In an unpublished draft preface to his General Theory, Keynes (1973, p. 470) wrote:

For Keynes, the struggle was to persuade his contemporaries to abandon classical economics with its theory of automatic full employment that was so at odds with experience of the Great Depression. This book is about the financial crisis and the Great Recession, and the task is to expose the consequences of neoliberalism, which include the restoration of pre-Keynesian thinking.

Part of the act of persuasion is to articulate clearly and persuasively one’s own interpretation of events, but part is also to show the limits of alternative hypotheses. Chapters 4 and 5 described the structural Keynesian explanation of the financial crisis and the Great Recession. The argument is that the crisis and recession were rooted in the neoliberal paradigm that spawned a flawed growth model, a flawed model of global economic engagement, and a flawed model of financial markets. Together, these three elements provide a comprehensive account of the economic history of the past thirty years. They explain developments in the real economy regarding wages and income distribution; developments in the global economy, including the emergence of global imbalances; and developments in the financial sector, including the emergence of financial fragility. They also explain why the crisis took the form of a financial crisis, why the Great Recession has been so deep and intractable, and why the outlook is one of stagnation.

Now, it is time to address the competing explanations offered by neoliberal economists. Figure 6.1 provides a taxonomy that helps understand the orthodox approach to explaining the crisis. Whereas the structural Keynesian approach is a unified general account, the orthodox explanation is a collection of piecemeal hypotheses, some of which are mutually consistent and others of which are inconsistent.

Figure 6.1. The neoliberal explanation of the financial crisis and the Great Recession.

The first hypothesis concerns regulatory failure. Hard-core Chicago School neoliberals view the failure as one of regulatory excess and excessive government intervention in financial markets. Soft-core MIT neoliberals view it as one of regulatory deficiency and failure of government to limit financial risk taking. The second hypothesis is failure of monetary policy, the argument being that the Federal Reserve pushed interest rates too low and held them there too long. The third hypothesis is animal spirits and black swans, whereby the crisis was due to a collapse of confidence combined with a surprise shock to the system that unleashed terrible unexpected consequences. The fourth explanation is that the crisis was due to global financial imbalances. This explanation, in turn, rests on several competing hypotheses about the cause of these imbalances.

Figure 6.1 highlights the difficulty of getting clean closure on debate about causes of the Great Recession. This is because many of factors identified in Figure 6.1 also play a role in structural Keynesian explanation discussed in Chapters 4 and 5. Thus, regulatory failure is an important ingredient in the process that allowed financial instability to develop. Similarly, low interest rates were critical in creating the housing price bubble that helped revive the economy after the last recession. Lastly, the U.S. trade deficit and global imbalances are part of the “triple hemorrhage” that hollowed out the U.S. economy’s income- and demand-generating process.

In trying to understand the differences between the structural Keynesian and neoliberal explanations, it is worth distinguishing between “causes” and “cogs.” Causes are fundamental drivers of the financial crisis and the Great Recession, whereas cogs are the mechanisms that transmitted the crisis. For instance, from a neoliberal perspective, monetary policy failure (i.e., excessively low interest rates) was a fundamental cause of the crisis. Contrastingly, from the structural Keynesian perspective, it was a cog, with the Federal Reserve being pushed to lower interest rates because the economy was unable to generate self-sustaining expansion after the recession of 2001.

This leads to a larger, more important point. From the orthodox perspective, the economic system is basically fine, and all that is needed is a patch. From the structural Keynesian perspective, the economic system is beset by fundamental failings, and it is those failings that drove policy in directions that postponed the crisis but also ultimately deepened it. A patch may stabilize the system but cannot rejuvenate it.

How should one choose between these competing perspectives? This book argues the test is that which offers the most coherent plausible explanation consistent with the historical record and the full range of developments over the past thirty years.

