Richard Posner: "Why the Economic Crisis Was Not Anticipated"
An article in the October 11 New York Times attributed the almost universal failure to anticipate our current economic crisis to "insanity" — more precisely, to a psychological inability to give proper weight to past events, so that if there is prosperity today we assume that it will last forever, even though we know that in the past booms have always been followed by busts. But experts on the business cycle, such as Federal Reserve Chairman Ben Bernanke, are not confined to basing predictions on naïve extrapolation. So why did he and other experts, inside and outside of government, neglect warning signs of a coming crash?
Real-estate bubbles are common. The supply of "good" land is fixed in the short run, the housing stock is extremely durable and therefore does not expand rapidly when demand increases, and land and the improvements on it cannot be sold short. And the bursting of a real-estate bubble can lead to bank insolvencies — as it did in Japan in the 1990s — because most real estate has heavy indebtedness, financed by banks or other financial intermediaries, and real-estate debt is a significant fraction of all debt.