What Caused the Financial Crisis?

More answers to this question:

• What caused the financial crisis? - Tyler Cowen
• How did it all happen? - Megan McArdle
• My Fantasy Testimony - Arnold Kling

[Others: Barry Ritholtz, Nick Rowe.]

Comments

[Bruce Wilder]

All complex social behavior is significantly overdetermined. Economic behavior is not an exception.

It would take more effort than I care to make, to construct a comprehensive analysis and narrative explantion of how the financial crisis came into being. There are a lot of factors, events and relationships, which are worth noting and considering.

One of the reasons I, personally, would hesitate to attempt a comprehensive overview is that I would feel obligated to do two difficult things:

1.) I would want whatever narrative I offered to rest on the foundation of an analysis that was consistent with some reasonable model of how the financial sector of the economy works -- "mechanically" if you will.
2.) I would want my explanation to be consistent with verifiable facts, and the most salient, verifiable facts to be consistent with my explanation.

It is much, much easier to just test one's hypotheses against one's own prejudices and ideological needs. And, certainly, much easier, if one doesn't feel obligated to at least wonder a bit along the side, about what it is that the finance sector does to add value, and what it means for the finance sector to perform those functions well.

Many of these explanations strike me as superficial and ill-considered. At best, they latch onto one piece of the jigsaw puzzle, describe that piece, and declare the puzzle, "solved". Ex: If every home "owner" had a minimum of 25% equity, this would not happen. (Not exactly brilliant insight into why down payments are generally required. Not at all a brilliant insight into how banking regulation works.)

The full-on effort to disappear de-regulation policy and regulatory malfeasance, along with management corruption, behind a wall of clever abstraction and pontification is particularly aggravating to me. But, do I want those hacks to dictate the agenda and framework for criticism?

[Not going to happen in the short run]

Kling writes:

Under the circumstances, there are two policy imperatives. First, regulators must sort out the banks that are sound from those that are insolvent. The insolvent institutions need to be merged or closed as expeditiously as possible. Sound banks should be encouraged to make loans to qualified borrowers

Kling is spot on. But i'm a realist. Which means it aint going to happen in the short run. Only after pumping up Zombies on life support has failed for the up-tenth time will something be done.

[swells]

Bruce Wilder's comments are well taken. But, I think one fundamental explanation explains a lot of what happened. Risk was partitioned into chunks that were thought to be manageable. The disconnect came when circumstances assumed to be improbable weren't and multiple risk partitions merged into essentially one risk event. The best explanation I've seen (meaning the one I was able to make sense of) is at: http://www.slate.com/id/2201428/

[Inflation is the Enemy]

AK..."Method A suffered a breakdown in the 1970's, because inflation was allowed to get out of control. The 6 percent mortgage interest rates that were commonly charged by savings and loans became untenable when inflation and interest rates soared to double-digit levels. The savings and loan industry went out of business."

This was it. Inflation got out of control. Inflation was brought under control over an extended period of time, instead of all at once. Interest rates fell faster than inflation did, eliminating confidence in the purchasing power of savings held at banks. Banks had inadequate deposits to loan out, so reliance on foreign loans began (selling securitized loans overseas). Since the banks didn't plan to keep the loans on their books, they didn't really care whether the loans would be paid back or not. They brokered loans that would not be paid back, and the system collapsed when foreigners refused to buy any more securitized loans (except for those backed up by full faith and credit).

[Margin is Dangerous]

"...with borrowers having made a significant down payment, often 20 percent of the price of the home."

High leverage encourages bubbles and subsequent credit crises. The problem is considerably magnified with very low real interest rates. The same thing in 1929 with stock margin. Too much margin helped destroy the system. The fact that the rest of the world doesn't use super low down-payment loans should provide useful information. Foreigners are mad at domestic institutions/regulators for causing/allowing this fiasco.

[Inflation is the Enemy]

MM..."Besides, the memory of the stock market crash was extremely recent and vivid. People began to see a home less as a place to live than an investment, a safe alternative to the risky securities market."

As well as the risky bank deposits. The risk of loss of purchasing power to inflation has been drummed into people's heads for many decades, and turned most people away from saving in a form that can be loaned out. Many flocked to stocks for inflation protection (driving the dividend yield to a historically unprecedented 1%), but the post Y2K bust turned many people away from the S&P also.

Now many are turning from homes as an inflation hedge also, and are frantically searching for some shelter from the inflation storm. It is becoming very hard to store value for retirement in our land.

