Diagnosing the Market Failures

In this article, we analyze the failures, specifically of stress-testing and other risk management tools, that contributed to the global financial crisis of 2007-2012. The market failure was the root cause of these risk management problems. These market failures fall roughly into three categories:

  • Disaster myopia
  • Network externalities
  • Misaligned incentives

All three have impeccable microeconomic credentials and potentially disastrous macroeconomic consequences.

Disaster Myopia

In a nutshell, disaster myopia refers to agents’ propensity to underestimate the probability of adverse outcomes, in particular small probability events from the distant past. It is well-established in cognitive psychology that economic agents have a tendency to base decision rules around rough heuristics or rules of thumb.

The longer the period since an event occurred, the lower the subjective probability attached to it by agents (the so-called “availability heuristic”).  And below a certain bound, this subjective probability will effectively be set at zero (the “threshold heuristic”).

If the period of stability is sufficiently long – a Golden Decade perhaps? - this subjective approach to evaluating probabilities looks increasingly like a fully-rational, Bayesian approach to updating probabilities.  As time passes, convincing the crowds that you are not naked becomes progressively easier.  It is perhaps no coincidence that the last three truly systemic crises – October 1987, August 1998, and the credit crunch which commenced in 2007 – were roughly separated by a decade.  Perhaps ten years is the threshold heuristic for risk managers.

In the context of financial crises, disaster myopia has been used to explain the LDC debt crisis, the US savings and loans debacle and various commercial property crises. The credit crunch of the past 18 months is but the latest in a long line of myopia-induced disasters.

Network Externalities

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