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 Ricardo A. Halperin

The Influence of Uncertainty

in a Changing Financial Environment

An Inquiry
into the Root Causes
of the Great Recession
of 2007-2008
The Influence of Uncertainty in a Changing
Financial Environment
 Ricardo A. Halperin

The Influence of
Uncertainty in a
Changing Financial
Environment
An Inquiry into the Root Causes of the Great
Recession of 2007–2008
Ricardo A. Halperin
Retired from the World Bank
Maryland, USA

ISBN 978-3-319-48777-9    ISBN 978-3-319-48778-6 (eBook)

DOI 10.1007/978-3-319-48778-6

Library of Congress Control Number: 2016959592

© The Editor(s) (if applicable) and the Author(s) 2017

This work is subject to copyright. All rights are solely and exclusively licensed by the
Publisher, whether the whole or part of the material is concerned, specifically the rights of
translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on
microfilms or in any other physical way, and transmission or information storage and retrieval,
electronic adaptation, computer software, or by similar or dissimilar methodology now
known or hereafter developed.
The use of general descriptive names, registered names, trademarks, service marks, etc. in this
publication does not imply, even in the absence of a specific statement, that such names are
exempt from the relevant protective laws and regulations and therefore free for general use.
The publisher, the authors and the editors are safe to assume that the advice and information
in this book are believed to be true and accurate at the date of publication. Neither the pub-
lisher nor the authors or the editors give a warranty, express or implied, with respect to the
material contained herein or for any errors or omissions that may have been made.

Cover illustration: © Ta da!/Alamy Stock Photo

Printed on acid-free paper

This Palgrave Macmillan imprint is published by Springer Nature

The registered company is Springer International Publishing AG
The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland
To Emma, Sofia and Thomas
 Acknowledgments

At the end of 2001, I retired from the World Bank, where I had worked
for 25 years, and soon after I recognized the splendid opportunity ahead:
I had free time and no longer had to worry about earning a salary for
a living! Even before graduate school, I had developed a love for eco-
nomics inspired by an excellent teacher at the University of Buenos Aires:
Julio H.G. Olivera, and after retirement I decided to rekindle the rela-
tion. While consulting assignments came my way from time to time, I was
finally able to catch up on my readings, which I had neglected due to the
demands of my work; it helped that I had unlimited access to the Joint
Library of the IMF and the World Bank.
Then came the Great Recession of 2007–2008, and a few years ago
I concluded that, while many excellent works discussing it were already
available, some important aspects had not received the attention that they
deserved, so I decided to write this book.
During this time, I received suggestions from many former colleagues,
as well as encouragement and support from close friends and family. I
particularly want to thank Miguel E. Martinez, who read through several
early versions of this book, providing me with very helpful comments.
After Palgrave Macmillan accepted to publish the book, they followed
their standard practice of sending it out to a peer reviewer, who provided
very constructive comments and suggestions, which I was happy to take
into account as best I could. He, or she, deserves my thanks!
As authors usually declare, I alone bear responsibility for the ideas pre-
sented here. To all those that helped this book come to print, my heartfelt
thanks!

vii
 Contents

1 A Failure of Imagination   1

Part I Crisis!  15

2 The Great Recession of 2007–2008  17

3 Fingers in the Dike  47

Part II The Financial Revolution  63

4 Financial Intermediation and the Economy  65

5 The Evolution of Financial Intermediation  89

Part III The Evolution of Economic Theory 107

6 Economics Quest for Relevance 109

ix
x Contents

7 Theories of Business Fluctuations 151

8 The Elusive Search for Economic Motives 167

9 Risk, Uncertainty and Economic Theory 179

Part IV Theory Confronts Reality 195

10 The Visible Hand 197

11 Regulation of the Financial Sector 203

12 Prudential Regulation 221

Part V Looking Forward 239

13 The Challenges Ahead 241

14 Economic Policy Options 255

15 Summing Up 267

Bibliography 275

Index 281
 About the Author

Ricardo A. Halperin was born in 1940 in Buenos Aires, Argentina. He

graduated from the University of Buenos Aires in 1963 with a CPA and
later attended Columbia University, where he obtained an MBA (with
concentration in Finance) in 1965 and a Ph.D. (with concentration in
Banking) in 1968.
After graduating from Columbia, he returned to Argentina, where he
taught Monetary Theory and Macroeconomics at the University of Buenos
Aires until 1974, and from time to time also advised the Government
on financial policy issues. While in Argentina, Mr. Halperin published a
number of articles on economic topics, all in Spanish, as well as a book:
Los Impuestos y la Inflación, which was published by Editorial Cangallo in
1975.
In 1976, he joined the World Bank at its Washington DC headquarters,
eventually rising through various management positions. At the time of
his retirement in 2002, he was Director of Infrastructure Operations for
Europe and Central Asia.
After retiring he collaborated with the World Bank’s Pension Finance
Committee, which oversees the investments of the Bank’s pension fund,
and carried out many consulting assignments. He also wrote several short
stories and essays in Spanish, which were published by the online literary
magazine Letralia.
Mr. Halperin is married and has two daughters and three grandchil-
dren, to which this book is dedicated. He lives in the Washington DC
suburbs.

xi
 CHAPTER 1

A Failure of Imagination

Why I Wrote This Book

After the financial crisis of 2007–2008 came close to ushering a depression
comparable in severity to the one that the world experienced in the 1930s,
Queen Elizabeth II rebuked the economics profession for failing to warn
in time about the dangers that the economy had faced and asked the ques-
tion in everyone’s mind:

Why did nobody notice it?

