Root Causes of the Current Crisis

We’ve gotten a fair amount of criticism over on our latest Baseline Scenario post for not correctly identifying the causes of the financial crisis. I understand the criticism that we don’t identify the one single, crucial cause, because historical events like this are always overdetermined: there are always multiple plausible explanations, and with a sample size of one there’s no way to know which explanation is correct. (It reminds me a key issue in torts, where you distinguish between cause-in-fact and proximate cause … well, never mind. It’s a fascinating subject, but a bit off-topic here.)

Anyway, luckily for all of us, today’s G20 communique reveals the “Root Causes of the Current Crisis.” In case you missed it:

(I’ve inserted my own numbers to count what I consider separate causes, as opposed to descriptions of what happened.)

During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and (1) failed to exercise proper due diligence. At the same time, (2) weak underwriting standards, (3) unsound risk management practices, (4) increasingly complex and opaque financial products, and (5) consequent excessive leverage combined to create vulnerabilities in the system. (6) Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

Major underlying factors to the current situation were, among others, (7) inconsistent and insufficiently coordinated macroeconomic policies, (8) inadequate structural reforms, which led to unsustainable global macroeconomic outcomes. These developments, together, contributed to excesses and ultimately resulted in severe market disruption.

To summarize:

  1. Naive investors
  2. Naive underwriters
  3. Bad risk managers
  4. Complex financial products
  5. Leverage
  6. Insufficient domestic regulation (note the lovely phrase “in some advanced countries,” enabling everyone to point at someone else)
  7. Insufficient global coordination
  8. Insufficient global regulation

There you go.

(We’ll have a more comprehensive review of the G20 meeting, probably later on Sunday.)

10 thoughts on “Root Causes of the Current Crisis

  1. In regard to number 6, I think we all know which country is chiefly responsible for this mess.

    It was so kind of the participants to be diplomatic.

  2. But there IS a root cause of the present crisis, according to folks I call the Fiat Money/Full Reservists.

    The fractional reserve banking system has been growing since the founding of the Bank of England 300 years ago. The FM/FR people insist that it is ultimateley unsustainable, because if requires ever increasing levels of debt.

    The day must come, they say, when debt becomes so large that creditable borrowers are no longer to be found, and the system will seize up in a credit crunch just like the one we are experiencing. (For a video exposition, see

    (I thought unqualified subprime borrowers were the final dregs, but just Friday Paulson was calling for increased levels of credit card debt.)

    Even more fascinating is their prescribed cure: pay down the national debt with fiat money issued by the government (“greenbacks”).

    At the same time, step reserve requirements up to 100% (which reduces bank-created credit money to zero), keeping the total money supply constant, thereby preventing inflation.

    At the end of one year, no national debt, interest payments on the national debt gone forever, no inflation and a sustainable banking system (because it’s full reserve.)

    (For more, see or or

    This sounds too good to be true. Is it? Why?

  3. In summary we are missing an important thing: loss of confidence in the market- bailing out AIG but not helping other invsting firms.

  4. It would be a mistake to focus on specific events like Lehman or AIG. If not them, it would have been someone else, a little further down the road. It would have been politically impossible to continue bailing out failing companies in a way that keeps creditors whole. It’s more important to figure out and prevent future gas leaks, than track down every source of random sparks.

  5. How about falling wages. I don’t think many wage earners benefitted from productivity increases and therefore took on debt to maintain their standard of living. Maybe we need more unions.
    All of this is clearly a muddle.

  6. Kong Jie has it right.
    There is blame enough to go around to many market participants and forces.
    Let’s get past the finger-pointing and institute the necessary regulatory oversight (with teeth,) full transparancy and sane degrees of aggregate leverage.

    Most of the points 1-8 summarized by the G20 are at play always in capitalistic markets (to one degree or another) as markets are composed of human emotions and reactions… very difficult to remove or legislate against human behaviour.

    Isn’t it wiser to eliminate the opacity and manipulative market practices by apolitical, strong oversight and full disclosure of outstanding risk exposure levels so that participants can properly assess with whom to do business? (counterparty risk.)
    Wouldn’t this return the markets to a state of confidence and isn’t systemic confidence truly the “bottom line?”

  7. I would very much like to see some one meaningfully respond to Tom Hagan. I’ve taken it for granted that the hard money people were nuts, in spite of the fact that I’ve read little to nothing about them. They always struck me as roughly akin to flat earthers. Having followed a couple of Tom’s links to the text of the MONETARY REFORM ACT, I’m having a hard time understanding why this approach is flawed, or even if it is flawed.

