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Cognitive Tics of the Herd

Paul Daly

 

Too Big to Fail, by Andrew Ross Sorkin, Allen Lane, 640 pp, £14.99, ISBN: 978-1846142383

That Joe Gregory, a former senior executive at Lehman Brothers, extolled the virtues of Malcom Gladwell’s Blink tells us something about Too Big to Fail and a lot about Gregory and his ilk. Andrew Ross Sorkin’s pulsating account of the 2008 crisis on Wall Street, from the rescue of Bear Sterns, to the collapse of Lehman Brothers to the huge government bail-out engineered by treasury secretary Henry Paulson, is full of memorable details. Ross Sorkin is the chief mergers and acquisitions correspondent of the New York Times, and he conducted wide-ranging interviews with the leading players in the drama, most of whom insisted on anonymity. In style, it resembles the 1990 classic Barbarians at the Gate, in which Bryan Burrough and John Helyar chronicled the leveraged buyout of RJR Nabisco.

There, as here, it is the little things that matter. Thus we learn that Gregory not only enjoyed Blink but proselytised about it: “He gave out copies of the book and had even hired the author to lecture employees on trusting their instincts when making difficult decisions. In an industry based on analysing raw data, Gregory was defiantly a gut man.” But Gladwell’s book is a simplistic discussion of controversial and difficult concepts developed in fields such as economics and psychology. For the average reader, it is none the worse for that, but it is hardly suitable for use in environments where billions of dollars may be at stake. As Richard Posner pointed out in an excoriating review, “Practice may not make perfect, but it enables an experienced person to arrive at conclusions more quickly than a neophyte. The expert’s snap judgment is the result of a deliberative process made unconscious through habituation.” Instincts may be good, but they have to be honed in order to be so.

To be fair to Gladwell, he does hint at times that the human cognitive function is a difficult beast to tame. One suspects, however, that the nuances were lost on Gregory. One of the lessons from Too Big to Fail and the current financial crisis is that Wall Street could have done with more exposure to concepts of cognitive psychology and behavioural economics. Consider, for example, the phenomenon of group-think. Individuals in an organisation may become obsessed with achieving the goals of the organisation, sometimes to the extent that they will fail to see storms brewing on the horizon. In the case of large financial institutions – and perhaps even financial markets in general – a sense of mission may have blinded key individuals to coming dangers. An Irish example seems ready to hand. Judging by media accounts, Anglo Irish Bank may have suffered from this phenomenon. Key executives were driven to establish Anglo as a major player in the Irish and British banking sectors. But the course they charted proved unrealistic and when they hit the squalls of the 2008 crisis, the ship was sundered.

A phenomenon which is both more common and more dangerous is group polarisation. Take a group of ten individuals, all of whom lean towards one proposition, say, that the property market is likely to remain buoyant. If the group is put in a room to deliberate about the proposition, individual members of the group – and the group as a whole – become more extreme. An initial leaning that property prices will continue to rise will transform into a leaning towards an eternally buoyant property market. Of course, where there are voices to advocate a leaning in the other direction, the group will tend towards moderation. Moderation, however, was not greatly in evidence either in individual financial institutions, financial markets or – especially in Ireland’s case – society at large, in recent years. Reading bullish accounts of the financial markets and flicking through endless glossy newspaper property supplements has an effect on what you say to your colleagues at the water-cooler or in strategy meetings, to your neighbour over the fence in the morning or to your friends at dinner parties.

A key driver of group polarisation is cascades, which have two main forms: information cascades and reputation cascades. An individual faced with a novel problem may not have enough knowledge to solve the problem independently. In such situations, people rely on the judgments of others who seem to know more and impute knowledge to individuals who have already acted. The property market provides an excellent example. Few individuals know enough to judge the value of a house. Ascertaining value objectively would require a complex computation involving, among other things: the quality of structure and future maintenance costs; likely interest and inflation rates; proximity to important services; anticipated improvements in transport infrastructure; the ongoing cost of renting an alternative property; and so on. Even experts would struggle to complete this computation. What hope does the ordinary individual have? But if somebody else has bought a nearby house, or a house of similar dimensions elsewhere, for a particular sum, that decision seems to yield useful information. “The house must be worth €500,000 if the guy down the road paid that much!” This is an information cascade. Notice that there is no analysis of whether the guy down the road actually had access to any more relevant information. In turn, he may have been relying on the decisions of previous purchasers. Hence the term cascade. A reputation cascade works in a similar way: “Murphy is a bank manager. He must know what he’s talking about.” In addition, individuals are worried about their own reputations. Cassandras don’t often make the guest list for the best parties, so there is a strong incentive to follow the herd.

