Why our models missed the financial crisis

The direct loss of wealth from dot-com bust was about the same size as from the housing meltdown. Perhaps even a bit less. So why did one create so much more economic damage than the other?

The difference, writes Peter Orszag, is that the housing crisis took place in “the highly leveraged financial sector.” And that’s why all the models missed the damage it would do: “The macroeconometric models used by the Fed -- like those used by the Congressional Budget Office, the White House and others -- had at best a very rudimentary financial sector built into them.” So “they treated the housing collapse as if it were merely dot-com bust 2.0.” And that’s still the case today, he says. Yikes.

”You’re probably wondering why economists would leave leverage out of our models,” adds Jared Bernstein. “Good question. It’s because we’ve historically viewed financial markets as basically an intermediate input in the economic process, distributing savings to their most productive sources. [Alan] Greenspan added the assumption the hyper-rationality would lead market participants to self-regulate.”

Oops. Bernstein also brings up another difference between a housing crisis and an stock-market bubble:

When a dot.com bubble bursts, it mops up more quickly because of the difference between “mark-to-market” in an equity bubble and “extend-and-pretend” in a debt-financed housing bubble. The fact that your pet rock shares go from valuations of $1,000 on Friday to $1 on Monday rips the bandaid off in a way you don’t get when banks can inflate for months on end their balance-sheet value of non-performing loans.

That said, my understanding is that if we had actually forced the banks to mark their assets to market, we would have needed to be prepared to take most of them over in mid-2009.