The Regulatory Excess Hypothesis

The regulatory excess hypothesis essentially blames government regulation and intervention in the housing market for the crisis.¹ There are a number of pieces to this argument, including tax deductibility of mortgage interest payments that encouraged a frenzied rush to home ownership that drove up prices; the Community Reinvestment Act (CRA) that compelled banks to make unsound loans to low-income households, which both drove up home prices and caused mortgage defaults; and Fannie Mae and Freddie Mac that distorted the mortgage market through the implicit guarantee they received from the government. That guarantee supposedly created moral hazard in the wholesale credit market, as lenders to Fannie and Freddie felt they were guaranteed and therefore provided an ocean of credit that enabled Fannie and Freddie to fuel the bubble.

What’s wrong with these stories? First, the mortgage interest deduction has been around for more than fifty years. It undoubtedly contributes to higher home prices and encourages U.S. households to hold more of their wealth in housing, but it is implausible to view it as the cause of the crisis because it has been around so long.

Second, the CRA was passed by Congress in 1977 and for much of the time has been viewed as largely ineffective, a feature that was sometimes touted as a reason for repeal. For instance, in 2000, the Cato Institute released a study titled “Should CRA stand for Community Redundancy Act?” The argument was that the CRA was being replaced by the subprime market.² Furthermore, only commercial banks and thrifts are obliged to follow CRA rules. This means nonbank lenders, who originated the bulk of subprime loans, were not subject to CRA, nor were the investment banks (Bear Stearns, Lehman Brothers, etc.) that bundled and resold these toxic mortgages as securitized loans. The CRA requires banks to lend to local communities, but it does not require they lend irresponsibly and make “No Doc NINJA” loans (no documents, no income, no job or assets).

Furthermore, huge loan losses and housing price declines have been recorded in prosperous cities such as Phoenix, Arizona; Las Vegas, Nevada; Miami, Florida; and San Diego, California. This is hard to square with the CRA being responsible for the bubble as these were not poor areas where CRA lending activity is focused. Finally, a study by the Minneapolis Federal Reserve reports that only 6 percent of higher-priced subprime loans were made by lenders covered by CRA, and these CRA loans performed similarly to other types of similar non-CRA-covered subprime loans.³ Such facts make it impossible to believe that CRA caused the bubble.⁴

A third piece of the regulatory excess hypothesis concerns the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, who supposedly caused the bubble by financing it. Here is conservative economist Kevin Hasset (2008) of the American Enterprise Institute writing about this:

As with the CRA story, there are significant inconsistency and overstatement problems with the Fannie Mae and Freddie Mac story. The GSEs participated in and facilitated the bubble but they did not cause it, and should instead be viewed as accessories.

First, Fannie Mae and Freddie Mac have been around more than forty years: The former was established in 1938 and the latter in 1968. Second, neither Fannie nor Freddie originated mortgages. Instead, both bought mortgages and securitized them, which means the original bad lending decisions were not theirs. Indeed, several mortgage lenders have been required to take back mortgages purchased by Fannie and Freddie on grounds that the mortgages were incorrectly originated and Fannie and Freddie were misled regarding their quality.

Third, Fannie and Freddie were late to the mortgage lending game and they were losing mortgage market share through most of the bubble. They jumped in late, after the bubble had actually peaked. That late arrival to the party explains their losses, but it also means they cannot have been the cause of the bubble.

Prior to 2005, the GSEs were not permitted to purchase nonconforming mortgages. Table 6.1 shows the rapidly declining share of nonconforming mortgages resulting from the flood of private-label mortgages, including subprime mortgages. The clear implication is that up until 2005, the housing bubble was not being funded by the GSEs, who were actually being squeezed out of the market. Indeed, that squeeze encouraged Fannie and Freddie to change their rules and buy nonconforming mortgages, which shows how Fannie and Freddie were followers of the bubble rather than causing it.

Table 6.1. Mortgage Originations, 2003–2009

Source: Conservator’s report on the Enterprise’ Financial Performance, Federal Housing Finance Agency, second quarter 2010.