The problems of information and reputation cascades are even more acute in the world of finance. In the 1990s, curious creatures known as mortgage-backed securities (MBSs), collateralised debt obligations (CDOs) and credit default swaps (CDSs) fully emerged onto the financial scene. The idea behind MBSs and CDOs was simple enough: take lots of mortgages, some good, some bad, bundle them together, collect the repayments, and sell the resultant security or the rights to repayments. You could even finance other transactions with the resultant security. Or, because these securities seemed so valuable, you could borrow money to buy them. Of course there were risks involved. So you got a CDS from an insurance company to cover you in case the income stream from the mortgage repayments dried up. An entire edifice – a house of cards or a pyramid, depending on your perspective – was constructed atop these complex financial instruments; ultimately, on mortgage repayments. It helped that property markets were booming and that banks and – particularly in the United States – quasi-governmental institutions were extending dubious lines of credit to individuals living beyond their means. Financiers could produce reams of printouts justifying their decisions, but what really mattered at the highest levels was the approval of the ratings agencies. If Moody’s, Standard & Poor’s et al were happy to put their considerable expertise and reputations behind these complex financial instruments, then the bundling, buying, selling, borrowing and insuring could continue apace. Moreover, most major institutions had invested in CDOs and CDSs. What was there to worry about? Cascades could not defy the laws of financial gravity forever, however. When interest rates spiked and mortgage repayments slumped, information came flowing out and the edifice came crashing down. Homeowners in Arizona and Louisiana who could not pay their bills contributed to a global financial crisis. With the streams of mortgage repayments dwindling to a trickle, the CDOs became “toxic”: because all of these mortgages (some of which were still profitable) were bundled together, the bad and the good were intertwined. Consternation resulted. Wall Street traders bellowed “Sell, sell, sell” with nary a thought given to whether the assets were really that toxic after all.

Other cognitive tics affect how individuals process information. Through the operation of the availability heuristic, important, high-profile events are given more weight than recurring, low-profile events. The collapse in airline travel after the 9/11 attacks is a good example. Did flying suddenly become more dangerous? Surely not, but the endless rewinds of planes crashing into buildings made the event a salient one, apt to influence people not to fly. Consider, by way of contrast, road fatalities, which are generally events of low salience and do not exert great influence on individuals’ propensity to drive. During the 1990s and 2000s, all the happy stories about individuals buying their beautiful first homes, about investors making millions in the markets and Wall Street executives pocketing enormous pay packets triggered the availability heuristic at all levels of society. A phenomenon known as hindsight choice bias contributes something to the availability heuristic. Individuals create narratives to explain past events. In those narratives, happy events are more likely to feature. The five friends who reaped huge capital gains when they sold their houses loom larger than the one friend who couldn’t meet the mortgage repayments. In the financial world, the collapse of Long Term Capital Management is discounted in favour of tales of the derring-do of Bear Sterns and Lehman Brothers. We all write our own Whig histories.

It bears mentioning that regulatory bodies are composed of individuals and are also subject to these cognitive tics. Once limitations on human cognition are understood, it is not as difficult to appreciate why Ireland’s Financial Regulator, and equivalent American bodies, did not intervene in markets that appeared to be running smoothly. Once the markets ground to a half, hindsight choice bias worked in the opposite direction. People roamed the streets, waving copies of Nassim Taleb’s The Black Swan or Morgan Kelly’s opinion pieces like Chamberlain’s piece of paper, declaring wildly that it had been perfectly obvious all along. It rarely is, as Ross Sorkin’s pitch-perfect description of the bafflement on a besieged Wall Street, traumatised by the emergence of the possibility of even the leading investment bank, Goldman Sachs, going to the wall demonstrates.