The London School of Economics felt compelled to respond:

…In summary, your majesty, the failure to foresee the timing, extent and sever-
ity of the crisis and to head it off, while it had many causes, was principally a
failure of the collective imagination of many bright people, both in this country
and internationally, to understand the risks to the system as a whole….

While this assessment is not totally fair, as several prominent economists

(which include Robert Shiller, Nouriel Roubini, and Raghuram Rajan)
did warn in time that the US economy was facing significant risks, by and
large it is true that most in public office as well as the media did not take
those warnings seriously into account. Years later, the then chairman of

© The Author(s) 2017 1

R.A. Halperin, The Influence of Uncertainty in a Changing
Financial Environment, DOI 10.1007/978-3-319-48778-6_1
2 R.A. HALPERIN

the Federal Reserve (Fed), the “Maestro” Alan Greenspan, would write
an article titled “Why I Didn’t See the Crisis Coming”.1
This book tries to shed some light on this question. It starts with a dis-
cussion of how the Great Recession unfolded and of the actions taken to
overcome it, and in the second part, it proceeds to examine the role played
by developments in the financial sector.
The third part of the book explores how economic theory has changed
over time, and why macroeconomic models were not designed to provide
warnings about the impending crisis. It argues that the explanatory power
of these models had been eroded by developments in the financial sector
and notes that this sector is especially vulnerable to public perceptions of
risk, driven by uncertainty about the macroeconomic environment and its
prospects.
The last section of the book explores some policy options to reduce the
likelihood of another major downturn originating in the financial sector
and also to address some of the major challenges that the economy pres-
ently faces.

Background
The Industrial Revolution that started in UK toward the end of the eigh-
teenth century and eventually spread around the globe changed people’s
worldviews and expectations. For centuries household incomes had hardly
witnessed any growth, but the technological changes that gave its name to
the revolution enabled a quantum rise in production, as well as important
changes in its composition.
Despite initial high human and social costs, the Industrial Revolution
eventually increased the well-being of the vast majority of the population
in those countries that, starting in the twentieth century, would be called
the “developed world”. This revolution provides the backdrop for the
economic theories that prevail today.
Presently we are living through a new wave of innovations in technol-
ogy which, though not as momentous as those of the past, continue to
improve the quality of our lives. Furthermore, today there is a widespread
expectation that technological progress will go on, providing an impor-
tant enabling condition for economic growth, despite the recent concerns
of some economists that this progress may not be powerful enough to
help us to achieve the rates of growth that we had in the past.
 A FAILURE OF IMAGINATION 3

Technological changes are unquestionably important and they may

account for our failure to notice that in recent times change has also been
taking place elsewhere, and it could also have significant consequences
for the future of our economies: I am referring to the expansion of the
financial sector, the appearance of new financial intermediaries and instru-
ments, and the reduced role (in relative terms) of commercial banking; I
argue that these developments constitute a financial revolution, and this
book examines its implications.

A Changing Environment
The economic growth that the USA experienced, particularly since the end
of the Civil War, has enabled households to save some of their incomes,
and over time this has resulted in a significant increase in national wealth,
which includes housing, durable goods (such as automobiles), buildings
and equipment used for the production of goods and services, and invest-
ments in education and technical training (human wealth). Excluding the
latter, wealth estimates for the USA amount to more than $80 trillion, and
this figure may be compared to annual gross domestic product (GDP),
which is about $18 trillion.
Most households do not manage directly the physical assets used for
production; this is mostly done by corporations. Households provide them
with the resources to do this and, in return, corporations issue legal instru-
ments that entitle those households to a “share” of the net assets of the
corporations, and consequently of their profits. Households also provide
corporations with loans, sometimes directly—by purchasing debt instru-
ments that the corporations issue—and more often indirectly, through the
financial intermediaries in which they place their savings. Governments
also have tapped into household wealth by selling them debt instruments.
Thus, other than for education, housing and consumer durables, the
wealth of households is largely held in the form of financial instruments;
it is financial wealth.
Housing ownership in the USA is widespread, and it is estimated
that over 60% of households own the home where they live. Ownership
of financial assets, on the other hand, tends to be more concentrated
among those in the middle and upper income brackets. Data compiled by
Campbell shows that housing accounts for over 40% of nonhuman wealth
in the USA; vehicles, valuables and other physical assets for over 22%;
4 R.A. HALPERIN

and financial wealth for 30%. Other developed countries exhibit a ­similar
pattern, the proportion of financial wealth depending on institutional
arrangements and rising with the countries’ average income per capita.2
In the two or three decades immediately preceding the Great Recession
of 2007–2008, the world economy experienced a number of significant
changes of which the most important was thought to be the spread of
globalization. On the other hand, until the Great Recession happened,
the rapid growth that financial intermediation had been experiencing,
accompanied by the proliferation of new financial instruments, did not
receive much scrutiny and—by and large—was not discussed critically by
the media. It would appear that at the time awareness of its broader impli-
cations was limited.
This omission has become an important shortcoming. When we exam-
ine macroeconomic developments, we should pay special attention to the
financial markets, and the macroeconomic models upon which we ulti-
mately rely should consider the linkages between the real and the financial
sectors, and identify the variables that impact the latter. The challenge, of
course, will be to do so without engaging in excessive complexity.