Moreover, even after they changed their rules and started buying private label nonconforming mortgages, Fannie and Freddie still lost mortgage market share. This is illustrated in Table 6.2, which shows the share of total mortgage-backed securities issued by the GSEs (Fannie and Freddie) and the Government National Mortgage Association (GNMA or Ginnie Mae). Their share collapses in 2004 under the onslaught of Wall Street private-label issues and keeps falling until 2007, when private label issuers withdrew with the end of the bubble. The implication is that the housing price bubble was fueled by Wall Street, and the GSEs played along. The subsequent recovery in Fannie and Freddie’s mortgage shares after 2006 is not a case of fueling the bubble, but rather the only reason the housing market has stayed alive and avoided an even deeper and more terrible collapse.

Table 6.2. Mortgage-Backed Security Issuance

Source: Conservator’s report on the Enterprise’ Financial Performance, Federal Housing Finance Agency, second quarter 2010.

Another piece of evidence about the non-role of Fannie Mae and Freddie Mac comes from their reported losses. The Conservator’s report of August 2010 shows that 73 percent of their losses between January 1, 2008 and June 30, 2010 were attributable to their core business of guaranteeing single-family mortgages rather than their investment portfolios that contained their subprime holdings. Issuing these guarantees was what they were established to do and had been doing for decades, and their subprime activities are therefore not central.

Putting the pieces together, the evidence shows Fannie Mae and Freddie Mac were squeezed out of housing market finance when the bubble began. Throughout the bubble they had a declining share of the mortgage-backed security-issuance market and were significantly displaced by Wall Street. Lastly, the vast bulk of their losses were on their traditional business rather than reckless subprime purchases. Instead of causing the bubble, the evidence is consistent with a picture of Fannie Mae and Freddie Mac sitting on top of the bubble and rising with it as the bubble inflated their business. Only toward the end of the bubble in 2005 did they start departing from their mission, and that was in response to competitive pressure from Wall Street. Rather than driving housing market trends, they were following.

The final piece of evidence debunking the regulatory excess hypothesis comes from Paul Krugman who has pointed out that the real estate bubble extended far beyond the U.S. housing market and infected the entire U.S. commercial real estate market.⁶Table 6.3 shows the Case-Shiller private housing price index and the Moody’s-MIT commercial real estate index from January 2000 to January 2009. The third row shows the ratio of these two indexes, which is normalized at unity in January 2000. The critical feature is that this ratio stays close to 1 throughout the period, showing how the two indexes essentially track each other. This shows that housing prices and commercial real estate prices both bubbled up together and have both fallen together.⁷ This is compelling evidence that the bubble involved much more than housing policy, the Community Reinvestment Act, and the activities of Fannie Mae and Freddie Mac because none of these were relevant for commercial real estate. Each argument of the regulatory excess hypothesis fails to stand up to scrutiny individually, and they all fail when it comes to explaining why the bubble extended into the commercial real estate market.

Table 6.3. U.S. Residential and Commercial Real Estate Prices

Source: S&P/Case-Shiller national house price index and Moody’s/MIT national commercial real estate price index. Normalized Jan. 2001 = 100.

The reality is that the regulatory excess hypothesis is ideological and empirically unsupported. Its purpose is to blame the government. Given that it is largely invoked by Republicans, its purpose is also to blame Democrats. However, here too it fails, because Republicans controlled Congress from 1994 to 2006 and the presidency from 2000 to 2008. Consequently, Republicans had the opportunity to rein in Fannie Mae and Freddie Mac had they wanted to. In sum, there is neither economic nor political merit to the regulatory excess hypothesis, yet it has still been embraced by many economists and has become part of the political mythology about the crisis.

The Regulatory Deficiency Hypothesis

A second hypothesis is that the financial crisis was due to insufficient regulation. This is more difficult to assess because it is based on a counterfactual. Whereas the regulatory excess hypothesis involves assessment of the effects of actual regulations, the regulatory deficiency hypothesis involves assessment of what would have happened had there been a particular set of alternative regulations.

