The Imaginot Line
Why we're still fighting yesterday's economic war.
Like military historians shaking their heads over the hubris of the Maginot Line, future historians of economic thought will make the regulatory structures that failed us in the financial crisis of 2008 and its aftermath seem like follies. They might perhaps, like tourists of the battlefields, marvel at the sturdy fortifications that were erected to guard against the dangers that had overwhelmed us in previous crises and admire the single-mindedness with which we were determined to avoid repeating the senseless casualties inflicted on us in the Great Depression. But they will wonder how we could have put so much faith in the solidity of our central banks and market-friendly financial regulators. It will come to seem obvious in retrospect that by the 21st century the nature of the threat to the world financial system had changed, just as it seems obvious in retrospect that by 1940 the trench fighting of the Great War would be superseded by blitzkrieg. But will this insight help us weather the next crisis any better? Will it really help to reflect continually on the naivete of the architects of the system that has just so spectacularly failed?
The answer is no. There are important lessons to be learned from the crisis. But we’ll learn them better if we realize that the intellectual and political architects of the system that failed us were not naive at all, but immensely clever and subtle; it was their cleverness and subtlety that undid them. And that is bad news for all of us, for naivete can give way to learning, but cleverness has no obvious higher state.
The Imaginot Line, as I’ll call it, was an idea about how to protect our economy, not a physical construction. It was a system of institutional and (as we can now see) ideological defenses against financial crisis erected over a period of decades beginning in the 1930s. It had three main components, and what was subtle about the system was that while none of the components seemed impregnable on its own, the whole appeared vastly stronger than the sum of its parts.
The front line of this defense was deposit insurance, and it was a response to the widespread perception that the U.S. banking crisis that began in 1929 was the result of panic on the part of household and small-business depositors and that the cure for panic was insurance. Although more than 5,000 U.S. banks failed in the three years from 1930 through 1932, in 1934 only nine banks failed. It seemed obvious that the introduction of deposit insurance in 1933 was responsible for the improvement, and deposit insurance for small depositors in retail banks is now virtually universal in regulated financial systems around the world.
The second line of defense in the Imaginot Line was a system of financial regulation designed to cope with an obvious flaw in the first line of defense: the moral-hazard problem. Banks with insured depositors have no incentive to be prudent, and the depositors have no incentive to take prudence into account when choosing where to park their money. So a complex system of financial regulation was put in place, based in particular on capital requirements — in effect, mandating that a minimum proportion of a bank’s assets be contributed by shareholders whose money is explicitly at risk. The purpose was to ensure that banks did not use money from insured depositors to take risky one-way bets and did not use the high returns from such one-way bets to compete against each other for deposits. Because the danger was thought to come only from the insurance of retail depositors, the risks of similar behavior by institutions courting large professional investors were not believed to matter; after all, these investors would shoulder their own risks.
One consequence was the growth of the unregulated "shadow" banking system, including in particular the so-called "repo" markets that provide the same sorts of services for large corporations that ordinary bank deposits provide for individuals and small firms. By the late 2000s in the United States, these repo markets were estimated to be as large as, if not slightly larger than, the regulated banking sector, with assets estimated in 2008 at about $11.5 trillion, well over $30,000 for every American man, woman, and child. But as we now know, the professional investors did not shoulder their own risks. The failure of the system was unimaginable, which meant that its participants were incautious and when fear of catastrophe loomed, the consequences of their incaution would be borne by others, notably taxpayers and the unemployed.
The third line of defense in this structure was central banking. Of course, central banks long predate the 1930s, but from the 1930s onward their official mandate has been to keep prices stable and promote a level of output consistent with reasonably full employment. The weight given to price stability increased in most countries over the postwar period, except in Germany, where it had already been high because of the memory of the Weimar hyperinflation. Price stability also came to be seen as the permanent goal of central banking, whereas maintaining output came to be considered a matter for occasional firefighting rather than permanent tinkering.
A growing perception that central banks would go wobbly on inflation led to a movement for their political independence, formalized in the establishment of the independent Bank of England in 1997 and the European Central Bank in 1998 and more informally entrenched in the United States since the 1980s via a cult of personality created around Federal Reserve Chairman Paul Volcker and his successor, Alan Greenspan. (The cautious and inscrutable utterances of the latter became so much the stuff of legend that great joy was caused by the report that when he first proposed marriage, his future wife had no idea what he was talking about.)
This third line of defense dovetailed in a very sophisticated way with the first two. For it’s not that financial regulation was governed by a blind faith in efficient markets — had that faith been absolute, there would have been nothing for regulation to do — but that we believed independent central banking was the bulwark allowing us to live with any weaknesses in the first two lines of defense. The idea of central bankers as austere, incorruptible, ever watchful, and in some sense married to the job was an integral part of the package.