The Financial Revolution and Economic Theory

While neoclassical economics was able to make a strong case for a market
economy free from government involvement, because under reasonable
assumptions it was shown to allocate resources efficiently through the
unconstrained working of the price system, the importance acquired by
the financial sector in recent times suggests that today a questioning of the
market deserves to be considered.
Financial decisions are not only based on interest rates but are also
driven by the desire to contain risks (mainly that of losing all or part of
the principal invested), and for this reason, they are strongly influenced by
uncertainty. Uncertainty is fed by a changing range of factors which are
unpredictable in their timing and impact; in today’s environment, it causes
macroeconomic expectations to change often, and as a result, financial
markets are volatile. In turn, this volatility affects economic activity, ulti-
mately impacting employment and welfare.
At present, the models that we use to examine economic policy options
do not take the impacts of uncertainty into account, and as a result, for
many purposes they have lost explanatory power. If Keynes had been
concerned about the influence of expectations on investment decisions,
 A FAILURE OF IMAGINATION 5

arguing that the latter’s sensitivity to them could result in economic

­fluctuations and unemployment, the financial revolution that we have
experienced makes such concerns even more relevant today.
An important school of thought within the economics profession has
argued that, by and large, expectations tend to be rational, which means
that the lessons of the past as well as the information available in the pres-
ent are appropriately weighed and fed into the decision-making processes
of firms and households and, of course, also of financial intermediaries.
Uncertainty, however, limits the usefulness of this perspective, as—by
definition—it implies that there is not enough relevant information avail-
able on which to base some decisions. The logic underpinning various
plausible normative criteria for decision making under uncertainty (which
are discussed later in the book) shows that in an uncertain environment
there is no unequivocally “best” criterion for rational decision making.
This provides a powerful rationale for exploring what can be done to limit
the effects of uncertainty on the real sector of the economy. In addition,
once uncertainty and its balance sheet impacts are taken into account, a
better understanding of the Great Recession becomes possible.
I am not suggesting that policymakers are naive and rely on simple
textbook models rooted in neoclassical works or in Keynes’ general theory
for their decisions. It is evident that they do not, but the abundant infor-
mation that comes to their attention often is not adequately integrated to
the models at their disposal. The chief merit of models is that they focus
our attention on a few important variables, but that—of course—is also
their Achilles heel, as it may downplay in the minds of some the relevance
of factors that they fail to take into account.
Ben Bernanke—who chaired the Fed through most of the Great
Recession—has been a pioneer in the theoretical development of mon-
etary policy models. Looking at other countries too, my sense is that, in
most cases, policymakers have been well aware of the complexities of the
environment in which they operated, even if they did not have all the tools
to formally integrate all these to ensure the optimality of their decisions.
On the other hand, it appears that many commentators sought to
“explain” the financial crisis by focusing on the complexities of the finan-
cial system while abstracting from economic fundamentals, while others
chose the opposite course. Meanwhile, the Keynesian framework/model
largely provided the lens through which most economists who lacked ade-
quate information on the issues faced by the financial sector assessed the
macroeconomic issues and policy options of the time.
6 R.A. HALPERIN

In part, the failure to appropriately take into account developments in

the financial sector or to explore balance sheet issues has to do with exces-
sive compartmentalization in the training of economists and of financial
professionals (though there has been progress, particularly in the last few
decades3). Still in many instances, both regard the other cohort as work-
ing in a related but still distinct field, and underestimate the need to thor-
oughly understand its linkage to their own interests.
Anecdotally, at his Nobel Prize award ceremony, Harry Markowitz
mentioned that when he defended his dissertation at the University of
Chicago, Milton Friedman remarked that he could not be awarded a
doctorate in economics, since the dissertation did not deal with econom-
ics….4 The joke (?) presumably echoed a sentiment shared by others at the
time. There has been much progress since, and in recent years, there has
been a renewed interest in financial economics, resulting in a growing and
valuable amount of research in the field, which is yet to fully percolate to
the realm of conventional macroeconomics.
Despite important advances in method, the buildup of ever more com-
prehensive databases and the explosive growth in econometric studies, no
major paradigm changes have taken place in the past few decades. While
during that time there have been many valuable contributions to macro-
economic theory, I have an uneasy sense that increasingly efforts have been
directed at topics of marginal value; the law of diminishing returns seems to
be applying itself with a vengeance to the development of economic theory.
Many economists appear to share this view, as evidenced in an article
published in the American Economic Review a few years ago, which was
commissioned by the journal to celebrate its 100th anniversary. Six promi-
nent economists5 were assigned the task of identifying the “Top 20” arti-
cles published in that journal, and the list that they put together includes
only one published within the most recent 30 years,6 while four had been
published 50 or more years ago!
A quick review of some of the textbooks now being used shows that
present thinking emphasizes “pure theory” and is heavily biased toward
mathematical economics, which is a useful tool but of limited value to
respond to the questions that are central to our time. Or, to use Mrs.
Robinson’s words:

the orthodox economists have been much preoccupied with elegant elaborations
of minor problems, which distract the attention of their pupils from the uncon-
genial realities of the modern world….7
 A FAILURE OF IMAGINATION 7

This led Hyman Minsky, a monetary economist concerned with economic

fluctuations, to the conclusion that8

the economic theory that is taught… – the intellectual basis of economic policy
in capitalist democracies – is seriously flawed… The model does not deal with
time, money, uncertainty, financing of ownership of capital assets, and invest-
ment… The Wall Streets of this world are important; they generate destabiliz-
ing forces, and from time to time the financial processes of our economy lead to
serious threats of financial and economic instability…

Minsky sought to reformulate the theory that he was questioning. Though

he deserves credit for posing the difficult questions and made some prog-
ress toward addressing them, much of the challenge remains ahead. This
book is a modest attempt in that direction.