Other phenomena afflict government agencies. Regulatory arteriosclerosis can set in over time. An initial burst of enthusiasm – such as that being shown at present by Professor Patrick Honohan, the new governor of the Irish Central Bank – leads to creative regulation, but as the years pass the enthusiasm begins to wane and the once vigorous body expends its decreasing energies on maintaining its position rather than innovating. A more troubling phenomenon is that of agency capture, the idea that government bodies tend to further the interests of regulated bodies, rather than the interests of the public. Agency capture is not as sinister as it sounds. Regulators are closely identified with the industry they regulate and because the success of the industry reflects well on them, they will tend naturally to promote the interests of the industry. If banks’ profits are increasing and share values are rocketing, a regulator will be loath to intervene. And if house prices are rising and the downtrodden can fulfil their ambition to own a home, a regulator is more likely to facilitate more lending than to call a halt to the extension of easy credit.

Plain vanilla economics is of assistance too in understanding the 2008 crisis. When Lehman Brothers teetered on the brink of the precipice, its head, Dick Fuld, seemed dazed and confused, lurching from prospective saviour to prospective saviour before wondering aloud in puzzlement: “So I’m the schmuck?” The problem, judging by Ross Sorkin’s account and by media and anecdotal evidence of what occurred elsewhere, was that the men (and they are almost all men) at the top of the financial world had little comprehension of what was going on beneath them. It was a classic problem of supervision. The traders and the analysts developing complex financial transactions were doing so at such a whirlwind pace that senior executives were unable to keep track. Nobody at senior management level, it seems, understood the extent of their liabilities and critically, nobody understood how inter-connected those liabilities were, even when behemoths such as Bear, Lehman, Merrill Lynch, Morgan Stanley and even Goldman Sachs approached the brink. Conversely, in the Irish context, supervision may have been all too close. The imminent banking inquiry may demonstrate that edicts from senior executives motivated branch and regional managers to offer loans to high-risk clients, and that central management knew all too well the lie of the financial land.

One myth which is exploded by Ross Sorkin’s account is that the 2008 crisis signalled an end of capitalism, an end trumpeted by several commentators in the wake of the collapse of Lehman Brothers. Any sane advocate of free markets will recognise that government regulation is a key component of any system of free exchange. At the very least, without a mechanism for enforcing contracts, which is best supplied by the state, a market could not function. That aside, the United States government played a key role throughout the 2008 crisis. The rescue of Bear Sterns by JP Morgan Chase would not have been accomplished without state support. Although Lehman Brothers eventually went over the edge of the precipice, Henry Paulson and Timothy Geithner, then at the New York Federal Reserve, tried to strong-arm Wall Street into organising a rescue. The participants too knew how crucial the government’s role was. As a Bank of America executive commented to Paulson about the bank’s proposed takeover of Lehman Brothers: “We’re going to need the government to help to make this work.” They did not get any such help and the proposed deal foundered.

However, if Too Big to Fail is a bad book for the end of capitalism hypothesis, it is also a bad book for any view of government agents as knights in shining armour. Broadly speaking, there are two approaches to making policy: the synoptic and the incremental; less technically, the broad and the narrow. In a world of perfect rationality, a decision-maker would first identify the relevant goals or values to be achieved; then identify the various means by which these goals or values could be achieved; then consider the likely consequences of each of the means; and would finally choose the most effective means of achieving the goal or value. But we do not live in a world of perfect rationality. We live in a world of what Herbert Simon called “bounded rationality”. No human decision-maker can, because of limitations imposed by cognitive and physical limitations, personal values which may diverge from those of the organisation, and the absence of full knowledge and information, perform this perfectly synoptic decision-making. Various heuristic devices are necessary. Humans satisfice – choose courses of action that are satisfactory rather than optimal – and deliberately over-simplify. Charles Lindblom’s still grimmer perspective on the making of policy is encapsulated in the title of a famous article: “The Science of ‘Muddling Through”. In the real world, decision-makers proceed incrementally, taking the status quo as their starting point, considering limited possible alternatives, and trying to do as little damage as possible by making slight adjustments to achieve their goals or values (which may in many cases conflict one with the other).