With regard to regulatory deficiency, attention has focused on three key regulatory events – the repeal of the Glass-Steagall Act in 1999, the Commodities Futures Modernization Act of 2000, and the Securities and Exchange Commission’s (SEC) 2004 net capital exemption rule. The 1999 repeal of Glass-Steagall allowed banks to become bigger by allowing them to undertake commercial and investment banking activities under one roof and by allowing commercial banks to engage in insurance activities. The Commodities Futures Modernization Act (CFMA) of 2000 exempted derivatives from regulatory oversight and allowed them to be traded off exchanges without central clearing requirements, capital requirements, or disclosure of counterparties. The Enron loophole (included in the Act at the behest of Republican Senator Phil Gramm) also exempted most over-the-counter energy and commodity trades from regulation. Lastly, the SEC’s 2004 net capital exemption rule limited the amount of capital Wall Street’s largest brokerage houses had to hold. This enabled the major investment banks’ to double their leverage ratios (debt relative to equity), which jumped from approximately 15 to 1 in 2004 to more than 30 to 1 by 2008. Additionally, the SEC’s rule allowed investment banks to adopt self-regulation in the sense that value-at-risk within banks was assessed using banks’ own internal models of risk levels.

Did these regulatory measures cause the crisis? The repeal of Glass-Steagall allowed banks to bulk up in size so that their losses were ultimately larger. By combining commercial and investment bank activities, it also likely encouraged significantly more risk taking, as commercial banks increasingly adopted the practices and culture of investment banks. However, it was the shadow banks and the pure investment banks (Bear Stearns, Lehman Brothers, and Merrill Lynch) that proved the weaker links in the chain, thus it is unclear whether keeping Glass-Steagall would have made much of a difference to the events as they unfolded.

The exemptions in the CFMA allowed AIG to engage in reckless credit default swap transactions and also facilitated the oil and commodity price bubble of 2008. However, the commodity bubble came late in the game, after housing prices had peaked in mid-2006. As for AIG, its collapse came after Bear Stearns, Fannie Mae, Freddie Mac, and Lehman Brothers had already collapsed. Moreover, many of the insurance bets with AIG appear to have been side bets – that is, bets made by speculators on the sidelines, already anticipating the collapse of the housing market. This suggests that the CFMA was bad policy that amplified difficulties, but it was not the cause of the crisis.

Lastly, the April 2004 net capital rule exemption does seem to have played an important role in pulling down the investment banks by allowing them to take on vast debt-funded risks that wiped them out. However, the housing bubble was already underway by this time. Moreover, it is likely that the shadow banking system and unregulated affiliate structured investment vehicles (SIVs) of commercial banks would have been sufficient to finance the bubble without the investment banks taking on extra leverage.

The regulatory deficiency hypothesis argues that had these regulatory events not occurred, the financial crisis and the Great Recession would not have happened. The corollary proposition is that fixing financial regulation can restore prosperity, and that proposition points to the implausibility of the hypothesis.

Financial deregulation and resistance to updating financial regulation are integral elements of neoliberalism. At the philosophical level, they derive from the ideology of efficient markets. That makes it hard to imagine the three decades from 1980 to 2008 without financial deregulation and regulatory neglect.

More importantly, at the functional level, financial deregulation and regulatory neglect played a critical role in filling the gap in demand created by stagnation of wages. As shown in Chapter 4, rising debt and asset price inflation were essential for driving demand growth and sustaining the neoliberal model. Absent these engines of demand growth, the neoliberal model would have avoided a financial crash and instead stumbled into stagnation earlier. The implication is that had tough financial regulation blocked the emergence of financial fragility, it might have prevented an extreme financial crisis. However, it would have done nothing to correct the destructive effects of the neoliberal model on the income- and demand-generation process. Instead of a financial crisis plus the Great Recession, the economy would simply have hit the wall of stagnation a decade earlier.

Looking ahead, the implication is that after the fact, financial reform (of the sort implemented in the Dodd-Frank Wall Street Reform and Financial Protection Act of 2010) will not solve the problem of stagnation, and may even worsen it by removing the impulse of financial exuberance. Neoliberal policy makers are blind to this danger because their theoretical perspective denies the existence of a threat of stagnation. The thinking that got them into the problem of stagnation also obstructs them from fixing it.

