The only truly surprising thing about the 2008 financial meltdown is how easily the idea was accepted that its happening was unpredictable. Recall the demonstrations that throughout the last decade regularly accompanied meetings of the International Monetary Fund and the World Bank: the protesters’ complaints encompassed not only the usual antiglobalization motifs (the growing exploitation of Third World countries, etc.) but also how the banks were creating the illusion of growth by playing with fictional money and how this would all have to end in a crash. It was not only economists such as Paul Krugman and Joseph Stiglitz who warned of the dangers ahead and made it clear that those who promised continuous growth did not really understand what was going on under their noses. In Washington in 2000, so many people demonstrated about the danger of a financial collapse that the city had to mobilize 3,500 local policemen. What ensued was tear- gassing, clubbing, and mass arrests. The police were used to stifle the truth.
After this sustained period of willful ignorance, it is no wonder that, when the crisis did finally break out, as more than one observer put it, “No one really knew what to do.” The reason being that expectations are part of the game: how the market will react depends not only on how much people trust this or that intervention but even more on how much they think others trust them— one cannot take into account the effects of one’s own choices. Long ago, John Maynard Keynes rendered this self-referentiality nicely when he compared the stock market to a silly competition in which the participants have to pick several pretty girls from a hundred photographs, the winner being the one who chooses girls closest to the average opinion: “It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.” So we must choose without the knowledge that would enable a qualified choice, or, as John Gray put it: “We are forced to live as if we were free.”
At the height of the crisis, Joseph Stiglitz wrote that, in spite of the growing consensus among economists that any bailout based on Treasury Secretary Henry Paulson’s plan would not work, “it is impossible for politicians to do nothing in such a crisis. So we may have to pray that an agreement crafted with the toxic mix of special interests, misguided economics, and right-wing ideologies that produced the crisis can somehow produce a rescue plan that works—or whose failure doesn’t do too much damage.” He is correct, since markets are effectively based on beliefs (even beliefs about other people’s beliefs), so when the media worry about “how the markets will react” to the bailout, it is a question not only about its real consequences but about the belief of the markets in the plan’s efficacy. This is why the bailout may work even if it is economically wrong-headed.
[Extract. Appeared in Harpers Magazine October 2009 issue.]