of the specific crisis behind and examining more what to do than what happened, though the two are, of course, related. Lo divides his books roughly into academics and journalists, though in the latter camp he also includes Treasury Secretary Henry Paulson's memoir. He includes some books that came too early in my labors -- William Cohan's "House of Cards," about the fall of Bear Stearns Cos. -- or those that I simply never got to or wasn't aware had been published; I particularly regret missing Carmen Reinhart and Kenneth Rogoff's "This Time Is Different: Eight Centuries of Financial Folly" and Raghuram Rajan's "Fault Lines: How Hidden Fractures Still Threaten the World Economy." For his part, Lo skipped both books that Federal Judge Richard Posner published in 2009 and 2010, "The Crisis of Capitalist Democracy" and "A Failure of Capitalism" (my review of the latter is here), which commendably wrestled with many of these issues of causation that Lo raises, and he passed over a number of volumes written on the fall of Bear and Lehman Brothers, some of which feature interesting perspectives.

If there's one thing we've learned in the Internet age, it's that the quest for comprehensiveness and universality is a form of folly. The question to ask about a paper like this is whether it's really all that useful, particularly for an academic audience, which does read for a living. Lo lacks the space for anything more than a cursory treatment of each of these 21 books. Generally, he is relatively kind bordering on bland -- he has to move fast -- discussing some ideas but rarely showing much judgmental bite. Not surprisingly, he is better on the academic texts than on the journalistic ones, upon which he displays just the mildest trace of condescension. He tosses out the old chestnut that academics are the "strategists, diplomats and gadflies" (how did gadflies end up there and not on the journalist side?) of this "financial war," while journalists, including Paulson (was he aware that a journalist did most of Paulson's writing?) were "the war correspondents" trying to capture those nonacademic concerns: "motives, psychology, personality and strong emotion" -- despite the fact that he deals with Robert Shiller and George Akerlof's "Animal Spirits," which is essentially about behavior and emotion.

Like anyone who tackles a task like this, Lo gets around to asking a philosophical question, which is part philosophy of history and part epistemology: How do we know what we know? Why can't we parse out the various causes of this great disaster more quickly, if at all? You know he's going there because he opens the paper with a hackneyed cliché of journalistic writing that good editors beat out of young writers all the time: Kurosawa's "Rashomon." This 1950s film, of course, embodies the reality of different perspectives and different realities. Lo uses it to illustrate "just how complicated it can get." (So does everyone else, which is why it's become a cliché.) He seems genuinely surprised by this, and he offers three examples of what he calls "folk wisdom" about the crisis that lack, he notes, empirical evidence: that investors were led astray by devotion to the efficient-market hypothesis, particularly on real estate; that Wall Street pay focused on short-term trading profits rather than long-term incentives; and that investment banks boosted their leverage in the years leading up to the crisis. All of these are terrific questions, though I wonder whether belief in efficient markets would constitute a folk wisdom, except in the way that nearly every market belief about fear, risk and behavior is forged by experience and emotion, not quantifiable empirical evidence, mostly because testability takes place in a future that has not yet emerged. But they are also extremely large, murky and complex questions -- I, a mere war correspondent, need to say this to an academic? -- shot through by paradox, counterintuitive lessons and that elusive shape-shifter, human psychology, whether in the form of an individual or a crowd. In short, history is a puzzle, and its link to the future remains a mystery.

In fact, the one area that Lo tries to nail down -- the question of Wall Street leverage -- quickly gets away from him. He argues that the Securities and Exchange Commission's decision to allow Wall Street firms to increase leverage never really happened (he provides a quote from one official, which seems pretty thin to me), and that leverage was actually higher in the late '90s. Various commenters and bloggers have argued with him on this, including James Kwak at The Baseline Scenario (Lo covers Kwak's book, written with Simon Johnson, "13 Bankers"), offering up various bits of evidence. I have my own sense of this. As Lo, a former Boston Stock Exchange governor, founder of hedge fund AlphaSimplex, which trades through his "adaptive markets" strategy, and head of MIT's Laboratory for Financial Engineering, undoubtedly knows full well, "leverage" on Wall Street is pretty squirrelly. Whether the SEC did anything or not, we've long known that Wall Street firms crank up leverage when they want to, then bring it down at the end of the quarter for reporting reasons. We also know much of the real risk lurked off the balance sheet, and that there was leverage that didn't always look like leverage. We also "know" (an ironic "know") that there was too much leverage beyond Wall Street, but interconnected, some of it hidden: in the government, in households, in companies. It's interesting to debate what really happened to that specific 2004 policy, but we saw several firms -- Bear and Lehman -- blow up because they were unable to fund themselves: That suggests that leverage, specifically short-term funding, was a problem.

It's pretty obvious we will be arguing about his other two examples of "folk wisdom" for decades as well. At the recently completed World Economic Forum in Davos, Harvard Law School's Lucian Bebchuk debated Ohio State's René Stulz on compensation and the crisis. Each party marshaled his empirical facts and arguments, though both really depend on a deep-seated psychological belief that shapes governance theories and their arguments: Stulz, that high comp, much of it in stock, aligned individual interests with firms; Bebchuk that high comp meant that they could take high risks knowing that their downside was protected.

Lo, in a sense, seems to be discovering through these books the world that journalists must cope with every day: wayward facts, patches of ignorance, ambiguities, complexities, oddities, mysteries. Why do people act this way or that? Is the conventional wisdom -- Lo's folk wisdom -- true, false, neither or both? If you're a conventional economist -- Lo, to his credit, is not -- you shield yourself with your utilitarianism and perhaps your efficient-markets hypothesis and draw broad conclusions. The best journalists, however, believe that no single theory will explain all behavior; that individuals, markets, crowds, electorates are impossible to accurately predict and that the world is, let's be honest, strange. Facts need to be nailed with a golden stake through their heart, or they'll get up and wander off. You read these books from both camps, I think, not to come to hard-and-fast conclusions -- pay caused everything! it was the government! it was Fannie Mae! -- but to begin to try to see where the pattern of facts, however defined and tested, emerges into something broader and more general that the academics can tackle and the public can absorb. It'll be awhile until we get there. In the meantime, there's lots to read to pass the time. - Robert Teitelman

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