That brings up the 13 Bankers thesis of Johnson and Kwak (2010) who argue that the root cause of the crisis was the concentrated political power of finance. According to their argument, the Great Recession was purely the result of the financial crisis. The banks took on too much risk in a search for profits, and they were able to do so because of their political power, which gave them influence over regulators and politicians.

This power is now more concentrated because of bank consolidations caused by the crisis. Consequently, the banks pose an increased threat. They have become “too big to fail,” which creates a moral hazard problem because banks can continue taking excessive risk, knowing they will be bailed out if things go wrong. And their political power means they are able to thwart legislation and regulation requiring them to put up more capital, which makes shareholders bear the risk of losses.

The Johnson and Kwak hypothesis is particularly attractive because of its explicit incorporation of politics and political power. However, a glass can be half-empty or half-full. Their hypothesis is half-right. Finance played a critical role in the neoliberal era, but the roots of the financial crisis and the Great Recession go deeper than excessive risk taking on Wall Street. That excess was part of a codependent relationship between financial markets and the neoliberal model of growth and global economic engagement.

The political power of finance mattered enormously, particularly with regard to financial regulation. However, that political power is part of a larger nexus of corporate power, and it was that larger nexus that drove the neoliberal policy agenda. Finance may have had the greatest influence regarding financial policy, but broader corporate power drove the overall model of growth and global engagement. Focusing only on the political power of finance misses that.

The Flawed Monetary Policy Hypothesis

A third widely presented hypothesis is that the Federal Reserve pushed interest rates too low and held them there too long, making the Fed responsible for the bubble. This argument is associated with Stanford economist John Taylor who argues had the Fed followed his so-called Taylor interest rate rule, the bubble would not have happened.⁸

According to the flawed monetary policy hypothesis, persistent low interest rates fueled the housing price bubble on both the demand and supply sides. Low interest rates attracted home buyers and also encouraged a chase for yield by lenders, which led to excessive mortgage lending. Thus, Taylor (2009) writes:

The Taylor rule is a policy rule for setting interest rates in response to inflation and economic growth. Figure 6.2 shows Taylor’s counterfactual estimate of what interest rate should have been, and he argues that had his rule been followed, the bubble would not have happened.

Figure 6.2. Actual versus Taylor’s recommended federal funds interest rate.

Source: Taylor (2007).

Taylor’s argument is riddled with problems. On one hand, it is absolutely right that had the Fed raised interest rates as Taylor suggests, the bubble probably would not have happened. Instead, the economy would likely have tumbled back into a second recession in 2003 and stagnation would have taken hold thereafter. Those who blame Federal Reserve interest rate policy want to claim that had the Fed raised interest rates, the economy would still have enjoyed the recovery it had, and it would also have avoided the bubble. That does not compute.

The reason the Fed pushed rates so low and held them there so long was that from 2001 to 2004, the economy was stuck in a second prolonged episode of “jobless recovery,” and there were persistent fears of falling back into recession. Total employment peaked in February 2001 at 132.5 million and did not recover that level again until February 2005. Private-sector employment peaked in December 2000 at 111.7 million and did not recover that level again until May 2005. Table 6.4 shows the unemployment rate, capacity utilization rate, labor market participation rate, real GDP growth rate, and CPI inflation rate for the period between 2000 and 2005. Through to 2004, the data clearly show significant excess supply in the economy in the form of unused capacity, high unemployment, large numbers of discouraged workers who had left the labor market, and lowered the participation rate. Growth was also sluggish and had failed to rebound as usually happens after a recession. There was some modest inflation pressure, but the inflation rate was close to the Fed’s target of 2 percent. Moreover, much of the inflation was attributable to the oil price spike caused by the Iraq war that began in late 2003, and oil prices received another jolt with Hurricane Katrina in 2005, which also triggered confidence fears about the U.S. economy. In sum, there is clear evidence of prolonged economic weakness that lasted until mid-2004 and warranted low interest rates to jump-start recovery and prevent a double-dip recession.