SO WHAT EXACTLY WENT WRONG with the Imaginot Line? As with the real Maginot Line, myths have multiplied. It is widely believed that the Maginot Line was flawed because it ran only to the Belgian border, allowing the Germans in May 1940 simply to walk through Belgium. In fact, the Belgian fortifications were impressive, and the Germans broke through at their strongest point, Fort Eben-Emael, which was where the attack was least expected. In the same spirit, we can’t understand what went wrong with financial regulation during the recent crisis until we appreciate that it failed at its strongest, not its weakest, point. It failed where failure was least expected.
Central banking in particular succeeded spectacularly well at doing what it was increasingly being asked to do. Volcker’s Fed famously brought down inflation from more than 13 percent in 1981 to just over 3 percent by 1983. More importantly still, under Greenspan it reacted to the October 1987 stock-market collapse with such swift and effective monetary loosening that the crash of ’87 came to be mythologized as the disaster that never happened. Similarly decisive action during the 1997-1998 Asian financial crisis provided timely liquidity to the U.S. and world economies, and the monetary loosening in 2001 after the collapse of the dot-com bubble was inevitably greeted as yet another example of the deft hand of those who really knew what they were doing. Inflation seemed to have been banished for good, and the occasional crises that regulators were still visibly unable to prevent were being reliably mopped up by central bankers.
By 2003, Robert Lucas, the Nobel economics laureate, was telling the American Economic Association that the "central problem of depression prevention has been solved, for all practical purposes." It was widely thought, and not just by economists like Lucas, that regulators and central bankers were getting better and better at doing their jobs. And that belief was persuasive because by and large they were.
Unlike for the real Maginot Line, nemesis did not come from a hostile assault, but from those who were profiting from the system as it stood. But it was no less due to a concentration of pressure on the system at its strongest point. There’s widespread disagreement about how exactly that concentration came about, but the simpler theories are clearly inadequate. For instance, the notion that "greed’s the sole cause of every financial crisis," to quote a June 2010 headline in Britain’s Daily Mail, is like the theory that water pressure is the sole cause of every flood — unhelpful even if it were strictly speaking true.
Similarly, the view that pervasive free market fundamentalism was to blame, as British economist Anatole Kaletsky, for one, argues in his book Capitalism 4.0, can explain only some of the facts, such as the refusal by U.S. Treasury Secretary Henry Paulson to bail out Lehman Brothers in September 2008. Kaletsky claims Paulson’s decision was driven entirely by his belief that in a free market system, investors deserve to suffer the consequences of their foolish decisions. As we now know, this led to a disastrous collapse in confidence in the banking system, not on the part of the small depositors whom the deposit-insurance system had been designed to protect, but on the part of the professional investors whose susceptibility to panics had never been seriously anticipated.
But pervasive market fundamentalism can hardly explain other essential components of the crisis, such as the remarkable asymmetry of the Greenspan interventions — stepping in at lightning speed in response to market falls, such as the miniature crash in October 1987, and doing little more than frown when the market rose too quickly. In fact, market fundamentalism was never as deeply infused into the system as some have thought. Market failure has been a central component of microeconomic courses at every reputable university for at least the last 20 years, and many if not most regulators had taken such courses. The reason why it was so easy to sell securities rated triple-A — like the higher tranches of the now notorious collateralized debt obligations — was not that every potential buyer was a true believer in the theory of efficient markets. It was because financial regulators insisted a triple-A rating was necessary for many of the investments made by pension and mutual funds, which the regulators would never have done had they been convinced that the market would take care of these investment decisions by itself. If the market is always right, why insist that investors choose highly rated assets? So the problem was not that market failure was thought to be impossible, but the much more sinister belief that someone else was going to take care of it when it happened.
In effect, the second and third lines of defense came down to this: trusting the other to do more of the work than either was prepared to shoulder. The better the central bankers performed, the more everyone else was content to rely on them to sort out the obvious tensions in the system, such as the fact that real U.S. housing prices rose nearly 150 percent from 1995 to 2006. Everyone knew it couldn’t go on forever, but if Greenspan had taken care of the crises of 1987, 1991, 1998, and 2000, surely he would be on hand if there were a crisis this time. Not everyone agreed there was a bubble, but the danger lay not with those who didn’t believe in bubbles. It lay instead with those who thought there might be a bubble but that we could handle it.
And Greenspan, what did he think? What did his British counterpart Mervyn King think? There was a time in the early 2000s when it was hard to attend a dinner party in London or New York without hearing someone’s boast — often delivered with mock-shy apology — of having sold a house or apartment for double the price paid only two or three years before. It’s hard to imagine that the world’s central bankers attended no dinner parties during all that time. We now know that a significant part of the demand for houses came from borrowers who would never have been granted loans had the real price of houses not been expected to go on rising. Regulators should never have let this happen — they were treating what were in effect highly speculative investments, with many of the properties of derivatives, like solid investments in bricks and mortar. But regulators considered the speculative hypotheses underlying mortgage contracts a problem for central bankers, and central bankers considered the mortgage contracts a problem for regulators.