The view of government agents as knights in shining armour often takes the rosier perspective of perfect rationality, or even bounded rationality. In 2008 though, the government muddled its way through. Individual firms were initially the focus of attention: first Bear Sterns, then Lehman Brothers and Merrill Lynch (eventually rescued by Bank of America). Concerted efforts were made to save the endangered firms, but it was not until the collapse of Lehman Brothers imperilled the entire financial system that Paulson, Geithner and Ben Bernanke, chair of the Federal Reserve, took a broader view. The Troubled Asset Relief Program (TARP) then emerged. Although some of Paulson’s staff members had outlined a basic TARP a few months previously, those calculations were of the “back of an envelope” variety. Initially, the idea behind the TARP was similar to the one underpinning Ireland’s National Asset Management Agency (NAMA). If lines of credit were becoming frozen because everybody knew that there were toxic assets in the financial system but nobody knew exactly who held the toxic assets, how much the toxic assets were worth, what the effect was on the value of non-toxic assets, or how the good could be separated from the bad, it followed that the financial system could not be restored to full health without removing the toxins. Moreover, because valuing the toxic assets was so difficult, purchasers were reluctant to buy them. But by setting up some sort of government-led auction to establish a floor price for the toxic assets, perhaps the value of the assets could be ascertained and boosted, ultimately allowing the toxins to be flushed out and credit to begin flowing through the system again. TARP, like NAMA, was a synoptic response to the toxic asset problem. Tellingly, it was only in the face of a full-blown crisis that TARP emerged as the solution: “The entire economy, [Paulson] said, was on the verge of collapsing”. Until that point, it had been incrementalism all the way. Similarly, in Ireland, NAMA came after the bank guarantee, the nationalisation of Anglo Irish Bank, and the pumping of capital into Bank of Ireland and Allied Irish Banks.

One factor that seemed to contribute to the incrementalism in the United States was regulatory overlap. The Treasury Department (Paulson), the Federal Reserve (Bernanke) and the Federal Reserve Bank of New York (Geithner) co-operated well. But Christopher Cox of the Securities and Exchange Commission (SEC) and Sheila Bair of the Federal Deposit Insurance Corporation (FDIC) made collaboration on comprehensive regulatory responses extremely difficult. Geithner and a colleague “had always regarded Bair as a showboat, a media grandstander, a politician in a regulator’s position whose only concern was to protect the FDIC, not the entire system”. Paulson and Bernanke’s plea for an across-the-board bank guarantee initially fell on deaf ears. Cox, the head of the SEC, was poorly regarded by his counterparts at the top of other federal agencies. During Lehman’s death throes, for example, “Cox, for whom Paulson had had very little respect to begin with, was proving how over his head he really was”. Cooperation might be needed to respond effectively in crisis conditions – and even in non-crisis conditions – but it may not be attainable. Amidst the chorus of criticism of the unified structure put in place in Ireland in the mid-2000s, voices noting the potential drawbacks of regulatory overlap should not be drowned out.

On an international scale, regulatory overlap is virtually unavoidable, because financial crises do not occur solely within national boundaries, and the problems it creates dwarf those of domestic regulatory overlap. When Lehman Brothers finally went over the precipice, more problems were in store, apparently unforeseen by the Americans: “Hedge funds that had traded through Lehman’s London unit were suddenly being cut off, sucking billions of dollars out of the market. While the Fed had kept Lehman’s broker-dealer in the United States open in order to wind down the trades, Lehman’s European and Asian operations were forced by law to file for bankruptcy immediately.” Puzzlingly the problems caused by overlaps are hardly irresolvable: they are caused by a simple absence of knowledge, understanding and agreed frameworks for corrective or emergency action. With hindsight, it is easy to suggest that the Americans ought to have known what the bankruptcy rules were in other jurisdictions. It is difficult to discern why they apparently did not make the effort.

Deeper problems are created when the interests of different countries diverge. Ross Sorkin recounts that Barclays was on the verge of rescuing Lehman Brothers until the move was torpedoed by British regulators. The SEC’s Cox was dispatched to try to hash out a compromise, but returned to Paulson and Geithner “notepad in hand, deathly pale”. Paulson then contacted Alistair Darling, the British chancellor of the exchequer, directly, to plead his case, but was unsuccessful. In a memorable phrase, Paulson described himself and his fellow officials as having been “grin-fucked” by the British. Bizarrely, news of the British government’s unwillingness to allow Barclays to make the deal (which was prudent, viewed with the benefit of hindsight and knowledge of Barclays’ subsequent difficulties) came as a shock: “I can’t believe this is happening now” was Paulson’s initial, stunned reaction. On the one hand, cooperating during the 2008 crisis would have been prudent, but on the other hand, undertaking inevitably complex and lengthy transatlantic negotiations in an ad hoc fashion as the financial world appeared to be crumbling might have been unwise. In the absence of some sort of international structure or agreed framework for addressing such crises, it will always seem more sensible for one party (here the Americans) to present a proposed solution to another party (here the British) as a fait accompli, with room for negotiation only around the edges.

