A Simple Theory of the Financial Crisis; or, Why Fischer Black Still Matters

The key question about the current financial crisis is how so many investors could have mispriced risk in the same way and at the same time. This article looks at the work of Fischer Black for insight into this problem. In particular, Black considered why the “law of large numbers” does not always apply to expectations in a market setting. Black’s hypothesis that a financial crisis can arise from extreme bad luck is more plausible than is usually realized. In this view, such factors as the real estate market are of secondary importance for understanding the economic crisis, and the financial side of the crisis may have roots in the real economy as a whole.The key question about the current financial crisis is how so many investors could have mispriced risk in the same way and at the same time. This article looks at the work of Fischer Black for insight into this problem. The crisis is plausibly the result of negative shocks that affected many sectors of the economy at the same time. In particular, plans in the real economy were based on systematic overoptimism, which placed many investors in excessively vulnerable, overleveraged positions. Black’s work, which considered why the law of large numbers does not always apply to expectations in a market setting, provides a framework for thinking about how systematic overcommitment is possible. Black’s hypothesis that a financial crisis can arise from extreme bad luck is more plausible than is usually realized. In this view, such factors as the real estate market are of secondary importance for understanding the current economic crisis. Although the crisis showed up in different parts of the real economy at different speeds, those different speeds do not necessarily have causal significance. The current downturn first appeared in the subprime mortgage sector simply because those mortgagors were the first to run out of money and were unable to maintain their unduly optimistic plans.