TOPICS > Economy

Evaluating and Preventing a Massive Financial Crisis

March 12, 2010 at 12:00 AM EDT
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As part of his continuing series of reports making sense of business and the economy, Paul Solman talks to MIT finance professor Andrew Lo about why he's asking Congress to keep investigating the financial crisis.

JIM LEHRER: Now another of our conversations on the future of Wall Street.

It comes as Senator Chris Dodd, the chairman of the Senate Banking Committee, prepares for a Monday unveiling of his proposals for reforming the financial system.

Tonight, “NewsHour” economics correspondent Paul Solman talks to someone who has studied that system for years.

It’s all part of Paul’s ongoing reporting Making Sense of financial news.

PAUL SOLMAN: MIT finance professor Andrew Lo, whose expertise ranges from math to the medulla, researching how we humans make economic decisions.

ANDREW LO, professor of finance, MIT Sloan School of Management: Pushing the risk out here.

PAUL SOLMAN: Including the disastrous ones that led to the great recession.

ANDREW LO: A situation like AIG.

PAUL SOLMAN: Lo thinks we don’t yet know what went wrong, and has been pushing in Congress and elsewhere a proposal to find out.

ANDREW LO: The first thing I think we ought to do is to create an independent agency whose sole function is to sift through the wreckage of every financial disaster and to be able to produce publicly available reports as to what happened, why it happened, and what may need to be done in order to prevent it from happening again, in other words, the National Transportation Safety Board equivalent for financial markets.

PAUL SOLMAN: After, say, the equivalent of an airplane disaster?

ANDREW LO: That’s right.

PAUL SOLMAN: Do you really think there is an exact analogy between of a part the failure of an airplane, a wing, a deicing system, and the financial crisis?

ANDREW LO: I do. I mean, think about how complicated a Boeing 747 is, and then ask the question, do you think the global financial system is even more complicated? I would argue it is, many, many more times more complicated.

PAUL SOLMAN: But we’re not going to find the frozen O-rings in the rocket that failed, are we?

ANDREW LO: I think we are.

For example, the case of the space shuttle Challenger, it turns out that the O-ring was the proximate cause. That was the actual reason on the day of the disaster that the explosion occurred. But the more important question is, did NASA know beforehand that this was a systemic frailty that they needed to be careful about?

And going through the evidence, the answer seems to be, yes, they knew. At least some engineers knew. Now, to me, that’s the really interesting and important question. Why and how does an organization fail so spectacularly, despite the fact that they have the information?

PAUL SOLMAN: Are we on the verge of creating a national financial safety board? I mean, you testified about such a thing in Congress more than a year ago.

ANDREW LO: Unfortunately, I think that we’re still pretty far away from that. In the case of an airplane crash, everybody wants to know what happened, and everybody wants to know how to prevent it, perhaps with the exception of some undertakers, because nobody, nobody benefits from airplanes crashing out of the sky.

However, it’s been argued that, when a financial firm crashes, or when there’s a major systemic fault, there are certain parties that do not want to know what the answer is.

PAUL SOLMAN: To pursue your cynicism for a moment, who benefits?

ANDREW LO: Well, for one, the individuals that have profited from the disaster. In the case of the recent financial crisis, there are a number of hedge funds, homeowners, mortgage brokers that have taken the money and have run, and are perfectly satisfied with the outcome.

Obviously, those homeowners that have been foreclosed upon, the investors that invested in these kinds of mortgage instruments, they’re left holding the bag. But there are winners, and there are losers. And, so, we have to keep that in mind.

PAUL SOLMAN: And the winners have their winnings to influence the system to keep the regulators at bay.

ANDREW LO: That’s certainly one aspect of it. Another aspect is regulators.

There is an argument that a certain degree of regulatory forbearance may have exacerbated, if not directly caused, this crisis. And, certainly, those regulators have an interest in not sifting through the wreckage, because it will potentially undermine their authority going forward.

I would argue that regulation project protects people from themselves. And the Federal Reserve and other regulatory organizations are really there to help us deal with human frailties, human behavior, coupled with technology.

PAUL SOLMAN: And you think human frailty is a big part of this story?

ANDREW LO: I think it’s the — by far the most important feature of financial crisis. It’s really the combination of human behavior coupled with technological advances.

We develop technologies that allow us to engage in a variety of pursuits that we wouldn’t otherwise be able to accomplish. And, sometimes, those technologies are more powerful than our abilities to manage them effectively.

Neuroscientists have documented that the component of the brain that gets stimulated when we engage in financial rewards is really the same component that is stimulated by cocaine. It’s the dopamine system. And, over time, as we engage in more and more financial gains, we will become desensitized to risks. We will become complacent. We will become much less able to engage in the kind of proper risk management of our portfolios that we should.

PAUL SOLMAN: Are human beings like those rats in the famous experiment that kept taking the cocaine, instead of eating, until they died?

ANDREW LO: Absolutely. All mammals have that aspect to their behavior. Because of our prefrontal cortex, we have other behaviors that we can engage in, like regulations, that prevent us from doing the things that rats can’t prevent themselves from doing. But we do have some common components to our decision-making processes with other mammals.

PAUL SOLMAN: There was a last piece to this interview that we just can’t resist including, though it may seem a bit far afield.

It has to do with another side of Andy Lo, who grew up a practicing Catholic, but now describes himself as an agnostic with an interest in Buddhism. He thinks both it and brain science have insights for financial regulation.

ANDREW LO: Buddhists often say that to live is to suffer.

And, at first, when I heard it, I thought that this was one of these Zen paradoxes that we were not really meant to understand. But it finally dawned on me that it actually is a very simple idea. The idea is that the will to live involves engaging in activities. And those activities are not necessarily happy activities. They’re not associated with pleasure.

More often than not, they’re associated with avoiding pain. So, for example, you need enough money in order to eat. Well, why is that? It’s because, when you don’t eat, you are hungry. And, when you’re hungry, it doesn’t feel good. So, you work in order to earn enough money to make that kind of suffering go away.

In fact, all of life can be viewed as a way to avoid pain. So, in other words, it is suffering. And this is a very deep insight, because what it suggests about us, about the human condition, is that there is a certain degree of hard-wired behavior that all of us engage in.

And in order for us to really understand how not only we behave, but how we as a society behave and what kind of regulations we need to deal with those kinds of behaviors, we have to develop what I think the Zen Buddhists would call a higher level of consciousness, and what I call a meta-model for human behavior.

PAUL SOLMAN: Which is why Andy Lo has been meditating long and hard these days on how to prevent another financial meltdown.