Even Ireland managed to contribute to the difficulties. The bank guarantee announced by the Minister for Finance in late September 2008 made sense in an Irish context, but its effects soon rippled out. Other European countries had to follow suit, if only to bolster national confidence, as panicked individuals and investors pointed to the Irish guarantee scheme as evidence that something must be terribly wrong. The information cascade caused a wave that swept all the way to Washington DC: “[Bair] thought Paulson was under enormous political pressure to put [a guarantee] programme into place, in part because a number of European governments were putting together similar facilities”. A better result for the world might have been no bank guarantees anywhere, because the European initiatives suggested that something was amiss in the global financial system, triggering further calls for government actions (which may in turn have forestalled the emergence of market-based solutions). It is unlikely that the European governments considered these ripple effects when deciding to guarantee domestic deposits, but it is also unlikely that they would have reached a different decision even if they had been aware of the ultimate global consequences. This is a classic collective action problem: the interests of the whole do not align immediately with the interests of the individual; hence the difficulties in securing any international agreement on financial regulation, short of an accord on capital requirements (which ultimately proved inadequate). The possibility of holding out for a better deal will always be present in the context of financial regulation. Ireland is likely to be presented with such an opportunity in the coming years, as the United States and Britain in particular ramp up regulation and impose taxes and charges on financial institutions. Global regulation might make more sense for the world, but from an Irish point of view it might be more prudent to welcome foreign financial institutions with a warm smile and a promise of light-touch regulation. If bankers are being squeezed elsewhere, a lighter regulatory grip could allow Dublin to further develop as an international financial hub.

Forms of regulation do not necessarily exert a great influence in crises, however. Cries of “necessity knows no law” are likely to ring out and, in many cases, to prevail. The authority of the Federal Reserve to effectively rescue AIG, the insurance group swamped by a torrent of CDSs whose holders required urgent payment, rested on an archaic statute dating from the 1930s, but at least the Fed could rely upon some sort of statutory authority. An exchange between Paulson and Christopher Cox about the power of the SEC to require Lehman Brothers to file for bankruptcy is instructive and probably more typical: “After barging in and slamming the door, Paulson shouted, ‘What the hell are you doing? Why haven’t you called them?’ Cox, who was clearly reticent about using his position in government to direct a company to file for bankruptcy, sheepishly offered that he wasn’t certain if it was appropriate for him to make such a call. ‘You guys are like the gang that can’t shoot straight!’ Paulson bellowed. ‘This is your fucking job. You have to make the phone call.’”. Law be damned!

Paulson’s attitude towards niceties such as legal authority is further revealed by the negotiations leading up to the authorisation and implementation of the TARP. Paulson went to Capitol Hill with a breathlessly brief document: “Even inside the [Treasury] Department there were worries that Paulson might look like he was over-reaching. The three-page bill had no oversight plan and virtually no qualifiers.” One of Paulson’s officials thought the bill was a memorandum of talking points, such was its brevity. Paulson, one might note, was seeking $700 billion to implement his three-page plan. Unsurprisingly, political leaders in Congress were unimpressed, and the House of Representatives rejected the first proposed bill. It was somewhat more extensive in its final form: “What had begun as a three-page draft was now more than 450 pages of legislative legalese …” But even before the legislation had been passed, Paulson and his officials were thinking of ways to circumvent it. Convinced that their plan to purchase toxic assets was unworkable and would perhaps not solve the underlying problems after all, they decided to invest the TARP money directly into financial institutions to shore up their creaking balance sheets, in the end strong-arming Wall Street executives into taking the money. But Paulson swung back in the direction of purchasing toxic assets when he received a communication from Warren Buffet, who advocated a public-private plan “with the sole objective of buying up whole loans and residential mortgage-backed securities”. In the end, both programmes were pursued and the beleaguered financial institutions returned towards an even keel.

