Arnold Kling of EconLog has done the hard work of setting out his theory of the financial crisis and what we should learn from it in a fifty-page but highly readable paper available here. I have some quibbles but think it is worth a read.
Here are the causes of the crisis in one table:
Menzie Chinn, one of my favorite bloggers, and Jeffry Frieden have a short and highly readable article up on the causes of the financial crisis. Chinn is not given to ideological ranting and is a great believer in actually looking at data, so I place significant weight in what he says.
Chinn and Frieden place the emphasis on excessive American borrowing, by both the public and private sectors.
This disaster is, in our view, merely the most recent example of a “capital flow cycle,” in which foreign capital floods a country, stimulates an economic boom, encourages financial leveraging and risk taking, and eventually culminates in a crash.
This guest post is contributed by StatsGuy, one of our regular commenters. I invited him to write the post in response to this comment, but regular readers are sure to have read many of his other contributions. There is a lot here, so I recommend making a cup of tea or coffee before starting to read.
In September, the first Baseline Scenario entered the scene with a frightening portrait of the world economy that focused on systemic risk, self-fulfilling speculative credit runs, and a massive liquidity shock that could rapidly travel globally and cause contagion even in places where economic fundamentals were strong.
Baseline identified the Fed’s response to Lehman as a “dramatic and damaging reversal of policy”, and offered major recommendations that focused on four basic efforts: FDIC insurance, a credible US backstop to major institutions, stimulus (combined with recapitalizing banks), and a housing stabilization plan.
Moral hazard was acknowledged, but not given center stage, with the following conclusion: “In a short-term crisis of this nature, moral hazard is not the preeminent concern. But we also agree that, in designing the financial system that emerges from the current situation, we should work from the premise that moral hazard will be important in regulated financial institutions.”
Over time, and as the crisis has passed from an acute to a chronic phase, the focus of Baseline has increasingly shifted toward the problem of “Too Big To Fail”. The arguments behind this narrative are laid out in several places: Big and Small; What Next for Banks; Atlantic Article.
Bill Moyers asked me to join his conversation this week with Michael Perino – a law professor and expert on securities law – who is working on a detailed history of the 1932-33 “Pecora Hearings,” which uncovered wrongdoing on Wall Street and laid the foundation for major legislation that reformed banking and the stock market.
My role was to talk about potential parallels betweeen the situation in the early 1930s and today, and together we argued out whether the Pecora Hearings could or should be considered a model for today.
Bill has a great sense of timing. On Wednesday night the Senate passed, by a vote of 92-4, a measure that would create an independent commission to investigate the causes of our current economic crisis; we taped our discussion on Thursday morning. In the usual format of Bill’s show, a segment of this kind would be 20+ minutes, but I believe that tonight our conversation will occupy the full hour (airs at 9pm in most markets; available on the web from about 10pm). Continue reading
Adam Davidson at Planet Money recently asked, “Who Do We Blame?” Which, I think, is a perfectly legitimate question. While the most important things are getting ourselves out of this crisis and reducing the chances of another one happening, asking who is at fault for this one is a reasonable exercise, for at least two reasons: first, it responds to our basic human curiosity; second, since many of the parties involved care only about their reputations (Bush, Clinton, Greenspan, Paulson, etc. have enough money for several lifetimes), going after people’s reputations is one of the few ways to create some measure of accountability. Politicians who inveigh against “pointing fingers” usually have something to hide.
I started writing a comment on the Planet Money thread, but they have a character limit on comments, and it’s hard for me to write anything in fewer than 1250 characters. So I emailed them my response and, what do you know, they put it up as a post on their blog. To save you any suspense, I think that if you are going to blame any individual (as opposed to, say, a whole category of activity, like “lax loan underwriting”), it should be Alan Greenspan, for reasons described further in that post.
Update: My friend Dave Sohigian blames an entire generation.
Posted in Causes
We are not short of causes for our current economic crisis. The basic machinery of capitalism, including the process of making loans, did not work as it was supposed to. Capital flows around the world proved much more destabilizing than even before (and we’ve seen some damaging capital flows over the past 200 years.) And there are plenty of distinguished individuals with something to answer for, including anyone who thought they understood risk and how to manage it.
But perhaps the real problem lies even deeper, for example, either with a natural human tendency towards bubbles or with how we think about the world. All of our thinking about the economy – a vast abstract concept – has to be in some form of model, with or without mathematics. And we should listen when a leading expert on a large set of influential models says (1) they are broken, and (2) this helped cause the crisis and – unless fixed – will lead to further instability down the road.
This is an important part of what my colleague, Daron Acemoglu, is saying in a new essay, “The Crisis of 2008: Structural Lessons for and from Economics.” (If you like to check intellectual credentials, start here and if you don’t understand what I mean about models, look at his new book.) To me there are three major points in his essay. Continue reading
Other posts in this occasional series.
I generally prefer systemic explanations for events, but it is obviously worthwhile to complement this with a careful study of key individuals. And in the current crisis, no individual is as interesting or as puzzling as Hank Paulson.
The big question must be: How could a person with so much market experience be repeatedly at the center of such major misunderstandings regarding the markets, and how could his team – stuffed full of people like him – struggle so much to communicate what they were doing and why?
Hank Paulson’s exit interview with the Financial Times contains some potential answers but also generates some new puzzles.