Melchior Payli and the roots of the Great Recession

One of the hardest things to do honestly in economics is to sort through all of the arguments and counterarguments about what 'caused' an economic crisis like the Great Recession.  Part of the difficulty lies in the fact that people confuse causes with conditions.  For example, one of the oft cited explanations for the crisis in the media was Wall Street 'greed'.  But I would argue that 'greed' is a constant, built into our very natures and as such cannot be an independent, causal variable in any model of economic behavior.  To argue otherwise is to argue that 'greed' has gotten worse over the past 20 years.  And of course when one makes that argument, I am forced to point out that over the past 20 years the voting and fund raising patterns of Wall Street have shifted from heavily Republican to heavily Democrat.  (Wait, of course Wall Street greed has increased, what was I thinking?)

The other really hard thing to do is to sort through all of the agenda driven ex-post analysis from both the left and right.  Everyone takes some facet of the crisis congenial to their worldview and on this narrow foundation, builds a theoretical castle in the air.  Now unlike Paul Krugman - whose intellect has apparently become completely detached from the beliefs and habits of mind that won him the Nobel - these economists are sincere.  But ex post analysis is fraught with this tendency to breathe one's own exhaust and become progressively more intoxicated by it.  Just ask Al Gore.

The only truly independent way to think about a problem like the Great Recession is to search for economists who made a priori predictions based upon what was known long before the crisis was upon us.  Developing theories and models and predicting the future outcome is a much better test of someone's handle on reality.  Did they get it right?  Why?  What did they get wrong?  Now my leftist friends might say "aha! then the greatest economist and predictor of all time was Karl Marx because he predicted this 'crisis' of capitalism over 150 years ago".  I disagree because I have two additional requirements of economic prognostication:  to make an a priori prediction one must be relatively specific about what is going to happen and how specific policy choices led to specific economic effects.  Secondly I require that the lifetime record of predictions by said economist be good - no lucky guesses.  Nothing that Karl Marx predicted has come to pass and there is no specific analytics to speak of in his work.  Essentially Marxian Economics (as opposed to sociology or psychology) is a black (and bushy bearded) box.

That's why Melchior Payli's work is so interesting.  Professor Payli was a (ahem) University of Chicago economics professor who made some very specific observations about the nature of risk in our banking system and from them made some predictions.  Predictions made seventy years before the crisis that turned out to be eerily accurate.  Here's a brief summary of the WSJ article from Marginal Revolution:

Decades before anybody had ever heard of a mortgage derivative, an economist named Melchior Palyi predicted key causes of the 2008-2009 financial crisis with precision that makes a modern reader's hair stand on end.

His warnings help explain why investors insist on trusting market gatekeepers they know to be fallible—such as policy makers, regulators and credit-ratings firms.

The seeds of today's problem were planted long ago, and its forgotten history holds important lessons. In 1936, as part of reforms under the new Banking Act, the U.S. government mandated that federally regulated banks could no longer hold securities that weren't rated investment-grade by at least two ratings firms.

...Mr. Palyi, then teaching at the University of Chicago, was a vocal skeptic from the outset. Looking back into the 1920s, he found that investment-grade bonds went bust with alarming frequency, often in the same year they were rated. On average, he showed, a bank that followed the new rules would end up with a third of its bond portfolio going into default.

The record was so unreliable that it would be "still more responsible," Mr. Palyi growled, to "stop the publication of ratings altogether." He was especially troubled that the new banking rules switched the responsibility for credit safety from bankers—and even bank regulators—to ratings firms.

"From there," he warned, it "will have to be shifted again—to someone else," presumably taxpayers. Liquidity, Mr. Palyi argued, was being replaced by what he scornfully called "shiftability," a new kind of risk that could someday "be magnified into catastrophic dimensions."

As they say, read the whole thing.