That Paulson probably had (on this occasion) the legal authority to pursue both programmes simply indicates how broad a degree of discretion was delegated to him by Congress. Delegation of broad powers to the executive branch of government is, in fact, a pervasive feature of emergencies, economic or military. Where decisive action is needed to deal with an emergency situation, responsibility is generally foisted on the shoulders of the executive, which unlike the legislative branch is not hemmed in by cumbersome procedures and rancorous partisanship. Where nimbleness and energy are necessary, they are more likely, it seems, to come from the executive branch. In Ireland, too, broad grants of authority were made to the executive. For example, pursuant to the Credit Institutions (Financial Support) Act 2008, the Minister for Finance may “provide financial support in respect of the borrowings, liabilities and obligations of any credit institution or subsidiary … in a form and manner determined by the Minister and on such commercial or other terms and conditions as the Minister thinks fit … [which may include] conditions regulating the commercial conduct of the credit institution or subsidiary to which the support is provided, and in particular may include conditions to regulate the competitive behaviour of that credit institution or subsidiary”. These powers or functions are very expansive indeed, and may be invoked if the Minister is satisfied that “there is a serious threat to the stability of credit institutions in the State generally, or would be such a threat if those functions were not performed; the performance of those functions is necessary, in the public interest, for maintaining the stability of the financial system in the State, and the performance of those functions is necessary to remedy a serious disturbance in the economy of the State”. That any scheme of financial support must be approved by the Oireachtas, and that the Minister must produce an annual report (the first is due soon), provides some reassurance, but the breadth of the powers cannot be gainsaid by the oversight provisions.

The 2008 Act, as with the TARP legislation in the United States, was an emergency measure. Of greater interest now is what legal measures will be put in place to avoid a repeat of the 2008 crisis. One of the most pleasing aspects of Too Big to Fail is that aside from a brief epilogue Ross Sorkin does not engage in finger-pointing or prepare a laundry list of reforms. As much as is possible the story is presented without an agenda and readers are left to draw their own conclusions. Whether those conclusions will match the facts as presented by Ross Sorkin is an interesting question. Groundswells of populist rage suggest that the answer will be no. Letting firms fail would be the ultimate manifestation of populism, but it seems singularly unlikely that any politician would stake their country’s reputation on the ability of a shattered financial system to rebuild itself in short order. In any event, now that the financial seas are somewhat calmer, the possibility of allowing financial institutions to go under does not really arise.

Populism may, nonetheless, manifest itself in other ways, such as capping pay. Limits on huge executive compensation seem overwhelmingly popular, but no conclusive evidence has been presented linking high levels of pay to poor company performance or excessive risk-taking. Indeed, giants of the banking world like Dick Fuld and Joe Gregory lost huge amounts of money when Lehman Brothers collapsed. Admittedly, those huge amounts of money might not have been on the table in the first place were it not for the risky behaviour the firm had engaged in during the early years of the current century. Doubtless, the lure of Mammon exerted considerable pull, but it seems more plausible to attribute the risk-taking more to the cognitive tics discussed above than old-fashioned greed. Nonetheless good reasons exist for developing creative mechanisms which can empower shareholders to limit executive compensation. Shareholders of a particular company are diffuse and may not be able to rally together to limit pay packets; where a recommendation is issued by a company board, it is difficult for shareholders, who have limited time and resources, to propose alternatives. If those making the recommendations are themselves executives of similarly situated companies, they may have incentives to award generous pay packets, in the hope that their own boards and shareholders will reciprocate. Sweeping and strict statutory limits on pay would, at the same time, surely be a bad idea, regardless of their popularity. Money in business is like water seeping into cracks in a pavement and such limits would surely be circumvented, by hook or by crook. Top executives would most likely simply go elsewhere, to firms not within the ambit of the relevant regulatory body, perhaps ratcheting the risks in the financial system up rather than down. Price controls have traditionally had significant unintended consequences, and there is no reason to think that limits on executive compensation would be any different.

Limiting the size of financial institutions seems a likely and probably popular outcome, in the shape of something like the so-called “Volcker Rule”, named after Paul Volcker, formerly the chair of the Federal Reserve and now a key adviser to President Obama. But even here problems abound. To begin with, although Too Big to Fail is an apt title, Ross Sorkin could just as easily have entitled his book Too Interconnected to Fail. The problem was not the size of any particular institution, it was the web of debt and systemic risk that connected them all. It was interconnectedness that permitted toxic assets to grow to form such a large chunk of the financial system. Indeed, the real lesson of Too Big to Fail is that some firms are too big to rescue and too interconnected to rescue. In any financial crisis, firms will be threatened. Here, however, the problem was so great and so pervasive that the financial institutions themselves were not able to bail out their comrades as they had done in previous crises and had to rely on dramatic, large-scale government interventions. Would imposing limits on size make a difference? Again, the water will surely find a crack. In a globalised world, in which firms have been merging into huge corporate conglomerates for several decades, the need for financing commensurate with corporate size will dictate that large financial institutions will continue to exist. And if they are outlawed in the United States and Britain, they can migrate elsewhere, to Dubai or the Dublin Docklands. In the absence of global governance of finance – the case for which has admittedly been strengthened by the 2008 crisis – some institution somewhere will inevitably be too big and interconnected to rescue.

