Lessons not learned: from the collapse of Long-Term Capital Management to the subprime crisis

The subprime crisis was largely unanticipated as the efficient market hypothesis held sway and the Gaussian techniques used to rate collateralized debt obligations were assumed to have diversified risk and reduced systemic risk. However, as this paper argues, many of the shortcomings stemming from these assumptions, together with the consequent economic policy of "light regulation," were clearly revealed by the collapse of the hedge fund Long-Term Capital Management in 1998. This nearly brought about the collapse of the U.S. banking system and gave a clear practical demonstration that the economy is nonergodic. The paper discusses the collapse of Long-Term Capital Management and shows how the lessons derived from that crisis were not learned. It also highlights the dangers of assuming that uncertainty can simply be treated as risk, as the Post Keynesians have long argued. Furthermore, it argues, following Akerlof (2007), that case studies can be just as, or indeed more, revealing than econometric testing.