A Changing Context
Today, financial transfers across borders are easy to carry out and respond
in real time to developments everywhere. Hence, economists and politi-
cians not only need to abandon the facile assumption that it is possible to
develop economic policies for a country largely in isolation from what is
taking place outside its borders; they must also work harder to coordinate
policies between countries.
At present, the accumulated amounts of liquid savings that can move
across borders have grown to such a level that, in many cases, currency
runs cannot be readily offset by monetary authorities, adding volatility to
exchange rates, potentially weakening their relationship to “real” variables
in the short run.
Economists need to shed their aversion to policies designed to constrain
short-term financial flows, and new instruments need to be enhanced or
developed to implement such policies, while preserving as much as pos-
sible the benefits of a substantially open economy.

Looking at the Past, but Focusing on the Future

Economics needs to regularly address emerging issues and respond to the
challenges posed by a changing environment. Mercantilism, classical eco-
nomics, neoclassical economics and Keynesian economics responded to
the questions that appeared critical at their time. Mercantilism helped to
8 R.A. HALPERIN

develop policies to strengthen the nation-state. Classical economics antici-

pated the growth potential to be unleashed by the Industrial Revolution
and enabled the expansion of free enterprise and international trade that
would usher the modern era. Neoclassical economics provided a strong
case for a market economy by showing that it enabled efficient resource
allocation. Keynes provided us the tools to understand the problem of
unemployment and the actions necessary to address it while preserving
the institutions of a market economy, and Friedman reminded us of the
linkage between money and inflation. The economic progress of the past
two centuries can be partly ascribed to this capacity of economic thinking
to adapt to changing external conditions.
Yet there is also a sense that over the past few decades, much of eco-
nomic thinking has isolated itself from its environment. Economics has
largely displaced political economy, generally regarded by today’s econo-
mists as the eccentric aunt who is no longer mentioned in polite society
and who ought to be prudently confined to the attic. As a result, the con-
nection between theory and reality has been weakened. Theoretical rigor
is important, but relevance is even more.
By 2016, the curtain had closed on the Great Recession of 2007–2008
(or, as pessimists may argue, on Act I). However, at the time there were
reasons to be concerned with the slow recovery of corporate investments
in the USA, as well as with the high degree of unemployment that still
prevailed in much of the EU and the high level of debt faced by several of
its member countries, which constrains their ability to rely on expansion-
ary policies to stimulate economic growth. Meanwhile, the slowdown that
was being experienced by China and Brazil, low oil and other commodity
prices, and the high levels of internal debt in China, and of external debt
in many developing countries (which sought to take advantage of the pre-
vailing low interest environment), feed further concerns about the not too
distant future.
Further fueling uncertainty, in June 2016, a referendum in UK called
for exiting the EU (Brexit), a complex divorce that may take two years to
be finalized and which will have economic, and financial ­sector implica-
tions that will depend on the course of negotiations that have not yet
formally started.
As if this range of problems were not enough, the future awaits us with
others, some of which may be subject to a similar type of analysis as the
one presented here, even though we may not have yet fully fathomed their
magnitude or implications.
 A FAILURE OF IMAGINATION 9

The limited success of ongoing attempts to use monetary policy as an

instrument to promote economic growth shows that governments need
to make use of a broader range of policy instruments, particularly fiscal
policy; central bankers deserve credit for effort but monetary policy on its
own cannot be expected to address all the problems that are being faced.
A price will be paid if political factors stand in the way of policy flexibility
to address prevailing concerns, and that price will ultimately reflect itself
in lower welfare for the population as a whole.
There is a concern that the monetary policies implemented to cope
with the consequences of the recession may have unduly inflated share
and bond prices and steered too many funds toward questionable invest-
ments, including junk bonds and risky consumer loans. Pension funds are
facing the consequences of very low interest rates, and in some cases have
decided to engage in riskier financial investments to earn an acceptable rate
of return. Meanwhile, many financial institutions impress as still vulnerable
and dependent on short-term borrowing, and tighter regulation of com-
mercial banks risks driving more financial business to the shadow-­banking
sector, somewhat less in the shadows than before Dodd-Frank but still not
as thoroughly regulated and supervised as the commercial banking sector.
It appears likely that present unhappiness with the failure of govern-
ments to stem the deterioration in income distribution that we witnessed
in recent years will continue to build up, leading to increased political
polarization and uncertainty about the course of economic policy. The
rhetoric during the 2016 presidential campaign suggests that the discon-
tent underlying these trends, which also reflects the relative decline of the
manufacturing sector of the USA (in part due to globalization), could lead
the USA toward protectionism, reminding us of the Smoot-Hawley Tariff
Act of 1930 and its impact on trade.9
The deterioration in income distribution is linked to other troubling
trends, such as the practice of many corporate boards, dominated by insid-
ers, to set executive compensations at levels which in many cases have
reached values that are impossible to justify, as well as the custom in the
financial sector to provide a substantial proportion of the remuneration of
key operatives and executives in the form of bonuses, often linked to the
results achieved during the year (thus encouraging a focus on short-term
results). These groups (senior executives and financial sector managers)
have seen their share of income and wealth rise substantially in the past
few decades, at a time when the vast majority of workers have witnessed
very limited gains, if any.
10 R.A. HALPERIN