The economics profession gave a wholly unwarranted imprimatur to this fateful division of labor. But it did so for some very sophisticated and persuasive reasons. One was that economists turned out to be powerless to explain, let alone predict, shocks originating from within the banking system, despite the detailed and impressive work of economists (including Greenspan’s successor Ben Bernanke) trying to understand how informational problems in banking markets could amplify monetary shocks. A second reason was that those macroeconomists who took the possibility of crises seriously were mostly expecting a threat from a quite different direction: a collapse in the U.S. dollar as a result of global trade imbalances. A Google Scholar search turns up 243 books, articles, and working papers with "global imbalances" in the title published between 2000 and 2007. It’s simply wrong to say that the profession never anticipated the crisis. It anticipated crises too often and from too many directions for any of the many warnings to be entirely convincing, even perhaps to those who uttered them.
The third and most serious reason why economists endorsed the division of labor between the second and third defenses in the Imaginot Line was that something like it is inextricably embedded in the very functioning of a modern banking system. Banking creates the illusion — the necessary illusion — that there exist islands of stability in a sea of risk. Depositors who settle payments with a check need not worry — most of the time — whether a check drawn on one bank is worth the same as a check in the same nominal amount drawn on another. As the economist Gary Gorton has put it, banking does for the nonexpert in finance what the electricity grid does for the nonexpert in electricity: allowing one to use the system and benefit from its technical sophistication as reliably as the expert can. How? By enabling most who ultimately bear the risk not to have to worry about it on a day-to-day basis.
But as we discovered once the crisis broke, it was not just nonexperts who had stopped worrying about risk on a day-to-day basis. Most professional investors had also gotten into the habit of not worrying about it either, including those who had money invested in the repo markets and other parts of the vast shadow banking system. Before we rail against their stupidity, we should remember that not worrying about risk is precisely what a modern banking system enables its customers to do. That the lack of worrying had gone too far is now undeniable, but it happened precisely because of how impressively the modern banking system works when it is working well.
This makes it very confusing to think about what must happen in the future, at both an ideological and a practical level. At the level of ideas, the macroeconomics crowd is still struggling to know how to absorb the lessons of the crisis. The problem is not a shortage of theories of market failure coming from microeconomics, but a difficulty in knowing how to integrate them within an understanding of the macroeconomy. For instance, John Moore, the 2010 president of the Econometric Society, used his presidential address in Shanghai to talk about "contagious illiquidity," the idea that a drying up of liquidity in one market can lead to a similar drying up in another market in which there is no intrinsic reason for this to occur. This is a very important phenomenon to understand, but it won’t tell us how to run macroeconomic policy during growth years to avoid the risks of financial collapse. And even if understanding the contagious nature of illiquidity might help us react faster to future shocks, we may be no wiser as to where the shocks will come from. The unhelpful lesson of the past seems to be that shocks will most likely come from where we least expect them, just as antibiotic-resistant bacteria will most likely (for good Darwinian reasons) be descendants of strains that have been most easily controlled by antibiotics until now.
The economics profession has a lot of ground to make up before it can compensate for the loss of trust in the public mind, which is already visibly affecting the willingness of voters and politicians to cede autonomy to experts even in fields as far removed from finance as climate change and competition policy. (The refusal by a large swath of the public to accept scientific recommendations on climate change is well known; much less so is the row over the revisions to U.S. merger guidelines: One trade commissioner attacked the process in his own agency last August because "of the six architects of the project, three were economists trained and steeped in price theory," a charge that would surely have raised a puzzled shrug just a couple of years before.) In a 2009 Financial Times op-ed, economist Devesh Kapur argued that "many of the intellectual underpinnings of the causes of the current crisis … come from the best and brightest in U.S. academia" and called for an examination of "the nature of their financial incentives and the resulting conflicts of interest."
The loss of trust has been deserved, and its reversal will be hard won. But in some sense, the reproach that too much trust was placed in economists is as much a criticism of those who trusted too much as it is of those in whom that trust was placed. Too many people in recent years trusted too many other people to be taking care of financial risk on their behalf. The failing was all the greater because the ability to delegate financial risk to others is justly regarded as one of the great triumphs of the modern banking system.
The real problem was that many investors sought to avoid responsibility for risk altogether. Reaffirming the need to take responsibility will require not just that individuals who are exposed to risk should realize that fact and act on it, but also that individuals who create risk bear more of the consequences. The fact that creditors have borne so little of the cost of recapitalizing failing banks is one of the great scandals of modern times. It is a scandal due to panic and not only to capture by special interests — policymakers bailing out creditors were rightly terrified of the consequences if the bailouts failed — but it is no less unacceptable for that. This massive bailout of imprudent creditors will matter for many reasons, not least of which is that crises will recur in the future and we shall need to anticipate how to manage the bailouts that will be needed when they do.
Above all, like historians assessing the Maginot Line, we must avoid comforting ourselves with the judgment that the system’s architects were naive and that therefore we might hope to do much better. Far more important is to be aware that defenses are vulnerable precisely where they are strongest and to be prepared to respond creatively and calmly when they fail, as they surely will again.
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