The Right and Left Brain Blog

There is a term in economics that many of us learned but everyone virtually forget in recent years. Ignoring this term is responsible for causing much of the current crises. The term is “ceteris paribus.” If you ever took an economics course these words are in every course and spoken in the first week or so. After those words you will see problems, lectures and formulas with all kinds of complex and impressive analytical tools that ignore them.

“Ceteris parabis” means all things being equal. In other words, this phrase becomes an excuse for all the assumptions that the formulas etc. ignore or can’t analyze if the results turn out incorrect. These include political change, social conditions, weather, other changes, scientific accomplishments etc. that may have more impact on outcomes than the variables that the extensive models analyze “ad nauseum.” For example, think of the predicative uselessness of economic or political models before 9/11 or the Iraq war.

Nowhere were wrong assumptions more apparent than in the results of the housing boom in 2000-2006.

• Home owners got cheap homes with low interest.
• Rules such as face-to-face meetings with lenders and buyers and appraisals were reduced.
• Builders got to build homes, employ people and sell the homes profitably.
• Banks got to lend money with low interest and earn significant fees.
• Traders were able to bundle the mortgages and earn more fees and interest.
• The government liked the economic growth and continued to foster and guarantee cheap loans.
• Housing values would continue to increase.
• Cheaper interest, lower down payments, lower standards, inflated housing starts etc. all followed the belief that housing prices would not decline.
• Everyone was a winner and seemed to think it would last forever.

What happened? There were two critical assumptions that were ignored in the housing mess.

• Individuals were allowed to pursue individual bonuses and commissions without regard to risk or organizational goals. With the opportunity to make millions based on individual performances, the financial executives acted normally in pursuing excess risk. What was wrong was that their organizations and financial regulators allowed them to ignore long-term risk and organizational goals.

• The second mistake was simply ignoring information and risk. Everyone had information that credit requirements became too lax and that all of the growth was based on the assumption that housing prices and demand would never reduce. In addition, as the securities were packaged and retarded, the oversight became less and less. Finally , any analysis of housing prices showed that an illogical bubble occurred that was contrary to long term trends or supply and demand.

The net result was that institutions like Lehman Brothers, Merrill Lynch and Bear Stearns no longer exist and many others are severely impacted. However, simply following normal financial procedures could have avoided much of the mess.