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Charles Perrow and causes of the meltdown

by Robert Teitelman | Published January 18, 2012 at 12:16 PM

Last week I posted on the question of whether systemic disasters like the financial crisis had a single precipitating cause, as Karl Smith at Modeled Behavior argued, or multiple causes, as I tend to believe. In support of my case, I cited the fascinating work of Charles Perrow, a Yale sociologist and systems expert who in books like "Normal Accidents" and "The Next Catastrophe" wrote with great penetration on the causes of systemic disasters. I received an e-mail in response from Perrow who corrected me on an earlier piece I had written saying he hadn't dealt specifically with the financial meltdown, and offering several recent papers on that subject. Perrow's perspective is an interesting one, albeit one that runs contrary to my argument about multiple causes.

As he wrote in his e-mail: "Re: financial meltdown, I veer dangerously close to a single factor explanation, which is contrary to my disposition, because so many colleagues were saying it was the complexity of the system or the dominance of a new economic culture (shareholder value, etc.). They were ignoring or downplaying the chain of successive deregulation actions that allowed complex financial vehicles to emerge, and made it convenient and financially rewarding for top managers to ignore signs that what their profits were based upon was likely to harm their own firms, their clients, and society. (Its rapid spread was the result of tight coupling.) I called it 'executive malfeasance,' because it was not inadvertent (normal accidents are inadvertent) or even that mysterious. The warnings were voluminous and loud; risk managers were fired for sounding them. It is not hard to set up an economic system that provides opportunities for large, quick gains, even if there will be a collapse; history has many famous precursors, such as the tulip mania and the South Seas bubble, and even an alarmingly close parallel when the U.S. was funding a real estate boom in Europe in the 19th century just as China did in our times. But most of the time there are institutional checks upon self-interest maximization; bubbles are almost always possible (everyone has their favorite candidate today), but are still rare (about every other generation at most)."

The two papers, a new preface for the paperback edition of "The Next Catastrophe" and a monograph, "The Meltdown Was Not an Accident," for a sociology volume focusing on the financial crisis, make essentially the same argument: that the crisis was caused not by the kind of structural features such as complexity and coupling that feature in what he calls "normal accidents" or by "neoinstitutional" mechanisms, such as ideology, world views, cognitive frames or norms. Instead, Perrow believes the crisis was precipitated by "key agents" who deliberately ignored warnings, "created the ideologies and changed institutions, fully aware that this could harm their firms, clients and the public."

Perrow works his way through the available evidence, from books by Gregory Zuckerman and Michael Lewis on hedge funders who shorted real estate, to the literature on what motivated Robert Rubin, Alan Greenspan, Charles Schumer and Phil Gramm, to the warnings in the press about real estate bubbles and derivatives. The first thing that's obvious here is how quickly we leave the black-and-white, even objective, analysis of structural features like coupling, complexity or mimicry (roughly herd behavior) and delve into more obscure matters of motivation, knowledge and individual psychology. Perrow argues that Wall Street elites must have known what lay ahead because they were "told" by experts like risk managers, some of whom were subsequently fired. This was undoubtedly true, though Perrow I think overestimates the ability of risk experts to accurately predict what the future may hold based on past experience and thus the persuasiveness and authority of their analyses. Risk and reward is always a guess, a probability, not a fixed certainty, which constitutes something less than "real" knowledge of the future. Moreover, and this applies as well to bubble stories in the press, there was no consensus. For every story on the bubble, there were others insisting that real estate was local, robust and, thanks to the new securitized techniques and the strong economy, capable of rising for many years. Confidence was high that the authorities (such as the godlike Greenspan) could manage the situation (that may well have exceeded the belief in a bailout, at least before the crisis began). Besides, no one could predict when the break would occur; well-paid elite agents, pressured by shareholders to maximize returns, probably saw no further than their own retirements. And on top of everything else, the warnings had proven to be wrong in the past. Nassim Nicholas Taleb's "black swans" had not appeared in the very long and confidence-building stretch of the Great Moderation. The past was known, the future was not.

This is not an excuse, but it is an argument for a more nuanced psychology of these agents and for the power of institutional pressures and structural factors to shape perceptions. Perrow argues that warnings about derivatives had been made for years, including Warren Buffett's characterization that they were "weapons of mass destruction" and a Fortune cover story warning about them in 1993. But again, these were warnings, not certain knowledge. The Fortune story occurred 15 years before the credit default swap problem at AIG; indeed, CDSs played no role at the time. Derivatives is a broad field, with a bewildering variety of instruments. Not all shared the same risk profile. And there was such profound complexity that no one could comprehend the entire universe of interacting instruments (as no one can today). In today's Wall Street Journal, Holman Jenkins discusses a new book, Jeffrey Friedman and Wladimir Kraus' "Engineering the Financial Crisis," that argues that the complexity of the financial scene spawned a widespread ignorance. I haven't yet read the book, but I do believe that it speaks to an analytical and perceptual myopia, undoubtedly combined with self-interest, greed and stupidity, that blinded many elite agents in the run-up to the crisis.

Personally, I'm not sure that we need to adhere to one or the other. The complexity of human behavior is remarkable. Agents can be flat-out wrong, partially blinded by greed, bureaucratically hemmed in or, undoubtedly in some cases, cynically and deliberately self-destructive. Perrow's weakest case, I think, involves what he argues is the deliberate construction of a free-market ideology to achieve self-interested ends. Again, I think there's lots of variety here: from true believers to the darkly cynical. But the case can certainly be made that self-interest can subtly buttress and confirm ideology -- particularly when the world (or history) seems to confirm their beliefs. We had an entire 20th century of lessons in the seductive power of ideology. I have grave doubts about rational expectations and the efficient-market schools of macroeconomics. But while I believe that some of these folks are probably careerists, most are not: They may be wrong (the debate continues) but they are not necessarily cynical. Indeed, even Perrow admits that Greenspan seemed to act not out of some crude financial self-interest but from deep, if mistaken, belief (though, in Greenspan's case, power may have been as much an elixir as money).

There's no absolute solution to this. The real subject is the human mind and the human heart and how they interact with a world of constant change and uncertain futures. Which is why we'll be arguing about this until the next disaster. - Robert Teitelman

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