[Bruce Wilder]

swells: "But, I think one fundamental explanation explains a lot of what happened. Risk was partitioned into chunks that were thought to be manageable. The disconnect came when circumstances assumed to be improbable weren't and multiple risk partitions merged into essentially one risk event."

The road to hell, and all that, eh?

This is where, I think, overdetermination makes nonsense of any "one fundamental explanation". The limits of portfolio diversification and the more complex business of hedging are certainly a part of the mechanics of banking and finance. Not to be dismissed, by any means, or ignored. But, in this explanation of professionally well-intended hubris is the housing bubble, and subprime lending (which killed Countrywide and WaMu and fatally damaged Fannie and Freddie), and Alt-A loans (which did in Wachovia) and the SIVs, and the crooks like Angelo Mozilo?

And, what if you leave aside the minutiae of financial models for a moment, and consider the really big picture of macroeconomic policy and foreign exchange. Do we consider Bernanke's "global savings glut", the prolonged imbalances in trade and payments, the devastation wrought in Ohio and Michigan manufacturing, by a high dollar policy and globalization?

Should we have an argument about the primacy of easy money and low interest rates, on the one hand, and banking deregulation on the other? How should the risk partitions of practical financial modeling be made to compete with the partition of banking by Glass-Steagall and Rule 23a? Are giant banks too big to fail enablers of "financial innovation", achievers of increasing returns, and vessels of vast portfolio diversification? Or, predators pre-destined to individual extinction, calamitous even if rare?

And, how about that "housing bubble"? Should we follow our esteemed host, in thinking that a "bubble" can not, by definition, be explained by fundamental factors? Must a "bubble" originate in the psychology of mass hysteria? Or, is the possibility of a "bubble" built into the fundamental structure of finance and the economy, just as macroeconomic instability is? (Is macroeconomic instability, fundamental?) Is it enough to get the "incentives" and central tendency right? Or, are there always latent "incentives" to cheat and corrupt? Must we act to keep the thieves and crooks at fish-and-chips stands, and away from bank management? Is the importance of central tendency sometimes overwhelmed by variance? Are the maxims of portfolio diversification proof against the instincts of the herd?

Quis custodiet ipsos custodes?

[Bruce Wilder]

Inflation: "It is becoming very hard to store value for retirement in our land."

Indeed.

First, they came for the unions, and I was a professional, so I voted for Reagan and damn those arrogant air traffic controllers. Then, they came for the Savings & Loans, but I had already moved my cash into a money market, and Jimmy Stewart is dead. Then, they came for the pensions, but "greed is good" and aligning executive compensation with shareholder interests has been great for the stock market. Well, that and tax cuts were great for the stock market . . . until they weren't.

But, hey, the key thing, my friends, is getting federal spending under control and gathering the courage to tackle entitlements. With our worst enemies attacking us with box cutters, we've got to increase defense spending, and can't let a few old geezers, who did not have the foresight to marry well, get in the way of this country's greatness!

[realpc]

My theory is that it was all an evil plot by the Republicans. So they would lose the election, and laugh while Obama tries to figure out how to rebuild the world. The planning started way back during Reagan.

[anon/portly]

It's probably a bit late, but in-deep Economist's View readers can go here:

http://www.mynorthwest.com/?nid=2

Click on the "Dave Ross Show - listen" and if you have right stuff on your computer, you can listen to some "economist" talk about the financial crisis. Compared to the excellent commentary we get here, this guy just doesn't make any sense at all.

There is a "listen to past shows" link....

Just to illustrate how brilliant this blog is, and how solid the commentary provided it on it is, right now I'm listening to some "economist" on the radio - KIRO 710 in Seattle - and I'm telling you, this guy makes no sense at all.

[anon/portly]

Crap - apologize for failure to edit properly before posting that last one - meant to delete last paragraph. (Not that anyone could tell this was mid-edited compared to my usual comments).

[Cynthia]

With Halloween just around the corner, I can't think of a better time than now to raise JM Keynes from the dead so that he can, once again, save Capitalism from self-annihilation...

But we oughta have a few fiscal counter-terrorists on hand just in case a gang of freaky Friedmanites with bombs strapped in their chests try to sent him back to the dead!

[anon/portly]

Anyway if you want to listen to a certain U of O economist discuss the financial crisis on the radio, I think at some point you will be able to go here

http://www.mynorthwest.com/?nid=163

and download an mp3 file for the October 7 show, 9AM-10AM hour. (I hope that's a permanent link).

