Economists have made numerous attempts to explain this apparent blindness without a great deal of success. The fact is that financial crises do not come out of the blue, and some people do see them coming. The world is warned about its folly, but chooses to ignore. Those who shout "WATCH OUT - THERE IS DANGER AHEAD" and try to suggest alternative courses of action are dismissed as Cassandras and their thinking is excluded from mainstream academia and the corridors of power. This suggests that the cause is more psychological than economic - it is rooted in people's behaviour. Like a Greek tragedy, the end is inevitable because of the nature of the players.
In this post I shall attempt a psychological explanation of the behaviour that leads to financial crises. I am not a psychologist, but I do have some training and experience in Transactional Analysis (TA) and it is that theory that I shall use in this post.
Economists are familiar with "Game Theory", but perhaps less so with the TA idea of psychological games. Yet the pattern of behaviour that leads to a financial crash looks to me very much like the sort of thing that goes on when people play psychological games - as we all do, all the time.
The creator of the concept of psychological games, Eric Berne, defined them thus:
"A game is an ongoing series of complementary ulterior transactions progressing to a well-defined, predictable outcome. Descriptively, it is a recurring set of transactions... with a concealed motivation... or gimmick."Games have a characteristic pattern: all players participate willingly in what appears to be a mutually satisfying serious of exchanges until someone breaks the rules ("pulls the switch") and the game comes to an abrupt end, accompanied by confusion, panic and anger as all participants are forced to face the truth they have been avoiding. In TA, games have one purpose only, and that is to avoid what Berne calls "intimacy" and we might call "reality". And they are anything but fun. Psychological games range from mildly upsetting to downright vicious and even murderous. Someone always gets hurt.
Despite their painful nature, psychological games tend to be repeated. Rather like a rugby player who gets injured every time he plays and yet continues to play, people have preferred games that they play again and again, even though they get hurt every time. Getting hurt in a psychological game is preferable to facing reality.
So if the 2007/8 financial crisis was caused by someone pulling the switch in a massive psychological game, what was that switch and who pulled it? I am indebted to Liam Byrne for unwittingly defining it, though he personally did not pull it. After he lost his job as Treasury Secretary in the UK General Election, Byrne famously left a note for the next incumbent which said "There's no money left". And that, in a nutshell, defines the belief switch that caused the financial crisis.
In the run-up to the financial crisis, the prevailing belief was "We will never run out of money", and more and more of it was created to satisfy demand. I'm not going to get into arguments about whether credit money created by financial institutions is "real" - as far as the participants in this particular game were concerned it was real, because they could use it to buy stuff and have a good time. But in 2007, someone highly influential indicated that the supply of money was running out. I don't know exactly who this was, though I'd regard the Fed's decision to raise interest rates as a fairly strong signal - raising interest rates does restrict the supply of money. Anyway, investors started to withdraw their funds. This caught out the Bear Sterns hedge funds, which collapsed in August 2007, at which point banks scared of losing their money stopped lending it to smaller banks. Smaller lending institutions such as the UK's Northern Rock suddenly found themselves unable to borrow money from the interbank market to fund their lending: American lenders were bailed out by the Federal Housing Association, but Northern Rock was forced to seek emergency funding from the Bank of England. The tragedy for Northern Rock was not that the Bank of England was operationally unprepared to provide emergency liquidity - the Treasury gave permission for the funds to be provided - but that someone at the Bank of England told the press that Northern Rock had run out of money. Suddenly the game was up and there was a very public run on Northern Rock as scared depositors queued up to withdraw their money. And the rest is history: unable to recover from the loss of both wholesale funding and deposits, Northern Rock was eventually nationalised. But the run on shadow banks continued for another year, ending with the collapse of Lehman Brothers and bailout of banks all over the world as the prevailing belief changed from "We will never run out of money" to "There's no money left".
It is wrong to assume that the first statement - what Berne calls the "gimmick" - is false and the second - the "switch" - is true. Actually neither is true. The switch is as false as the gimmick: the entire game is illusion. And notice what happened next. Instead of confronting the reality of global economics (to which I will return shortly), the world embarked on a new game, called "Austerity".
What is depressing is that the world has played this sequence of games before: "Profligacy" ("we will never run out of money") followed by "Austerity" ("there's no money left"). The last time this sequence was played in earnest, it caused enormous suffering across the developed world and ended in world war. We played a milder version in the 1970s and 80s, which ended with the collapse of the Soviet Union and wars in Eastern Europe. Perhaps the "switch" in the Austerity game is popular uprising and replacement of political regimes - but as Orwell described in "Animal Farm", one political regime looks much like another.....
But it is unnecessary. The Austerity game is as much an avoidance of reality as the preceding Profligacy game. We do not have to cut support to the poor and vulnerable. We do not have to increase people's tax burden. We do not have to pour money into banks in the hopes that they will lend to people who already have too much debt. We do not have to suppress interest rates to extract money from savers. We do not have to bail out foreign creditors at the expense of domestic production (are you listening, Greece?). And above all, we do not have to accept that money is scarce. If it is scarce, it is because we have made it so. And in the developed world, where goods are anything but scarce and can be produced at very little cost, it is a disgrace that people are increasingly poverty-stricken because of shortage of money. I am reminded of Steinbeck's description of fruit, fallen from the trees and left to rot because consumer prices had fallen so low it was not worth farmers' while to pick it, being ruined with petrol to prevent the starving migrants from the drought-stricken American Mid-West from taking it. Nowadays, of course, we wouldn't use petrol - it's too expensive - but there are other ways of preventing people from getting the necessities of life for nothing.
What is needed is for economists and politicians to put their various ideologies to one side and take a hard look at how the economy ACTUALLY works, and what is really going on. Shortage of money is not the problem: allocation of money is the issue. Money is being created, but it is not going where it is needed, and this leads to unnecessary shortages of goods that actually are in abundant supply. That is the defining characteristic of both games - Profligacy as much as Austerity. The underlying reality is gross inequality and misallocation of resources. Until the world recognises this, we are doomed forever to play out the same sequence of games.
UPDATE December 16th 2012: I think we've discovered who pulled the switch in 2007 (thanks to @Hatti_Fattener on Twitter). This NYTimes report from August 9th, 2007 discloses that BNP Paribas suspended three of its funds because it was unable to value subprime MBS used as collateral. The press report of BNP's decision alone would have been sufficient to trigger the repo collateral margin calls that according to Gary Gorton forced banks to sell assets at fire sale prices, triggering a general collapse of asset prices. Further digging reveals that, according to the NY Fed, this was actually a run on ABCP, which started when the sponsor of a single-seller mortgage conduit, American Home, declared bankruptcy and three mortgage programs extended the maturity of their paper; in response to this BNP Paribas halted redemptions at two of its mortgage-affiliated programs due to being unable to value ABCP paper. DTCC data shows that this triggered a run on over 100 investor programs, not all of them directly connected with subprime. This was a third of the entire ABCP market, and caused the closure of the MBS market. So it seems the switch-puller was a Fed primary dealer.