In addition to the issues that are discussed in the pages of the daily
media, there are others of a long-term nature that are building up pres-
sures that will require the development of suitable policy responses.
Demographic trends and progress in medicine are expected to con-
tinue, resulting in an aging population structure in the developed and
most of the developing world, and this will require savings to continue to
steadily grow to enable a growing elderly population to support itself after
retirement. Consequently, an important policy challenge will be to protect
savings and their earning capacity from wide swings in value, as this would
have an important impact on the elderly.
At the same time, two related concerns arise: (a) as the labor force
becomes a smaller proportion of the total population (because the spike
caused by the incorporation of women to the labor market is largely
behind us, and also because younger people spend more time studying
before entering the market at the same time as life expectancies con-
tinue to increase), will productivity continue to increase fast enough to
offset these impacts and enable per capita incomes to continue to rise
as they did in the past?, and (b) will investment opportunities become
available at the same pace as savings increase, or will excessive savings
become a recessionary force that will need to be offset by government
spending?
Climate change looms as a major concern that will only increase in
importance as time passes; it will inevitably require governments to invest
in infrastructure to ameliorate its impact much more than they are doing
at present, and additional policy actions will need to be taken to conserve
energy and reduce carbon emissions; in both cases, fiscal policy will need
to play an important role.
We would be naïve to think that with this short list we have exhausted
the issues that economic theory will need to address and there are oth-
ers, such as the vulnerability of the financial sector to cyberattacks, which
lie outside the traditional domain of economic analysis, but which pose
a concern about their potentially devastating impact. Furthermore, with
time, new challenges that we cannot identify today will develop and
­economic theory will need to periodically revisit its assumptions and mod-
els to ensure that they remain relevant.
This book does not explore these other important issues and is focused
on how we can develop a better understanding of our economic environ-
ment to help us to avoid repeats of financial crises, such as the one expe-
rienced in 2007–2008.
 A FAILURE OF IMAGINATION 11

What the Book Is About

The book advances four related arguments:

(a) The past century has witnessed an impressive growth in privately

owned wealth, a large share of which is represented by financial
assets. As a result, the financial sector has become much more
important within the economy. Despite this, macroeconomic mod-
els typically leave out an important part of all financial activity and
limit themselves to the money market (which is but a segment of
the financial sector, and does not capture what is happening else-
where), and as a result, their explanatory power has been eroded.
(b) The growth of the financial sector has been accompanied as well by
changes within it, in particular, the development of “shadow bank-
ing” (intermediaries that compete with commercial banks in some
of their markets but are not subject to the same level of regulation
and supervision), which puts into question the focus of Central
Bank policy on the stock of money and on commercial banks.
(c) Despite a better understanding of issues of risk and uncertainty
than a few decades ago, our grasp of the factors driving microeco-
nomic decisions has not been well integrated to our thinking about
macroeconomic policy, and conventional macroeconomic models
still fail to adequately come to grips with these factors.
(d) The short-term approach implicit in most macroeconomic models,
which focus on how some key aggregate flow variables, such as
income, consumption and investment, come into equilibrium, is
inadequate. This is because long-run equilibrium also requires that
the composition of the balance sheets of households, firms and
financial intermediaries be optimal. If these balance sheets are over
(or under) leveraged, or if they include too many (or too few) risky
assets, then these actors will take actions to bring them to their
desired levels, and in some cases, these adjustments can be suffi-
ciently large to have important impacts on the real sector.

Is This Book for You?

Many of the findings and conclusions presented in this book are rooted in
a growing body of literature examining the causes of the Great Recession
and the policies that were implemented to deal with it. Some of these
12 R.A. HALPERIN

studies explore what should be done to strengthen the resiliency of the

financial sector and the economy in general, to try to avoid major reces-
sions in the future. The book starts with a review of the factors at play
prior to and during the collapse of the housing markets during 2007 and
beyond, and then discusses the policy responses that followed the financial
crisis and its aftermaths. It argues that changes in the financial sector con-
tributed to the onset of the Great Recession and helped to account for its
severity, so it proceeds to describe these changes.
The book also argues that economic models failed to take into account
the changes that had taken place in the financial sector in recent years,
which helps to explain why policymakers were caught off guard when the
Great Recession happened. Against this context, the book argues that in
today’s environment perceptions of risk, driven by uncertainty, have a
much more significant on the financial sector, and consequently on the
economy, than they did in the past. For this reason, the book also exam-
ines how risk and uncertainty affect economic decision making.
While the book probably falls short of coming up with all the answers,
I hope that I was able to focus its readers on the important questions that
policymakers will be facing in our time, and will spur the interests of some
who will continue to investigate these topics and to test the hypotheses
that it poses. This is still a challenge, as the financial sector has been chang-
ing so quickly that we do not have enough reliable data to enable much
econometric work.
Trained economists may feel withdrawal symptoms at the lack of equa-
tions and graphs, which largely responds to my wish to reach a broad audi-
ence. Having dabbled in econometrics and subjected my students to torture
by mathematics earlier in my career, I now consider that, by and large,
mathematical models should be limited to serve two principal purposes:
first, as a pedagogical tool to help students to understand basic principles
or, second, to develop stylized models that enable their users to examine
with rigor the ultimate implications of some of the ­assumptions that econo-
mists may adopt. Beyond these objectives, however, such models may steer
us toward simplistic representations of reality, which can provide a mislead-
ing sense of precision when we are trying to understand the workings of
an economic system. On the other hand, seeking to integrate context and
historical background to the analysis of economic reality can enable us to
bring to life characteristics that mathematical models often miss.
I hope that most will find that plain English goes a long way toward
providing a coherent argument and to the extent that it falls short, I am
afraid, that the fault lies with me and not with language.
 A FAILURE OF IMAGINATION 13

