Groupthink and the Markets

| Tue Apr. 27, 2010 12:46 AM EDT

David Brooks suggests that since the establishment herd mostly missed the housing bubble, financial reform ought to take power away from the establishment:

One might have thought that one of the lessons of this episode was that establishments are prone to groupthink, and that it would be smart to decentralize authority in order to head off future bubbles.

Both N. Gregory Mankiw of Harvard and Sebastian Mallaby of the Council on Foreign Relations have been promoting a way to do this: Force the big financial institutions to issue bonds that would be converted into equity when a regulator deems them to have insufficient capital. Thousands of traders would buy and sell these bonds as a way to measure and reinforce the stability of the firms.

....The premise of the current financial regulatory reform is that the establishment missed the last bubble and, therefore, more power should be vested in the establishment to foresee and prevent the next one....But the bill doesn’t solve the basic epistemic problem, which is that members of the establishment herd are always the last to know when something unexpected happens.

I don't have a firm opinion on the Mankiw/Mallaby idea. But I will say this: it wasn't just the "establishment" that missed the housing bubble. It was also the market, represented by those thousands of traders who buy and sell bonds. In fact, pretty much by definition, the market always misses bubbles.

Brooks has the causation backward here, I think. The establishment didn't miss the housing bubble because of generic groupthink. It missed the housing bubble because of a specific case of groupthink: the nearly unanimous belief that markets can't be wrong. Thus, if the market price of housing is going up, it had to be the case that housing prices should be going up. All that was left was to invent reasons to explain skyrocketing property prices, and the establishment did that in spades. But it was market delusion that drove establishment delusion, not the other way around.

Brooks is right that the market and the regulatory establishment and the political establishment all colluded to allow the bubble to get out of control. Merely giving regulators more authority probably isn't enough by itself to prevent a repeat. But relying on the market isn't either. That was the ur-delusion that brought the global banking system to its knees in the first place.