(Editor's note: This post forms part of the HBR Debate, "Finance: The Way Forward.")
It would be nice if we could predict bubbles; even nicer if we could prevent them. Unfortunately, this would violate the laws of nature: asset bubbles occur because of the limits of our ability to process information and coordinate activity in a market setting, where no-one is in charge, and no-one has a complete view of the big picture.
Here's how it works. On occasion, the enthusiasm for some growth opportunity or new technology attracts interest from people in the capital markets. Financing is suddenly available. Sooner or later the flow of new money starts to have an impact on the value of the assets being financed. But it takes time for people in the market to become fully aware of that impact.
In the case of the US housing market, prices began to accelerate beyond their sustainable path sometime around, say, 2003 thanks to global capital flows from savings-rich economies, advances in securitization technology, and an insatiable appetite for housing on the part of American consumers and investors. But it took until 2007 for the securitization markets to shut down. It took the broader equity markets another year to understand the severity of the housing crash and the resulting damage to the banking system. The government finally took steps to stabilize the system with TARP in late 2008 and stress tests for the banks in early 2009.
Why did it take so long for us collectively to come to our senses? Because consumers, mortgage brokers, lenders, investment bankers, regulators, CDO managers, rating agencies, and investors in distant countries didn't understand individually what the totality of their actions would mean for US home prices, the financial system, or the global economy.
We may criticize individuals, firms, leaders, and regulatory policies. But it would be unrealistic to think we could expect immediate, collective self-consciousness on the part of any group of people operating in a market setting. Each individual faces a practically infinite quantity of information in our complicated world. And we all have extremely limited resources with which to process this information. No system can be perfectly self-conscious. The kind of immediate social awareness that would prevent bubbles from forming or bursting is a physical and mathematical impossibility.
The inevitability of surprise does not mean that our financial system cannot be made more resilient — the key is to prevent the build-up of leverage (which makes outcomes more severe) and react more quickly during the crisis so that we can speed on our way to recovery. Here are some steps we can take now:
• Make sure public leverage does not become excessive. In addition to bringing down US Treasury debt levels, we should put Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System into run-off, which would help pay off roughly $3 trillion in so-called "US Agency" debt (a close cousin to Treasuries).
• Identify sources of "hidden leverage," such as the reliance by many institutions on similar statistical models (like Value-at-Risk) or credit ratings. We should reform the rating agencies so as to break up the oligopolistic market position of Moody's and Standard & Poors.
• Impose shorter term limits on certain public officials, for example the chairman of the Federal Reserve, to prevent the build-up of excessive investor confidence in the power of personalities or institutions to forestall economic crisis.
• Develop systems to recapitalize the financial system more quickly, with less taxpayer exposure, such as so-called "contingent capital," which consists of debt that automatically converts to equity during a crisis, stabilizing an institution without requiring protracted negotiations among investors or enactment of emergency government programs.
• Develop better corporate governance protocols, so that boards of directors can react more quickly to crisis including, if necessary, replacing CEOs who are caught in the grips of "cognitive dissonance" and unable to react to crisis or change.