Notes
1. Greenspan, Alan “Why I Didn’t See the Crisis Coming”, Foreign
Affairs, November/December 2013, pp. 88–96.
2. Cf.: Campbell, J. “Restoring Rational Choice: The Challenge of
Consumer Financial Regulation”, The American Economic Review,
May 2016, p. 5.
3. In this regard, Jean Tirole’s “textbook” on corporate finance
deserves a special mention, as the approach he pursues is largely
indistinguishable from that of conventional microeconomics, and
the many references that he provides come more from books and
articles by economists than from the more conventional literature
on finance. Cf.: Tirole, Jean, The Theory of Corporate Finance.
Princeton: Princeton University Press, 2005.
4. Markowitz wrote on portfolio selection and the article through
which he introduced his approach was originally published in the
Journal of Finance.
5. American Economic Review, February 2011. The panel was inte-
grated by Kenneth Arrow, Douglas Bernheim, Martin Feldstein,
Daniel McFadden, James Poterba and Robert Solow.
6. An article written in 1981 by R. Schiller, “Do Stock Prices Move Too
Much to Be Justified by Subsequent Changes in Dividends?”
7. Robinson, Joan An Essay on Marxian Economics. London:
Macmillan and Co., 1964, p. 2.
8. Minsky, Hyman Stabilizing an Unstable Economy. New York: Mc.
Graw Hill, 2008, p. 4.
9. This legislation was approved in 1930. It is named after the two
Republican legislators who promoted it. By levying taxes on US
imports, it resulted in retaliatory actions from most trading part-
ners, resulting in a reduction not just in imports but alsoin exports.
When it was being considered by Congress, over 1000 US econo-
mists, including Irving Fisher, asked President Hoover to veto the
bill. However, this did not happen and Bernanke, who studied the
Depression in depth, has argued that it increased its severity. Looking
back, it appears that the tariff increases under the law were not that
significant and that the most negative consequence was its impact on
international economic relations, shifting the position of the USA
on trade issues from promoting free trade toward protectionism.
PART I

Crisis!
 CHAPTER 2

The Great Recession of 2007–2008

Introduction
By 2007 most people believed that the Great Depression belonged in the
history books, and in prior years some economists had argued that we had
the knowledge and the tools to ensure that a repeat incident could not
happen.1 Yet, to some degree, in 2007 some of those weaknesses that John
Galbraith found present in 19292 were still there, and the fear of a major
Depression soon awoke.
Until 1998 real estate prices had been increasing a little more than
inflation, but not by much, but by 1998 the rises started to accelerate,
averaging about 7% nationwide; the next year they went up again to over
8%, then almost 10% in the year 2000, continuing at roughly that pace
until 2004 when they further accelerated to almost 15%, repeating that
gain the following year. Of course, these national averages hide the fact
that some regions experienced much larger increases.
Then, in late 2006, housing markets started a free fall that lasted for
several years, causing many financial intermediaries with a significant stake
in those markets to run into serious trouble. These developments cascaded
throughout the financial sector and eventually the economy, causing a drop
in output and an important increase in unemployment. They triggered a
massive policy response from the government and the Fed, which eventu-
ally stemmed the downturn and caused the economy to slowly improve.

© The Author(s) 2017 17

R.A. Halperin, The Influence of Uncertainty in a Changing
Financial Environment, DOI 10.1007/978-3-319-48778-6_2
18 R.A. HALPERIN

The seeds of the recession had been planted well before 2007, when
economic prospects looked bright. Interest rates then were relatively low,
providing an incentive to borrow. At a time when the growth of incomes
tended to concentrate in the most affluent sectors,3 the incentive to bor-
row appears to have been strong among those with lower incomes, who
may have regarded it as a low-risk strategy to enable them to eventually
increase their wealth.
Abundant liquidity caused financial intermediaries seeking returns
higher than those from more conventional investments to invest in
mortgage-­backed instruments that were heavily weighted with sub-prime
mortgages. This appetite was fed by mortgage originators who proceeded
to securitize mortgage loans and sell those securities at a pace not wit-
nessed before. While securitization was not a new phenomenon, Tirole
notes that between 1995 and 2006 the rate of securitization of housing
loans increased from 30% to 81%.4
All these factors were known and could be regarded as ingredients for
the perfect storm. Despite this, how did the crisis of 2007–2008 creep
upon us, seemingly without warning? Or is it that policy makers failed to
understand them—or chose to ignore them?
Akerlof and Shiller answered these questions by arguing that:

… so many members of the macroeconomics and finance profession have gone so

far in the direction of rational expectations and efficient markets that they fail
to consider the most important dynamics underlying economic crises. Failing
to incorporate animal spirits into the model can blind us to the real sources of
trouble.5

