The Global Financial Crisis according to Hersh Shefrin

Global Financial Crisis Survey

Hersh Shefrin is a Professor of Finance at Santa Clara University's Leavey School of Business. Professor Shefrin is a pioneer of behavioral finance and has published in over a dozen journals and won numerous awards (often for papers coathored with colleague Meir Statman or Richard Thaler). In 1985, Shefrin and Statman introduced the concept of “the disposition effect” into the behavioral finance literature, and coined the term. He has authored numerous books including A Behavioral Approach to Asset Pricing, Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing, and Behavioral Corporate Finance. Some of his articles related to the crisis that are available online include "How Psychological Pitfalls Generated the Global Financial Crisis" in Insights into the Global Financial Crisis (a free download) from The Research Foundation of CFA Institute and Ending the Management Illusion: Preventing Another Financial Crisis in Ivey Business Journal (January/February 2009).

1. Which FCIC View best represents the causes of the Financial Crisis?

Majority Conclusions

2. Which narrative presented by Douglas Elliott and Martin Baily of the Brookings Institute in Telling the Narrative of the Financial Crisis: Not Just a Housing Bubble best represents the causes of the Financial Crisis?

"Everyone" was at fault: Wall Street, the government, and our wider society.

3. The Global Financial Crisis is ongoing and will end in the year

2013 or beyond.

4. What were the primary causes of the Global Financial Crisis?

Psychological pitfalls generated the global financial crisis, which evolved in accordance with Minsky's script. Underlying Minsky's script is the psychological framework at the heart of behavioral finance. Minsky told us that economists have historically ignored the part of Keynes's theory that relates to the relationship between Wall Street and the overall economy. In this respect, McClean and Nocera's book All the Devils are Here point out that during 2003-2007, it was Wall Street that provided the financing for much of subprime mortgage origination, which it then securitized. Lying at the center of Minsky's analysis of what drives a financial crisis is financial innovation involving excessive Ponzi finance, meaning short-term lending by financial institutions against long-term cash flows that rely too heavily on price appreciation. In this respect, much of the mortgage lending associated with the housing bubble relied on house prices continuing to rise at rates that exceeded historical averages. Minksy argued that the financial sector is politically more agile and powerful than the regulators who oversee them, which is why the financial sector will ultimately win the regulatory game. In this respect, the passage of the Gramm–Leach–Bliley Act, also known as the Financial Services Modernization Act of 1999, and the political pummeling of CFTC chair Brooksley Born for having proposed increased scrutiny of derivatives trading are examples of end results favored by the financial sector. Minsky was also concerned that the Fed was overly focused on monetary policy at the expense of overseeing the quality of lending in financial markets. In this respect, during 2011 Fed chair Ben Bernanke made the same point, in describing lessons to be learned from the financial crisis. Underlying the complex Minsky dynamic are a series of critical psychological phenomena such as excessive optimism, overconfidence, confirmation bias, and aversion to a sure loss. These are manifest in asset bubbles, weak regulation, excessive leverage, excessive risk taking, and the shattered belief expressed by Alan Greenspan that self-interest can be relied upon to produce rational decisions.

5. What still should change as a result of the crisis?

Minsky warned us that the seeds of the financial crises of tomorrow are sewn when we address the financial crises of the past. In this respect, the sovereign debt crisis of 2011 in Europe comes to mind, although the downgrade of Treasury debt by S&P shows that the U.S. is not immune. He went on to say that these crises are baked into the system, and are unavoidable. Therefore, we are well advised to establish mechanisms to soften the blows when they arrive. Minsky's reforms feature four categories: fiscal, employment, industrial, and financial. It means running large enough fiscal deficits, short-term, to offset dramatic decreases in aggregate demand in the private sector. It means having public employment programs in place to keep employment from plummeting. It means having measures in place to keep systemically important firms from becoming too large, therefore too big to fail. It means having the Fed play a more active role in financing at the discount window, so as to keep tabs of the growth in speculative and Ponzi financing, which is the locus of where blowouts happen. Interestingly, Minsky proposed eliminating the corporate income tax, because he felt it encouraged excessive corporate borrowing. In a nutshell, we would be well served by embracing the insights of an economist who died a decade before the financial crisis, but whose ideas, although spot on, received too little attention from academics, public policy makers, and the media. Whether or not we move to embrace Minsky's ideas more strongly in the future will depend on our collective vulnerability to psychological phenomena such as confirmation bias (discounting views counter to our own) and availability bias (overweighting information that is readily available). Indeed, confirmation bias is so strong, that it typically prevents us from overcoming our ideological positions and learning efficiently from experience. That is why Minsky's view is likely to prevail in the long run, meaning financial crises are inevitable.

Compiled by Gary Karz, CFA
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Global Financial Crisis Survey

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