Table 6.4. The Unemployment Rate, Capacity Utilization Rate, Labor Market Participation Rate, Real GDP Growth Rate, and CPI Inflation Rate for the Period 2000–2005

Source: Economic Report of the President (2009).

Taylor’s (2007) counterfactual interest rate calculation is also fundamentally flawed. His estimate of what the interest rate should have been is based on actual economic data produced in part by the Federal Reserve’s interest rate policy of which he is critical.

Moreover, his simulation methodology is doubtful because it uses past economic structure to simulate what an alternative economic policy might have looked like. However, the problem was that the economy was not acting as it had in the past, hence the jobless recovery despite easy monetary policy and massive fiscal stimulus.

Federal Reserve Chairman Ben Bernanke (2010b) has further rejected Taylor’s claims by showing that if real-time forward-looking data (i.e., forecasts the Fed had available at the time it was setting interest rates) are used in the Taylor rule, the policy the Fed actually followed was the policy recommended by the Taylor rule.

Neither is Taylor’s ex-post critique supported by the bond market. Table 6.5 shows the federal funds interest rate and the ten-year Treasury bond rate for the period between 2001 and 2005. The ten-year interest rate is virtually constant over this period, reflecting the fact that the market saw no danger of inflation or economic overheating. In a sense, the bond market was endorsing the Fed’s policy (although some have argued that the market was distorted because of China’s trade surplus – an issue that is discussed later).

Table 6.5. The Federal Funds and the Ten-Year Treasury Interest Rate, 2001–2005

Source: Economic Report of the President (2010), table B-73.

This pattern of interest rates makes sense from a structural Keynesian perspective. The economy was being hollowed out by the flawed model of growth and global economic engagement, which together were creating growing demand weakness that lessened the likelihood of inflation. This explains the behavior of long-term interest rates, and it also explains why conventional econometric models were unable to predict the crisis. The hollowing out of the economy meant the economic structure was changing. Consequently, econometric models could not predict events because they are estimated using historical data generated by the prior discontinued structure.

In sum, Taylor’s critique amounts to playing Monday morning quarterback and his claims are not supported by the evidence. The Federal Reserve is not to blame for the bubble and it actually pursued reasonable interest rate policy given economic conditions. However, that does not mean that the explanations of Alan Greenspan and Ben Bernanke regarding the financial crisis are right. Nor does it exculpate Greenspan, Bernanke, and Federal Reserve policy makers and economists. They and other neoliberal policy makers are responsible for promoting the economic policies that created the conditions that undermined the economy and necessitated a bubble to keep it going. They pushed the neoliberal policies that undermined the economy and they blocked regulatory policy that would have helped contain financial instability.

The Yield Chasing, Animal Spirits, and Black Swan Hypotheses

Another hypothesis, which is part of the blame the Fed school, is that the Fed’s low interest rate policy encouraged a chase for yield. This argument is also made by Taylor (2009):

Low interest rates certainly explain why borrowers flocked to borrow but they do not explain why lenders failed to do due diligence. This is Alan Greenspan’s conundrum, captured in his ruminations about having found a “flaw” in his theory.¹⁰ The big insight from the chase-for-yield hypothesis is not that the Federal Reserve set interest rates too low, but rather that the neoliberal theory of efficiently functioning financial markets is a fiction.

The yield chasing story actually fits with Hyman Minsky’s (1992, 1993) theory of financial markets, and not with the efficient markets theory of finance that has been used to justify financial deregulation in the United States and the global economy. According to efficient markets theory, the yield chasing argument is groundless because rational investors do not chase yield.

