Did the Banks Go Crazy?

The great financial crisis of 2008 has provoked an extraordinary round of soul searching among economists. The reasons for this are not difficult to find. Not only did most members of the profession fail to predict the impending catastrophe, but many actively contributed to it, by aggressively rationalizing the very practices and institutional arrangements that gave rise to the collapse of the U.S. investment banking system.

In the background was the assumption, widely shared among economists, that contractual arrangements entered into by private parties were efficient until proven otherwise—so that if a particular financial arrangement (say, a bank making a huge loan to a person with no money or job) looked like it was crazy, that was only because it had not been well enough understood. Look more carefully, and you can find the hidden rationale, the secret genius of the market at work.

Thus buckets of ink (or terabytes of keystrokes) were wasted...