A crisis of incentives or a crisis of ignorance?

I've previously discussed the work of Jeff Friedman regarding the financial crisis, and for me the key points he makes are:

• The financial crisis was predominantly caused by ignorance, not bad incentives
• This is an Austrian argument

It's therefore very revealing to see economists intuitively reject his hypothesis, and prefer to explain the crisis in terms of incentives. Consider Russ Roberts' recent post:

I don’t think bankers planned on being bailed out. But I think it affected their decision-making. Jeffrey Friedman doesn’t think so

Whether this is a strawman or not, Russ provides two pieces of evidence that are new to me. Firstly, that Jimmy Cayne, (CEO of Bear Stearns) lost $1bn due to the financial crisis. He clearly wasn't gaming the system. Secondly, Russ points to a quote from Andrew Haldane, (Executive Director of Financial Stability of the Bank of England):

There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight.

So here's my question to Russ: even if there was no incentive for individuals within banks to run stress tests, what were the details of the stress tests that they didn't run?

You might respond "we don't know, because they didn't run them", but we should be able to formulate in a broad sense the type of stress test they might have done, had there been an incentive to do so. My hypothesis would be that they would not even come close to replicating the actual conditions that we witnessed during the credit crunch. Owners of private companies clearly did have an incentive to run stress tests, but to my knowledge even those intimately familiar with Austrian cycle theory (i.e. those who saw the credit crunch coming and prepared for it), were still surprised by the severity and the intricacies of the crisis.

In short, even if the banks had incentives to run stress tests, they wouldn't have known which stress tests to run. Therefore the empirical identification of a lack of incentives is pretty mute unless it's combined with evidence to show that the actors had the necessary knowledge to learn from the results. Where's that evidence?

Update: Whilst i'm at it, here are a couple of Jeff's quotes that I like a lot:

as the crisis unfolded, all the books on the crisis show that the principals were shocked, frantic, and bewildered. If they had deliberately taken risks because they had a bailout in the back of their minds, would they not have have reacted with knowing cynicism and serenity?

I've not got round to reading the "histories of the present" accounts of the financial crisis (I haven't even got round to buying them yet), but I strongly expect to read about people who did not understand what was going on. This is a clear empirical assumption (unintended consequences or deliberate divergence between professed and intended actions?) and the evidence will emerge to settle it. My understanding of the accounts that are public support this view, and the notion that bankers deliberately over-leveraged will be refuted. Throughout this I recollect a conversation I had with Russ in class once, where I cast doubt on the "follow the money" implications of public choice. He suggested that if you look hard enough it's usually the case that poor policy stems from vested interests. At the time I was unable to articulate my feeling that often it's simply mistaken beliefs. I still can't.

I respectfully submit that the bankers--like the regulators--simply did not realize that this was the first-ever significant nationwide housing bubble. And they did not realize how fragile the bubble was, due to subprime lending. Meanwhile, the Basel regulators encouraged them to leverage into the bubble by buying AA- or AAA-rated MBS. That is the crisis in four easy sentences.

Together with Steve Horwitz's work, what else do you need as an explanation?

Comments

[dissertation]

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