This leads to the ultimate neoliberal chutzpah, which is that yield chasing and market failure were the product of deregulation. Having pushed financial deregulation for forty years, neoliberals now want to argue the government is to blame for allowing deregulation. Here is Richard Posner (2009), neoconservative Chicago University law professor and federal circuit judge, writing in the Wall Street Journal opinion page:

There is an old saying: All roads lead to Rome. For American conservative economists, all roads lead to government. Government is to blame if it regulates and it is to blame if it does not. That is a hard rap to beat: guilty if you did it and guilty if you did not.

The chase-for-yield hypothesis links with the animal spirits hypothesis developed by Akerlof and Shiller (2009). A surge of animal spirits caused the boom by promoting excessive optimism among both borrowers and lenders, creating a “Wile E. Coyote” economy that ran over the cliff. Once participants realized they were running in thin air, animal spirits went into reverse, creating the bust and the prospect of stagnation.

The term “animal spirits” was coined by Keynes (1936, p. 161) in his General Theory, and evolving animal spirits are an integral part of Minsky’s theory of modern capitalism’s inherent proclivity to financial instability. In principle, animal spirits can also be given an important role in neoliberal theoretical constructions of the economy – although doing so also undermines some of the claims regarding the optimality of laissez-faire markets and adds another reason for government intervention and regulation of markets. However, as an account of the crisis, the fluctuating animal spirits hypothesis is inadequate because it is like saying “gravity is responsible for plane crashes.” Yes, that is true, but it is also uninteresting and unhelpful. Gravity is always present. The question is what part of the aircraft failed and why.

The animal spirits hypothesis lacks a structural account of the crisis. Animal spirits are an amplifying factor that is present at all times. However, the effect of fluctuations in animal spirits depends on the structure in which they are placed.

Viewed in that light, the animal spirits hypothesis is seductive but incomplete. Animal spirits fits with every theory, but every theory does not fit with the evidence. And the animal spirits hypothesis is of no help identifying which is the best theory because it fits with all.

A final hypothesis that resembles the animal spirits hypothesis in its abstract generality is Nassim Taleb’s (2007) black swan hypothesis. Black swan events are defined as having three characteristics: they are outliers or rare events; have a large impact; and can be rationalized after the fact but are not predictable before. The crisis is described as a black swan event.

Taleb’s black swan hypothesis is a paradox in that it is both extremely conservative and radically critical. As economics, it is shallow and conservative: as philosophical rumination, it is deep and radical. With regard to economics, it too easily becomes an apologetic that provides cover for existing theory and the failures of policy makers. As a philosophical rumination, it is profoundly critical of the attitudes and practices of economists and policy makers.

The economic shallowness of black swan theory stems from its framing of the world in terms of surprise rare events. This framing places it squarely within the orbit of mainstream economic theory, which also relies heavily on surprise shocks and random disturbances. These shocks are rationalized and described by mathematical probability theory, which has the additional benefit of conferring pseudoscientific legitimacy.

However, the appeal to probability theory suffers from two serious failings. First, it constitutes a form of social science mysticism in which explanation rests on a deus ex machina. Second, probability is not a good approach to history, which is a nonergodic process. People may talk about the probability of World War III but that is a linguistic and cultural convention. It has no basis in probability theory, which relies on an unchanging data (i.e., event) generating process. Probability theory makes good sense for analyzing games of chance like rolling of dice or picking playing cards; it makes good sense in chemistry analyzing molecular motion; but it makes little sense regarding political or economic history.

By adopting the language of probability theory black swan theory merges seamlessly with mainstream economic theory. In doing so it also provides economics with a cover that excludes the possibility the theoretical paradigm was straight plain wrong.

The reality is black swan theory is not a theory or explanation of the financial crisis and the Great Recession. Instead, it is a philosophical rumination about the limitations of knowledge, the importance of recognizing those limitations, and the implications that follow. These implications include guarding against intellectual hubris; keeping an open mind with regard to different theories; and maintaining awareness that group-think promotes conditions in which extreme events happen because people are unprepared and blind-sided.

This message about the limitations of knowledge connects black swan theory with a long tradition in the sociology of knowledge. It is also what gives black swan theory its critical dimension because mainstream economics and policy making have denied these limitations.