Daron Acemoglu

Arnold Kling points to some thoughts from Daron Acemoglu on what caused our blindness:

The first is that the era of aggregate volatility had come to an end. We believed that through astute policy or new technologies, including better methods of communication and inventory control, the business cycles were conquered. Our belief in a more benign economy made us more optimistic about the stock market and the housing market. If any contraction must be soft and short lived, then it becomes easier to believe that financial intermediaries, firms and consumers should not worry about large drops in asset values.
Even though the data robustly show a negative relationship between income per capita of an economy and its volatility and many measures did show a marked decline in aggregate volatility since the 1950s, and certainly since the prewar era, these empirical patterns neither mean that the business cycles have disappeared nor that catastrophic economic events are impossible. The same economic and financial changes that have made our economy more diversified and individuals firms better insured have also increased the interconnections among them. Since the only way diversification of idiosyncratic risks can happen is by sharing these risks among many companies and individuals, better diversification also creates a multitude of counter-party relationships. Such interconnections make the economic system more robust against small shocks because new financial products successfully diversify a wide range of idiosyncratic risks and reduce business failures. But they also make the economy more vulnerable to certain low-probability, “tail” events precisely because the interconnections that are an inevitable precipitate of the greater diversification create potential domino effects among financial institutions, companies and households. In this light, perhaps we should not find it surprising that years of economic calm can be followed by tumultuous times and notable volatility.

Posted by on January 9th, 2009 at 12:42 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.