Skip to Navigation

Rethinking the Financial Crisis: An Interview with Andrew Lo

Rohan Mascarenhas, Russell Sage Foundation
January 9, 2013

financial crashA professor of finance at MIT, Andrew W. Lo is an editor of the RSF volume Rethinking the Financial Crisis. The volume addresses important questions about the complex workings of American finance and shows how the study of economics needs to change to deepen our understanding of the financial sector.

Q: In a recent paper, in which you review more than 20 books on the financial crisis, you wrote, "there is still significant disagreement as to what the underlying causes of the crisis were, and even less agreement as to what to do about it." What is it about the financial crisis that has prevented economists from offering a definitive account of its origins?

A: There are at least three challenges in understanding something as complex as the recent financial crisis: the breadth of knowledge needed to span the various parts of the financial system, the data, and the motivation. The crisis involved regulatory issues, financial innovation, real estate markets, accounting rules, investment and commercial banking, and monetary policy. No single individual has all the necessary expertise to span all these issues, which means that the individuals with the domain-specific knowledge must collaborate to piece together this incredibly intricate jigsaw puzzle. But even if we had the collective expertise, we would still need to gather significant amounts of data to test the various hypotheses proposed by the experts. Finally, while some of this forensic analysis is being done by economists such as those in Rethinking the Financial Crisis, much greater resources are needed to conduct a larger and more systematic analysis, and those resources aren't forthcoming because there isn't a consensus that we need to get to the bottom of these issues. For example, the Dodd-Frank Act was passed more than half a year prior to the final report of the Financial Crisis Inquiry Commission, and that report wasn't even able to come to a common conclusion (the bipartisan commission came to three mutually contradictory conclusions!).

Q: Many people believe that the financial crisis revealed major shortcomings in the discipline of economics, and one of the goals of your book is to consider what economic theory tells us about the links between finance and the rest of the economy. Do you feel that economists understand enough about the nature of financial instability or liquidity crises?

A: I think that the financial crisis was an important wake-up call to all economists that we need to change the way we approach our discipline. While economics has made great strides in modeling liquidity risk, financial contagion, and market bubbles and crashes, we haven't done a very good job of integrating these models into broader macroeconomic policy tools. That's the focus of a lot of recent activity in macro and financial economics and the hope is that we'll be able to do better in the near future.

Q: Let me continue briefly on this thread. One topic that has been particularly controversial concerns the efficient-market hypothesis (EMH). Burton Malkiel discusses the issue in his chapter in Rethinking the Financial Crisis, but I wanted to ask your opinion of this idea that EMH fed a hands-off regulatory approach that ignored concerns about faulty asset pricing.

A: There's no doubt that EMH and its macroeconomic cousin, Rational Expectations, played a significant role in how regulators approached their responsibilities. However, we should keep in mind that market efficiency isn't wrong; it's just incomplete. Market participants do behave rationally under normal economic conditions, hence the current regulatory framework does serve a useful purpose during these periods. But during periods of extreme growth and decline, human behavior is not the same, and much of economic theory and regulatory policy does not yet reflect this new perspective of "Adaptive Markets."

Q: The years preceding the financial crash saw the rise of fairly innovative financial products – ABS’s, CDOs, credit-default swaps, etc – and a number of chapters in your edited volume investigate their utility. Let me pose a broader question: assuming we could do it, should we strive to recreate the "boring" era of finance that lasted between the 1930s until the 1980s? Or do these recent innovations actually make the economy more efficient and add more value?

A: Financial innovation is a double-edged sword that supports real economic growth during good times but can also wreak havoc during bad times, and this has always been the case. For example, one of the factors that contributed to the Great Depression of 1929 was the excessive leverage available to stock-market investors through margin accounts, but this leverage was also responsible for the prosperity that preceded the Depression, now known as the "Roaring 20's". In the aftermath of 1929, we enacted a series of new financial regulations to deal with these excesses, including limits on leverage (Regulation T), and the 33 Act, 34 Act, and 40 Act largely determined the financial regulatory framework we've been living under until Dodd-Frank. But it's important to keep in mind that the 1930s to 1990s were not that "boring" -- there were a number of really important financial innovations during that time including: hedge funds, mutual funds, options, futures, swaps, CDOs, electronic trading, etc. The key difference, though, between the 1930-2000 period and the past decade is, in my opinion, the advances in computer technology, telecommunications and connectivity, and world population. These features enabled us to greatly magnify the impact of financial innovation across markets, borders, and asset classes, so that the speed of financial innovation outstripped the ability of regulators and regulations to keep pace. You can cut a lot more trees much more quickly with a chain saw than a hand saw, but chain-saw accidents tend to me a lot more serious than hand-saw accidents.

Q: Given how little we apparently know about the financial crisis, how do you rate the performance of regulators and policymakers in the crash’s aftermath?

A: I think regulators and policymakers have done a pretty decent job in responding to an extraordinarily challenging set of circumstances since 2008, and while no one is happy with the outcome, I believe things would have been much worse if the response was not as quick or as strong is it was. However, it could be argued that these same individuals underperformed significantly prior to the crisis by allowing it to develop into the crisis that it became. But rather than point fingers and cast blame, I think a more productive approach is to determine how to change the regulatory framework so that we might be able to avoid future crises. One way to do this is by having more conferences like Rethinking Finance and studying previous crises to determine what the root causes of these events were. Only by developing a deeper understanding of financial crises can we begin to develop a more robust financial system.