As I went through the literature, I realized that initially many commenta-

tors, including some economists who had not been paying close atten-
tion to developments in the financial sector, were not clear as to what
had driven the preceding real estate boom, how significant its impact had
been, and why it had come to an end bringing the financial sector so
close to collapse. Eventually, however, a good understanding developed
on what had happened.
What originated the rise in housing prices that preceded the Great
Recession? Several factors appear to have played a role, starting in sev-
eral foreign countries (led by China) where savings well in excess of their
domestic investment needs caused them to look elsewhere for investment
opportunities. With interest rates low worldwide, financing real estate
 THE GREAT RECESSION OF 2007–2008 19

purchases in the USA through mortgage lending impressed as a seemingly

safe choice providing good returns, and this perspective gained traction
when financial wizards developed the instruments to handle the default
concerns associated to individual mortgage loans by slicing them and
packaging the slices in “mortgage portfolios” against which they issued
securities, arguing that they were substantially mitigating risks through
diversification.
A second contributing factor was the widely held view among the
population at large that investing in housing is always a sound long-run
choice. In addition, mortgage interest is tax deductible while rent pay-
ments are not, which makes the option of purchasing more attractive than
renting. In addition, there was a sense that an aging population would
cause increased demand for land and housing in states with warmer cli-
mates, which would result in rising land prices, in turn providing an incen-
tive to purchase homes in those parts of the country.
Finally, the behavior of mortgage originators contributed: they devel-
oped new mortgage instruments that required less cash from home pur-
chasers for the down payment than conventional mortgages and helped to
relax lending standards and the qualifying criteria to obtain a loan. Many
housing purchasers could not qualify for a conventional mortgage and did
not fully understand the potential risks of real estate investments. Were it
not for the relaxation in lending standards that took place to accommo-
date the supply of funds available, they would not have been able to carry
out those housing purchases.
The combination of relaxed lending standards and securitization proved
lethal: mortgage originators sold off mortgage-backed securities to inves-
tors, thus divesting themselves of risk. The more they lent, the more they
profited. Meanwhile, most of the purchasers of mortgage-backed securi-
ties typically were not commercial banks but other financial intermediaries
as well as foreign investors, seduced by the higher yields and apparent
lower risks of these securities. To add fuel to the forthcoming fire, some
financial intermediaries (such as AIG) were willing to engage in credit
default swaps (CDS), which insured mortgage-backed securities from the
risk of default. That is the heart of the story, for when problems started to
develop in the housing market and borrowers started to default, the hous-
ing sector crisis became a financial sector crisis.
Initially, I was influenced by Stiglitz, who argued that the potential for
a crisis went largely unnoticed partly due to failings in economic models.
He wrote6:
20 R.A. HALPERIN

But economists (and their models) also bear responsibility for the crisis. Flawed
monetary and regulatory policies were guided by economists’ models, and the
dominant models failed to predict the crisis … One of the reasons for the failures
of those models was their inadequate modeling of the credit markets (banks and
shadow banks) …

When the bubble burst, many financial intermediaries, particularly in the

shadow banking sector, faced the double punch of portfolio losses and
loss of access to funding, and their struggle to stay afloat resulted in wide-
spread concerns about the health of the financial system in general and loss
of public trust in its executives and their integrity.
An interesting perspective was recently advanced by Mian and Sufi.7
They do not challenge the view that many financial intermediaries exposed
themselves to excessive levels of risk, which eventually led to a loss of con-
fidence and curtailed access to funding, leading to fire-sale losses and even-
tually the now infamous bailouts or, in some cases, bankruptcy. However,
Mian and Sufi also show that excessively leveraged households (they point
out that the household debt to income ratio rose from 1.4 to 2.1 in the
period going from 2000 to 20078), which may have purchased a house
enticed by the very low monthly payments that many of the m ­ ortgage
instruments available initially required them to pay (possibly in the expec-
tation that they could sell at a profit in a short time), could not stand the
reversals in real estate price increases that started late in 2006.
Under this interpretation, the financial sector debacle was the second
act of a tragedy that started in the real sector of the economy. They point
that the National Bureau of Economic Research (NBER) has dated the
beginning of the recession to the fourth quarter of 2007, by which time
real estate prices had been dropping for about a year.
This reading ought to be complemented with the following observa-
tion by Eichner, Kohn and Palumbo9:

… the years leading up to the financial crisis and recession were characterized
by an increase in net investment by the US household sector that was funded by
borrowing rather than saving. The household sector’s shift from its role from the
1960s through the 1990s as a net funding source for other sectors’ investment to
a net borrowing position is something that appears to have been unprecedented
in the US postwar period

In his memoirs, Bernanke tells us that the Fed was well aware of develop-
ments in the housing markets, which it monitored. However, the potential
 THE GREAT RECESSION OF 2007–2008 21