Such use of taxpayers’ money to bail out distressed financial institutions that are too big to be rescued by the private sector qualifies as what economists call an externality. As with pollution, it is a by-product of otherwise valuable activity which imposes costs on society at large. Also, as with pollution, calibrating the correct amount of the appropriate tax to cover the risk of a future bailout is very difficult. The temptation is to use the logic of taxing externalities to justify imposing a punitive charge on a politically unpopular group of bankers. For President Obama, prime minister Brown and other leaders, a substantial charge would be a politically popular move. But punishing people simply because it would be politically popular to do so is a bad way to develop policy.

A solution which is certain to be implemented involves adjusting the capital requirements of financial institutions. If the institutions have more capital on their balance sheets, it will be easier for them to absorb losses. Implemented globally, new capital requirements could provide a buffer which prevents a crisis from bursting its banks and flowing into financial systems around the world – and because capital requirements are already in place, increasing them does not give rise to the same collective action problems as would starting from scratch. The solution is so simple that one wonders why it was not adopted before the crisis hit in 2008. One fears that just as capital requirements appeared flawless before the 2008 crisis, the new capital requirements will appear flawless before the next crisis, whenever it occurs.

Common to all of these solutions is the same flaw. They are essentially reactive, incremental responses to the 2008 crisis. A set of problems was made clear by the crisis and now politicians and regulators will scramble to develop solutions to those problems. But to borrow from Donald Rumsfeld, financial crises are known unknowns, things we know we don’t know: we know they will occur, but not the form in which they will occur. Another financial crisis will inevitably develop, we will not realise it until it is too late, and the tools developed to respond to the last crisis will prove inadequate. Where information about the future is uncertain, it is difficult to engage in broad, synoptic policy-making; incremental responses do not rely to the same extent on guesses as to future risks. The story of the 2008 crisis may, however, assist in developing some synoptic reforms, because there are also known knowns. When the next crisis occurs, cognitive tics will be sure to have played a role. Information cascades and reputation cascades will have abounded; groups will have become polarised; and people will have woven fairy tales about the likelihood of future rises in asset prices. On the other side, regulators will suffer from regulatory arteriosclerosis and, as a result of agency capture, will stand on the sidelines, cheering. It may not be the derivatives market the next time, but it will be some other type of market and when it crashes, the same recriminations about greed, lax regulation and people succumbing to hyperbole and hysteria will ring out. Just like last time, it will take something of a Nietzschean Superman to stand athwart history and shout stop, that this time really isn’t different.

Enough is now known about humans’ cognitive tics to start trying to tame them. What if the regulators of financial institutions were required to undergo intensive and ongoing training in behavioural economics and cognitive psychology? What if people within financial institutions were required to do the same? What if they were required to apply these principles to their own balance sheets and publish their findings to shareholders? In short, what if we started thinking about how to stop crises emerging in the first place? We could also profitably think about what to do when crises do emerge. What about advance planning and “war-gaming” for crises? Would it not make sense for the various regulators to plan and develop protocols as to how they ought to react in crisis situations? It might even be possible to enact legal frameworks to help manage financial crises. Unlike comprehensive global financial regulation, countries would not have a strong incentive to hold out for a better deal, simply because of the uncertainty about the precise form future crises would take. Judging by the chaotic scenes and crossed lines of communication that characterised the financial crisis of 2008, the development of such frameworks, domestic and international, cannot come too soon.

Naturally, booms and busts will continue. There will always be manias that lead to the shoeshine boy giving share tips or the taxi driver selling villas in Bulgaria and crashes that lead to values plummeting and lives being ruined. But if there are known knowns about financial crises, perhaps we could begin to deal with them. Perhaps then the booms and busts would be less severe and the manias and crashes less debilitating. Getting the likes of Joe Gregory to read something more substantial than a popular journalistic account of cognitive psychology seems like a modest, but good start.


Paul Daly holds a National University of Ireland Travelling Studentship at the Faculty of Law and Queens’ College, University of Cambridge and is researching in administrative law. He is a graduate of the University of Pennsylvania Law School and University College Cork.

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