    The easy explanation may also be the cynical one. That political will is roughly equivalent to political influence, which is roughly equivalent to political contributions. Any action that would diminish the concentration of wealth would diminish the efficiency of political fund raising. Particularly after you have the current wealthy trained so well to contribute to your campaigns. That would explain the dearth of proponents of this kind of approach.

    Is it really possible that there could be a policy decision that could be implemented tomorrow that would restore confidence to the system over night; a policy decision that would be good for the country but bad for funding political campaigns? Are we really not discussing this because we believe our leaders are beyond just saying “no” to the current level of their election year infusions of graft? Somebody say it aint so.

  8. First on the Gold/Fiat Money topic; then on the causes of the crisis.

    I will strongly refute the “Gold Bug” argument of Tom Hagen and anyone else. The reasoning is simple: bubbles and crises were common even when the gold standard existed. See MacKay or Kindleberger. Low rates can also not be the sole cause, because manias sometimes occurred when rates were high. This is not to say that Austrian Economists are useless — they have some very valid points to make; the problem is that their overall framework is not consistent and not coherent.

    More importantly, on the causes of the crisis, Secretary Paulson recently reiterated most of the comments of the G20 ( I think he was somewhat less harsh on investors and banks than he could have been. I agree that these sowed the seeds of the disaster. But like an inept surgeon in an operating theater, or an unprepared reactive general without a plan in a war, the Fed and Treasury have been culpable in bringing the crisis to a worse level. We aren’t as bad at handling the situation as Japan, but there have been MANY mistakes made, and the damage is often irreversible.

    I would list:
    i) the removal of the TARP as a buyer / recycler of toxic assets. This caused CMBS to tank, and is probably going to put Citi into receivership, for which I’m sure the Feds are not ready
    ii) cutting rates too slowly, sterilizing too much (back when Libor still functioned)
    iii) enacting a nearly-useless fiscal stimulus, though I agree with Simon that repairing balance sheets is not a waste, it doesn’t give you a multiplier effect
    iv) letting Lehman fail without ring-fencing counterparty risk, and possibly rejecting a buyer
    v) dithering over the TARP
    vi) giving AIG and the banks capital without commensurate oversight, allowing them to pay dividends and buy Chinese banks (!)
    vii) not nationalizing anything, and not making it clear what future regulations and punishments will be doled out, thus frightening potential buyers.
    viii) short-sale bans, which don’t address the root causes, and in fact, by eliminating a hedging tool of hedge funds, causes selling of long positions and wholesale deleveraging.

    We need to point the finger at the people responsible for these errors, and make it clear that it is unacceptable! The other worrisome thing is that the Fed is not taking enough action to prevent deflation, which could be catastrophic… see Lacker’s sunny comments and lack of imagination today (11/21).

  9. “Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities.” That’s from the Federal Reserve.

    If reserve requirements are 100%, how does anyone get a loan?

    (I confess I have not followed any of the links in Tom Hagan’s post.)

  10. Well, until I followed the links myself I knew nothing about this line of thinking so if I get this wrong please forgive me. If you believe what they say, the best I understand it, apparently, in the administration of Abraham Lincoln either the president or congress ordered the treasury to print a dollar for every dollar of leverage in the banks and in the national debt. They tied this into the discussion of the “green backs” which I have a very vague memory of from school, lending at least some plausibility to their narrative.

    So, as their explanation goes, the reserve requirement of 100% prevented the banks from creating new money through new lending, so the proposition was not inflationary. The proposed legislation suggests that the money supply which is now represented by real paper notes for every dollar in the system is increased by 3% per year. This money is available to congress for infrastructure, or similar expenditures, and to the extent it is not used, it is rebated to the tax payers on a pro rata bases depending on their contribution to the treasury through income tax.

    Now if someone understands what they are saying better than I do, please feel free to correct me. I don’t see that that is exactly a gold bug argument. But again I haven’t had enough patience to read many gold bug arguments so I could be wrong about that too. It doesn’t sound too much to me like Bretton Woods, at least the gold component of it.

    It seems to me, that under their proposal, that money is introduced into the economy not by lending but by spending. And that at this 3% predetermined rate Congress and the president take direct responsibility for this activity and are answerable to the electorate as envisioned in the Constitution.

    As you think about this, there seems to be a need to provide some additional capital to banks to facilitate some reasonable level of activity in the home market, etc. I’m not sure that I have an answer for that, short of buying one of their books. However that may be, Congress would have discretion to make these funds [3%] available where they may be needed. It is different enough from the way we normally think about the economy that it is a little bit hard for me to get my mind around it. Again if someone understands their argument better than I do, please correct me.

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