for a major financial meltdown was underestimated until it was too late,
and this may be in part because the shadow banking system did not get
from the Fed the attention it deserved.
Geithner also confirms that by the summer of 2007, the Fed had
become concerned about the course of the economy and points to the
failure of Countrywide (a large mortgage originator) that took place in
August 2007 as the starting event of the financial debacle.10 In a more
recent speech, Stanley Fischer points to even earlier indications of trouble
in the financial sector, going to late 2006 and culminating in the failure
of Ownit Mortgage Solutions, a large sub-prime mortgage originator, in
December of that year.11
Reading Bernanke and Geithner’s memoirs, one gets the sense that the
Fed did have timely information on many important developments in the
real as well as in the financial sector but failed to adequately interpret it
until it was too late. It may be that they were too close to the trees to be
able to see the forest, and it does appear that still in 2007 concerns about
inflation (which had been a perennial problem ever since the 1950s) were
in the minds of some decision makers. “Group-thinking”, perhaps just as
much as models, may account for this.
On the other hand, the data then available on operations in the shadow
banking system12 was sketchy, and even the Fed was dealing with frag-
mentary information, a shortcoming that appears to have not been fully
resolved to this day.
While, in hindsight, what took place in 2008 was qualitatively similar to
the financial bubbles that the world saw in the past,13 there were also some
differences arising from the increased importance achieved in recent times
by the financial sector, reflected in the larger share of financial holdings in
households’ wealth, and from the role played by the shadow banking sys-
tem. At the time, the increased importance of the shadow banking system,
highly leveraged and dependent on short-term funding was not recog-
nized by macroeconomic practitioners, who failed to capture its activities
in their models.

The Evolving Nature of Risks

Before the Industrial Revolution, households faced risks that largely orig-
inated outside the economic system, such as wars, theft, poor weather,
fire, and epidemics. Money consisted of gold and silver coins, which
families held in their homes facing the risk of robbery, and the notion of
22 R.A. HALPERIN

“hiding it under the mattress” dates back to these times. Counterfeiting

and coin-­shaving occurred often, sometimes leading people to weigh
the coins that they received in payment to verify that they had not been
tampered.
The wealth of most households was very small and at best consisted of
their home and furnishings, tools and cattle. The wealth of the rich was
largely invested in their lands and buildings, as well as in precious metals,
art and jewels. Industry, as we now know it, did not exist; but there were
artisans and tradesmen, who mostly resided in towns and villages. In some
cases, states did issue bonds, typically to help finance their wars, and these
were force-fed to the rich and the few banks around, which were privately
owned and had a limited customer base.
As the economic system became more diversified and complex, new
risks developed and many originated within the system itself. Expectations
of large gains drove speculative ventures, such as the South Sea bubble in
1720, which happened from time to time as improvements in navigation
gave rise to business opportunities, opening new markets and allowing
access to valuable foreign products.
The development of banking was an important supporting factor for
the growth of the business sector subsequent to the Industrial Revolution
but it also gave rise to other risks, those associated to the potential losses
that depositors would face when a bank went under, and during the nine-
teenth and early twentieth centuries, bank runs occurred from time to
time throughout the developed world. Stock markets and the develop-
ment of new forms of financial intermediation, as well as new financial
instruments further expanded the range of investment opportunities, and
also of risks, that households and firms faced, at the same time that the
expansion of the insurance industry helped to provide protection against
other risks.
In 1952, American economist Harry Markowitz wrote a seminal article
on what would become the theory of portfolio selection. Whereas until
then the conventional wisdom had focused on profit maximization as
the driving force behind financial investment decisions, Markowitz (who
focused on the stock market) argued that this perspective was too narrow
and that those decisions were driven by dual goals: the search for returns
but also the wish to contain risks. But, how do you measure those risks?
Markowitz argued that the history of fluctuations in the price of a security
provided a measure of how likely it was that it could fall in value in the
future. Moreover, he went on, the behavior over time of all securities was
Exploring the Variety of Random
Documents with Different Content
Sunday during the Dark Ages, 362-398
Sunday edicts of kings, emperors, popes and councils, 342-346,
349, 353, 359-361, 366, 372-398
Sunday festival, origin and growth of, 223, 224, 352, 353
Sunday festival defined by the reformers, 434-436
Sunday, first witnesses for, 228-243
Sunday, how mentioned prior to a. d. 194, 218, 219
Sunday labor in the early church not sinful, 283-289, 296, 299,
316-322, 343-345
Sunday labor in the fourth and fifth centuries, 363-366
Sunday Lord’s day not traceable to the apostles, 204-228
Sunday on a level with other festivals in the early church, 264-
266, 295, 296
Sunday sustained only by the Romanists’ rule, 202, 203, 223,
224, 294, 477, 478
Sunday, when first called Sabbath, 370, 371
Superstition of the Jews concerning the Sabbath, 113, 114

Tabernacles, feast of, defined, 83, 84

Ten commandments alone on the tables of stone, 79-81
Tertullian’s excuses for Sunday observance, 277, 278
Tertullian on Lord’s day, 222-224
Tertullian’s self-contradiction, 276, 277, 305-307
Theophilus mentions no Lord’s day, 212, 213
Time defined, 9
Time, great week of, 9
Tradition characterized, and exemplified, 198, 201, 227, 228
Tradition for the passover more apostolic than for Sunday, 227,
228
Transylvanian Sabbath-keepers, 460-463
Trask, Mrs., sufferings of, 481-483
Troas, Paul at, 178-182
True God distinguished from false gods, 25, 26
Typical observances no part of the Sabbath law, 98, 99
Time to commence the Sabbath, 107, 108

Unfairness of anti-Sabbatarians, 131, 132

Waldenses, 403-415
Weeks, how and when made, 16, 30, 31
Wilderness of sin, record of, how connecting Gen. 2:1-3, and
Ex. 20:8-11, 46, 47
 ERRATA.
Page 141, chapter xix., in the notes, should be chapter xxvii.
” 255, “and,” in the Latin notes, should be “&.”
” 295, “exaltation.” in line 16, should be “exultation.”
” 505, for “$70,000,” read $82,000,—Auditor’s later report.

Transcriber’s Note: The errata have been corrected.

 Catalogue of Publications
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