[swells]

Bruce, certainly all the things you mention were contributing factors. I'm not an economist. I'm more of a student of evolutionary theory. I tend to look at bubbles in the same way I look at predator / prey population cycles. The tacit assumption I make is that most everything is amenable to an evolutionary mindset, particularly things like economies and the systems and subsystems within them. What I was trying to focus on was the linkages between those systems and subsystems. In essence, what the risk partitioning derivatives did was akin to opening many of the watertight doors on a sailing vessel. Makes for more freedom of movement, better ventilation, easier communications when the weather is nice. Pretty disastrous if a rouge wave comes along and one ships water.

But then again, I'm used to thinking of inefficient systems that don't get evaluated in terms of their excellence but instead get evaluated in terms of whether they suffice compared to their competitors.

[Rising]

So what would happen if we allowed interest rates to rise to market values? Credit at positive interest rates is better than no credit. Insisting that loans be extended at negative interest rates, with absolutely no possible provision for covering normal default rates, may be unrealistic in a solvency crisis.

[Bruce Wilder]

swells: "In essence, what the risk partitioning derivatives did was akin to opening many of the watertight doors on a sailing vessel. Makes for more freedom of movement, better ventilation, easier communications when the weather is nice."

Excellent metaphor. Don't know if it applies, but it is a plausible hypothesis.

[acerimusdux]

"But then again, I'm used to thinking of inefficient systems that don't get evaluated in terms of their excellence but instead get evaluated in terms of whether they suffice compared to their competitors."

That sounds like a fair description of Capitalism.

[flow5]

Professional economists, et al, are absolute morons. (1) Commercial banks enlarge the money supply when they make loans or buy securities from the non-bank public. The only time a CB is a financial intermediary is when it has a 100% reserve ratio applied to its deposit liabilities. (2) you cannot take money out of the CB system, only the FED can force bank credit contraction. (3) If the CBs would get out of the savings business (i.e., store their liquidity & not buy their liquidity), they would be immensely more profitable, the banking system would be smaller, inflation would be slower, & there would be an immediate and large increase in the supply of loan-funds to the non-banks, accompanied by a decrease in long-term interest rates which would feed back to the short-term rates. 1966 is a perfect example

[swells]

acerimusdux, I am not a huge fan of capitalism. I do however realize that there are a lot more ways to be dead than to be alive. In that sense, it certainly behooves one to value a system that works and to be really, really rigorous when evaluating the risk associated with moving away from something that works. I do look at it like a fitness landscape. I can realize, as J. Maynard Smith did, that a system can be evolutionarily stable without being anywhere near optimal. That stability is not a virtue to be dismissed out of hand on that basis.

Do I think there could be a better system? Absolutely. But, I think humans are nowhere near prepared to move away from the contingent effects of our evolution as primates that have left us with hierarchical systems of social organization. Until we prepare ourselves to transcend the contingent realities of our evolutionary history, we need to understand those realities and respect them.

[Holly W.]

I think Megan McArdle does a fairly good job of explaining how a worldwide psychosis took hold.

I'm starting to think that perhaps a new Cabinet position should be created, that of Head Contrarian, who would be required to talk people out of bubblicious mentality instead of cheering it on ... yeah, good luck with that, I know.

An acquaintance of mine steered me to this excellent Power Point presentation about the mortgage securitization craziness: www.buildermarketingideas.com/?p=8
It contains a bit of profanity, if anyone is sensitive to that, but is also very funny.

[Ciphernerd]

I am still trying to get a serious economists' opinion on the argument presented in the animated film "Money as Debt" on Youtube. It seems to reflect the views of some heterodox economists. It explains a lot of observations about the business cycle: long periods of growth and sudden declines, the decline in inventories during declines, and so forth. The central premise is that every dollar in circulation has been borrowed by the government or by an individual, so it must be repaid with interest. Mark Thoma mentioned this in his video lecture on monetary theory; modern governments raise money by borrowing and taxation, but not by printing money.

In order to repay the old debts, more money must be borrowed. Eventually, debt outstrips growth. There isn't enough real stuff to use as collateral for new borrowing, and people have maxed out their credit cards, so there is inevitably a liquidity trap and a panic. It all seems perfectly reasonable to me.

People seem to be too caught up with the obvious villains in this crisis. Sure, people shouldn't be selling insurance to do zero-per-cent reserve banking. Sure, people shouldn't borrow beyond their means. But why does this seem to keep happening? Couldn't it be that we haven't tamed economic volatility? The so-called Great Moderation was marked by a huge increase in private debt, from about 170% of GDP to over 350% of GDP. Couldn't it be that all of that debt prevented the market from responding to changes in the real economy? Couldn't it be that it was unsustainable? Couldn't it be that economic volatility is a healthy part of an economy, and that numbing the pain just sets us up for more pain later?