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Grasping Reality with at Least Three Hands 2018-08-06 19:26:53

Summary:
I would say: "policy was fantastic between Lehman and the trough, grossly subpar after the trough, and —if you believe the Fed—criminally negligent before Lehman": Niccola Gennaioli and Andrei Shleifer: A Crisis of Beliefs: Investor Psychology and Financial Fragility: "Instability from Beliefs... ...1. Excess optimism, excess lending and investment. 2. Correction of expectations (due to bad news or waning of optimism)/ 3. Recession (impaired intermediation or excess pessimism). Crises are due to non-rational beliefs, which may be amplified by traditional mechanisms. See Minsky (1977), Kindleberger (1978).... Why was Lehman so pivotal? ▪ Tail risks neglected by both investors and policymakers. ▪ Liquidity interventions, but no aggressive attempts to get banks to raise capital. ▪

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I would say: "policy was fantastic between Lehman and the trough, grossly subpar after the trough, and —if you believe the Fed—criminally negligent before Lehman": Niccola Gennaioli and Andrei Shleifer: A Crisis of Beliefs: Investor Psychology and Financial Fragility: "Instability from Beliefs...

...1. Excess optimism, excess lending and investment. 2. Correction of expectations (due to bad news or waning of optimism)/ 3. Recession (impaired intermediation or excess pessimism). Crises are due to non-rational beliefs, which may be amplified by traditional mechanisms. See Minsky (1977), Kindleberger (1978)....

Why was Lehman so pivotal? ▪ Tail risks neglected by both investors and policymakers. ▪ Liquidity interventions, but no aggressive attempts to get banks to raise capital. ▪ Markets learn the system was more interconnected–through derivative contracts and fire sales–than believed. ▪ Lehman was a huge dislocation because markets and regulators learned they were wrong. Alternative Theory I: Moral Hazard ▪ Banks are too big to fail and knowingly took risks of housing exposure. Alternative Theory II: Bank Runs ▪ Lehman crisis was the result of a Diamond-Dybvig bank run. In a 2015 speech at the National Bureau of Economic Research, Bernanke stated that “the Diamond-Dybvig model describes what happened in the financial crisis extremely well.”...

Hard to see Lehman as a non-fundamental sunspot. ▪ Need more sophisticated theories like Goldstein-Pauzner. ▪ But then the question of policy passivity comes back. ▪ The fragility of the financial sector cannot be surprising in the summer of 2008. ▪ Errors in expectations are critical.

Extrapolative expectations central to the housing bubble. ▪ Continued neglect of downside risks central to understanding 2007-2008. ▪ Policy was fantastic after Lehman, behind the curve before Lehman. ▪ Hard to tell the story of the crisis without beliefs.


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Bradford DeLong
J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.

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