Shock Therapy

ANNIVERSARIES ARE OCCASIONS that call for celebration and at times for introspection, in case events panned out differently from what one expected. They also serve as excuses for dishing out something in case one is unable to come up with a right ‘peg’, as journalists say. It is rare that a single event forces one to look at the past, present and the future at the same time. In the last quarter century or so of the Great Moderation—political and economic—there has hardly been an event that could force an appraisal of that kind. Except one: the 2008 financial and economic crisis that has now mutated into a far wider set of political changes.

Plenty that has been written on the topic this year. One can be sure that more is yet to come. Two books, however, stand out in their own different but ultimately linked ways. A Crisis of Beliefs: Investor Psychology and Financial Fragility by Nicola Gennaioli and Andrei Shleifer (Princeton University Press; 264 pages; Rs 1,854) and Identity: The Demand for Dignity and the Politics of Resentment by Francis Fukuyama (Farrar, Straus and Giroux; 240 pages; Rs2,089).

The big question for Gennaioli and Shleifer is the beliefs that motivated various people—homebuyers, creators of mortgage-backed securities (MBS), analysts who put a value to these securities, investors who demanded them and ratings agencies that labelled them. There is ample proof that all these participants in the property market had exceedingly rosy beliefs about the continuing rise in the prices of homes and, of course, the securities backed by these assets. Ultimately, a gigantic pile of MBS turned out to be worthless and in its wake brought down key US financial institutions like Lehman Brothers. A meltdown of financial markets was averted just by a whisker.

The period in the run-up to the crisis can be divided into two parts. One, from 2000 to 2007, when property prices witnessed a gigantic boom—one that had not been seen for a century—and finally began deflating in the summer of 2007. Two, from summer 2007 until 2008, a full year. The questions are simple, even if the answers are complicated. Why did the deflation of the bubble take so long to lead to a full-blown crisis? What were market participants and policymakers thinking, especially after March 2008, as they watched the financial system disintegrate, first slowly and then all at once?

‘Our best judgment is that for a year after the summer of 2007, neither investors nor policymakers fully appreciated the tail risks that had built up in the financial system. The liquidity interventions starting in the summer of 2007 calmed markets down and perhaps assured investors and policymakers that they would stay calm, despite the fact that the losses of the financial institutions kept growing at a brisk pace,’ the two economists conclude.

The real story of the book is about modelling the complicated manner in which memory, appreciation of risk and belief formation interact with each other. Gennaioli and Shleifer have built a neat model that uses two key human psychological attributes—conjunction fallacy and base rate neglect—that created beliefs that systematically lulled property market participants into believing that ‘things were under control’ and that ‘it could never be that bad’ even as the financial system was hurtling towards meltdown. To oversimplify a bit, conjunction fallacy and base rate neglect are conditions that mix general and specific information about existing conditions and do not permit humans to form correct beliefs.

These are, of course, part biological and part psychological reasons that led to the near-destruction of a particular set of markets—the financial markets. But if these were necessary conditions for what happened, the sufficient ones were put in place over a span of the previous 15-odd years. During this time, controls against capital flows were dismantled steadily and flows acquired a depth that had not been seen before. By 2008, one could already sense a Schumpeter- like ‘vanishing investment opportunity’. The manufacture of ‘AAA’-rated MBS was enabled by these gigantic flows.

The larger point is that in the fall of 2008, a political moment of singularity was at hand. It is, of course, a leap of faith from that moment to claim that markets and liberal democracy are doomed. But something of that kind has been speculated over the years. For example, it has been speculated that events since then have weakened the West to the point that China and Russia are models for a new economic and political order. The claim being what these authoritarian countries offer is sustainable and stable as compared to what the West has put forward. This may still be reversed as China and Russia suffer from weaknesses—a brittle political system in Russia’s case and the wonky shape of China’s financial system—that can unhinge them.

The original proponent of the ‘weakness of strong states’, Francis Fukuyama has a different but cognate take on the beliefs that are undermining the global liberal order. His analysis takes us back to Ancient Greece and the Socratic interplay between the City and the Soul. He argues that contemporary distempers have their root in what Greeks called thymos or spiritedness. In the ancient classification of reason and thought, the soul was supposed to have two parts—the desiring part and the reasoning part, with the latter keeping the former in check. But beyond these two lies another part, thymos, that defies attempts at being tamed.

‘This third part of the soul, thymos, is the seat of today’s identity politics,’ he says adding that, ‘Thymos is the part of the soul that seeks recognition. In [Plato’s] Republic, only a narrow class of people sought recognition of their dignity, on the basis of their willingness to risk their lives as warriors. Yet the desire for recognition also seems to lie within every human soul. The shopkeepers or artisans or beggars on the street can also feel the pang of disrespect.’

Fukuyama is a great scholar but there is something deliciously amiss here. He’s been criticised for first being too optimistic about human progress in The End of History and the Last Man (1992), in which he theorised that liberal democracy was the end-point of political evolution, and then trying to wriggle out of its straitjacket. Subsequent events have not been kind to his formulations. When The End of History was written, thymos was to be channelled along harmless lines and produce ‘The Last Man’, contented in a world of consumption. But barely a quarter century later, the drive for recognition is causing political upheavals from the Potomac to the Ganga.

Modern life, especially its extreme liberal variant, is premised on a denial of any link between the City—understood as a political grouping of like-minded people—and the Soul. In one famous rebuttal to the link (elaborated in Book IV of the Republic), philosopher Bernard Williams carried out a careful logical exercise to deny that link (‘The Analogy of City and Soul in Plato’s Republic’ in The Sense of the Past: Essays in the History of Philosophy, 2006). It was a neat demonstration of denial. But it began unravelling soon after that. The truth is that the human yearning for recognition—from the level of beggars to the desire for vibrant and strong nations—has for long mirrored the interplay between the City and the Soul, even if the forms of desire and political organisation have changed over time. It may sound harsh, but free markets, money and wealth are hardly a recipe for keeping thymos in check. Fukuyama suggests a new national creed to fix the problem. But on reading Identity, one feels it is a half-way house, a holding operation which hopes that the achievements of globalisation are not washed away in the tide of nationalism in evidence now. It is a weak remedy, a reminder of the same political lack of legitimacy that authoritarian states faced in the 1980s. Just that the shoe is now on the other foot.

bookseconomyfinancial meltdownFrancis Fukuyamaidentitypolitics