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'Shared Delusions' Run Deep with Risks

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 Andrew Kahr's excellent discussion of how "Systemic Risk Is About Assets, Not Size" rightly focuses on bubble-inflating movements in the aggregate balance sheet of the financial sector. We should expand on three of his insightful points:

1. "When the industry as a whole gorges itself on a new class of assets," it is likely to be assets previously well behaved with attractive credit experience. As Richard Milne wrote recently in the Financial Times, "Risky assets do not cause crises.  It is those perceived as being safe that do." Precisely because they are perceived as safe, they become risky.

Perceptions of uncertain future events like credit safety or credit risk are inherently subjective and highly influenced by the views of all the others who are doing what you are doing. That is why (in my paraphrase of a famous thought of J.M. Keynes) a prudent banker is one who goes broke when everybody else goes broke!

2. "Banks' shared delusions generate systemic risk" — yes indeed, but bankers are far from alone in sharing the delusions. The cognitive herding also includes regulators, consultants, central bankers, investment bankers, investment managers, entrepreneurs, brokers, accountants, academics, rating agencies, borrowers, speculators, and in a leading role, politicians. Plausible and clever rationalizations for why the systemic risk-generating asset expansion is a good idea are always produced by very intelligent people, going back at least to John Law in 1717, whose ideas turn out to be self-falsifying.

3. "A sappy emotional preference for promoting further European integration" led the march into the European sovereign debt debacle. Yes: and a sappy emotional preference for promoting housing led our own mass march into the debt quagmire.  O Tempora, O Mores!

Alex J. Pollock
Resident fellow
American Enterprise Institute
Washington, DC

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