Seven years ago, John Cassidy wrote an interesting article in The New Yorker titled, “Before the Fall: Disaster Myopia at the Fed.” He shared his appreciation of deliberations on monetary policy by the Federal Open Market Committee. Because of Cassidy’s glasnost, or policy of greater transparency; and thanks to wider information dissemination pioneered by Alan Greenspan (continued by Ben Bernanke), monetary policy making-dynamics is for the world to read, and even judge, years after the Global Financial Crisis (GFC) of 2007-2008.
Cassidy narrated that the Fed thought it “had things under control.” It was almost out of their playbook for a catastrophe such as the GFC to shock the US subprime mortgage bond market and spill over to Wall Street, High Street and the rest of the US economy.
Prior to GFC, only a few prescient skeptics imagined that two decades of business prosperity would be disrupted by the deepest depression since the 1930s. The Black Swan was yet to be made known to the markets.
The problem was that the Fed under Bernanke did not drill down into the problem. Cassidy cited Bill Dudley who was then head of the markets desk at the New York Fed (and who would later become its president). Dudley reported to the Committee that “market participants generally believe that the downside risks to growth have diminished.”
Based on this, the Fed economic staff raised their growth forecast and reduced their unemployment forecast. There was a happy consensus as summed up by Bernanke himself who declared: “I agree with the general view around the table that, except for housing, the economy looks to be healthy.”
Six weeks later, two European banks were in trouble. In the US, there was general panic among financial institutions, the subprime market collapsed. Over the next several months, banks and corporates followed one another in insolvency.
Not that the US Fed did not fully understand the unfolding scenario. They were blindsided. They underestimated the subprime market risks. According to the meeting minutes, only Richard Fischer, Dallas Fed president, indicated some concern. A former banker and hedge fund manager, Fischer correctly read the writing on the wall. He declared: “This has broader dimensions than those we had before. If you look at the growth rate of these instruments… it has been a straight upcurve. The numbers are quite huge.”
Cassidy considered the decision making process as a case of “disaster myopia.”
Disaster myopia is a theoretical paradigm that when favorable conditions persist for a prolonged period, policy makers and the market generally tend to discount any elevation of potential risks for the present and for the near future. It is the thinking that the probability of any adverse outcome experienced in the past recurring — such as the 1930s depression — is low and diminishing to almost zero. It’s no different from being nearsighted. Far objects are too distant to be seen, or for that matter, remembered.
In literature, there is evidence of disaster myopia in the macroeconomy as well as in the banking sector.
Bernanke, his officials and staff, including New York Fed president Timothy Geithner (who was to become Treasury Secretary) were lulled by many years of good US economic performance. So lulled that relevant information about increased risks in the market was discounted.
Disaster myopia is similar to the phenomenon of the Pink Flamingo syndrome. In previous columns we wrote about the “pink flamingo.” Distinguished from the Black Swan, the Pink Flamingo should come as no surprise. The current global pandemic was cautioned about by health experts and IT practitioners over the years, but their warnings were ignored because of “cognitive biases of a senior leader or a group of leaders trapped by powerful institutional forces.”
A prime example that comes to mind is climate change.
This year’s challenges are all Pink Flamingos: the Taal eruption and ashfalls; the successive earthquakes in Mindanao; and the untold damage and loss of lives brought by typhoons Rolly and Ulysses. Should we say our level of forgetfulness has become legendary that the rapid succession of these natural calamities month after month, year after year has not affected our sense of probabilities? Perhaps something less than disaster myopia is our stubborn spirit, “hindi matuto” (can’t be taught/doesn’t learn).
To mitigate the tendency to be caught off-guard, preparedness and resilience are absolutely necessary.
Unfortunately, in the matter of natural disasters and COVID-19, the Philippines has demonstrated neither. As a result, our extended community lockdowns froze business activities and produced three quarters of economic recession, one of the deepest in the world.
Is there evidence of disaster myopia?
Lately, Government is stressing that we have macroeconomic buffers in the areas of growth, prices, external payments and public finance, while glossing over the fact that the COVID-19 pandemic has brought our economic growth to its knees, with millions out of work and overseas Filipinos sent home.
While it is incumbent upon public authorities to encourage civil society during this difficult period, it is also the Government’s responsibility to prepare households and businesses for the worst.
There is disaster myopia when we assume that the benign past will simply replicate itself. The lessons of the debt crisis of 1982-84 and Asian Financial Crisis of 1997 should not be forgotten because economic dynamics, like life, is never linear nor repetitive.
During the G-20 virtual meeting last week, no less than the IMF warned that “while the United States and other major economies turned in better-than-expected economic performances in the third quarter, the world now faces slower momentum with a resurgence in coronavirus cases.”
Despite the vaccine being forthcoming, the Fund highlighted risks, including the threat of viral resurgence that might again require strict economic lockdowns.
In the spirit of Game of Thrones, “Winter is coming.” This is the sober warning.
This was also the message of APEC leaders last week. They pledged to work together to accelerate economic recovery. They recognized the imperative of developing an affordable vaccine.
In the US alone, more than a million cases are reported weekly. Mortality has also risen fast. This is true in Europe. This is also true in many Asian capitals. Thus, the initial signs of victory in Manila should be received with guarded optimism especially as international travel — the inadvertent platform for global disease transmission — is again allowed.
We cannot just assume that the economic green shoots we have been seeing would be sustained despite a pandemic resurgence. Flattening of the epidemiological curve must still be the priority.
Another indicator of disaster myopia is the confidence that current fiscal support is already enough to fix the problems in the real sector — the way it worked in the past. Economic scars will not easily disappear. There are tangible and felt consequences of unemployment, decreased output, lower productivity and soon, rising inflation. Cash transfers and small business support may be dismissed as subsidies or as acts of charity. But in reality, these help heal wounds caused by the pandemic on livelihood. These can make scars less permanent.
There is disaster myopia when we keep interest rates low and pat ourselves on the back when extraordinary amounts of liquidity are released into the financial system.
There is disaster myopia when we fail to recognize this is just pushing on a string. Lest we forget, it was a prolonged regime of low interest rates that caused the IT bubble during Greenspan’s time. Sustained low interest rates was also behind the subprime crisis that birthed the GFC.
While right now, we still have the monetary space, it would be wise to conserve it. Otherwise, we run the risk of mispricing risks, higher debt levels and the so-called leveraged “reach for yields.” These would increase the economy’s vulnerability to future shocks.
Current and consistent monetary policy cuts might unwittingly lengthen the period of recession because both savings and capital formation may be unduly weakened.
These lessons are etched in history.
We need to remember them.
Sadly, disaster myopia has become more pervasive, affecting various layers of both the bureaucracy and the private sector.
Could it be the new pandemic?
Diwa C. Guinigundo is the former Deputy Governor for the Monetary and Economics Sector, the Bangko Sentral ng Pilipinas (BSP). He served the BSP for 41 years. In 2001-2003, he was Alternate Executive Director at the International Monetary Fund in Washington, DC. He is the senior pastor of the Fullness of Christ International Ministries in Mandaluyong.