Why were arguments against taking on risk discounted heavily during the boom?

Barry Eichengreen writes exceptionally well:

"THE GREAT Credit Crisis has cast into doubt much of what we thought we knew about economics. We thought that monetary policy had tamed the business cycle. We thought that because changes in central-bank policies had delivered low and stable inflation, the volatility of the pre-1985 years had been consigned to the dustbin of history; they had given way to the quaintly dubbed “Great Moderation.” We thought that financial institutions and markets had come to be self-regulating—that investors could be left largely if not wholly to their own devices. Above all we thought that we had learned how to prevent the kind of financial calamity that struck the world in 1929.

We now know that much of what we thought was true was not. The Great Moderation was an illusion. Monetary policies focusing on low inflation to the exclusion of other considerations (not least excesses in financial markets) can allow dangerous vulnerabilities to build up. Relying on institutional investors to self-regulate is the economic equivalent of letting children decide their own diets. As a result we are now in for an economic and financial downturn that will rival the Great Depression before it is over."

What went wrong? Eichengreen argues that those who wanted to take big financial risks were biased toward theories that supporting taking big financial risks.

"the problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking"

That seems generally right.

Especially as those who tend to be better at seeing risks than opportunities tend to warn of trouble well before it breaks out, and even if they identify certain underlying vulnerabilities, are unlikely to call every move in the market.

Back in 2004 Nouriel Roubini and I argued that the United States’ large external deficit was a risk to global financial. Dr. Eichengreen, Dr. Rogoff, Dr. Obstfeld, Dr. Frankel, Dr. Wolf and no doubt many others issued similar warnings. Yet as late as August 2007 Dr. Wolf felt compelled to acknowledge that: "A world in which capital flows from poor countries to the world’s richest seems to be more stable, more dynamic and and altogether more satisfactory than that of the 1980s and 1990s .... "*

Cassandras generally supply their critics with plenty of ammunition.

One financial implication of the Roubini/ Setser 2004 argument was to short the dollar, which wasn’t all wrong (until recently). Another was to take on less leverage. Nouriel and I implicitly were arguing against the assumption that a highly imbalanced world would also be a low volatility world. And that wasn’t the right financial bet for 2005, 2006 or the first part of 2007. Those who took on leverage -- and bet that the various imbalances in the US and the global economy wouldn’t create any immediate problems -- made money. Those who sat the dance out didn’t.

And while I think our general warnings about the risks associated with an imbalanced world were right, some of our specific concerns never panned out. We generally focused financial risk that those who were holding low-yielding dollar assets were taking; and thus the possibility that the rest of the world’s credit line might have limits. Far more people expected the dollar to fall than expected major financial institutions to fall. Dr. Rajan and Dr. Roubini are the honorable exceptions. Few realized that the US household deficit could be financed only if US and European financial intermediaries took on credit risk even as the world’s central banks took on currency risk. The US economy was generating riskier assets while central banks generally still wanted fairly safe assets.

US banks -- not foreign central banks -- proved to be the weakest link.

In a rising market, acting on a worry that doesn’t pan out is risky; your portfolio underperforms. The higher home prices rose, the more wrong those who warned of the risks at an early stage looked. Those who warned of the risks of a large trade deficit were in a similar position.

Ultimately, though highly leveraged bets on securities backed by homes were more risky in 2006 than in 2004, as the higher valuation of the underlying collateral implied a larger risk that the underlying collateral would fall in value. Financial institutions should have insisted that folks put more down, not less, as home prices rose.

And there was a bit too much faith, especially on the part of the regulators, that securitization had dispersed risk.

I would have expected most financial institutions back then to have run a stress test where the ratio of home prices to income fell back to historic levels. It doesn’t seem, though, that many such tests were run -- or if they were, key institutions didn’t act on the results. And we all have paid a price.

Read Eichengreen.

* Fixing Global Finance, p. 111. Emphasis though needs to be placed on the word "seems"; Martin Wolf clearly didn’t believe a world where capital flows uphill was optimal in 2007 -- and certainly doesn’t believe such a world is optimal now.