What Caused the Crisis?

Tyler Cowen says a combination of three things, and the bad luck to have them hit at once, caused the financial crisis:

Three Trends and a Train Wreck, by Tyler owen, Economic View, New York Times: How did the world’s financial system get into such a mess? It’s tempting to blame specific politicians, decisions and laws (or the lack thereof), and leave it at that.

While it’s certainly true that a great number of serious, identifiable mistakes have been made, we need to broaden our thinking... The crisis is global in nature and its causes are more general and less country-specific than is commonly reflected in the political discourse...

The current financial crisis comes from a conjunction of three major trends, common to many countries and to a wide variety of financial institutions.

The first trend was a positive one: an enormous growth in wealth that needed to be moved into investments. ...Ben S. Bernanke wrote of a “global savings glut,” particularly from Asia. ...

Of course, more wealth is a good thing overall, but the question is whether that wealth has been invested in an effective and prudent way.

This leads us to the second trend, the greater willingness of both individuals and financial institutions to take on risk. This trend has shown up in many areas, including real estate, derivatives markets, loans..., and overpriced equities. Heavy debt, particularly in financial institutions, created a low margin...

Greater risk-taking was driven by investor hubris and collective delusion. ... People pursued profits rather than prudence because their minds and emotions were geared to expect further rewards.

The third component has been weak governance and oversight. That includes inadequate control and monitoring by shareholders, regulators, creditors, accounting systems and ratings agencies, among others. Most people, including informed insiders, simply did not understand the systematic risk that financial institutions were accepting. ...

The end result was that both markets and governments failed miserably — at the same time and on the same issues. With hindsight, it is easy to argue that regulation should have done more, but in most countries, governments were happy about rising real estate and asset prices and didn’t seek to slow down those basic trends. ...

Over all, then, the three fundamental factors behind the crisis have been new wealth, an added willingness to take risk and a blindness to new forms of systematic risk. All three were needed to bring about the scope of the current mess — so that means we’ve had some very bad luck on top of everything else.

One prophet of today’s crisis was Fischer Black,... who developed the Black-Scholes formula for options pricing... Mr. Black ... argued that major business downturns could be caused by a combination of excess risk-taking and simple bad luck. ... Mr. Black’s revolutionary idea was simply that we are not as shielded from a sudden dose of bad luck as we might like to think. ...

We can do better the next time around, but we have to start by seeing that the current failure is far-reaching... The real problem is not some particular villain but rather the very fact that we cannot help but put the evaluation of risk into all-too-human hands.

Comments

[Bruce Wilder]

TC: "Most people, including informed insiders, simply did not understand . . ."

Tc: "Greater risk-taking was driven by investor hubris and collective delusion."

Once again, the sleight-of-hand, which makes everyone innocent, strikes me.

The narrative thread, which suggests that some may have understood their opportunities all too well, and took them -- that narrative thread of fraud, greed and ill-intent -- is disappeared from Tyler's worldview.

Oh, sure, Tyler is willing, in a general way, to criticize the regulators, but none too harshly, because, after all, "no one knew", but of the subjects of regulation, of those we must restrain, and that from which we must restrain them -- these are allowed to scuttle into the penumbras of Tyler's analysis.

It is a selectiveness in his thought that reflects tellingly on Tyler's role as an apologist for the kleptocracy. I am a little surprised that he doesn't add a footnote on the role of ACORN and the CRA in the financial collapse -- those grasping poor people brought down on our financial system!

But, I'm sure we'll be back to the best of all possible worlds, real soon now.

[bob mcmanus]

Over all, then, the three fundamental factors behind the crisis have been new wealth, an added willingness to take risk and a blindness to new forms of systematic risk.

I do believe Minsky would say these three are causally related, at least in finance, and not coincidences at all.

[Bruce Wilder]

TC: "The crisis is global in nature and its causes are more general and less country-specific than is commonly reflected in the political discourse . . ."

TC: "we have to start by seeing that the current failure is far-reaching... The real problem is not some particular villain but rather the very fact that we cannot help but put the evaluation of risk into all-too-human hands."

What a tool!

[bob mcmanus]

But, I'm sure we'll be back to the best of all possible worlds, real soon now.

Daniel Davies said macroeconomic crises have macroeconomic causes. We shouldn't let our rage and disappointment limit us to vengeance. Our analysis of the causes will partly determine the solutions, and I have greater ambitions than a tighter Sarbanes-Oxley and some hiring at the SEC.

It was an inevitable systemic collapse. Our economic assumptions should be ruthlessly re-examined in order to facilitate a full systemic reorganization.

[S Brennan]

This apologia of the ruling class is characteristic of the sycophant class.

"...so many asses to kiss..it's hard to know where to start...best to start the wealthy..eh?

- a friend commenting on a highly regarded sycophantic fellow

[ken melvin]

"The first trend was a positive one: an enormous growth in wealth that needed to be moved into investments.

Very interesting. More wealth than investment opportunities; whatever shall we do? Must be something that can be done, assuming of course that there really is as much wealth as we're being told. We must all have a look about and see if there is anything that might needs fixing, replacing, built, ...

[Bruce Wilder]

bob mcmanus: "Daniel Davies said macroeconomic crises have macroeconomic causes."

I'm pretty sure that is nonsense.

bob mcmanus: "We shouldn't let our rage and disappointment limit us to vengeance. Our analysis of the causes will partly determine the solutions, and I have greater ambitions than a tighter Sarbanes-Oxley and some hiring at the SEC."

Fair enuf. We shouldn't let ideological hirelings of Koch, Inc. hide important aspects of the truth, either. I suspect Tyler Cowan rather hopes to avoid a tighter Sarbanes-Oxley and hiring at the SEC. Is that indicated by any fact on the ground, other than who butters Tyler's bread?

bob mcmanus: "It was an inevitable systemic collapse."

"Inevitable" could be a dangerously pessimistic word. Tyler would like us to think financial crisis was just one of those things, a routine necessity, and not the product of the stupidity and greed of a careless, ruthless plutocracy.

[Leverage]

"“global savings glut,” particularly from Asia..."

Which helped drive real yields negative, so a frantic search for positive real net yield took place. 1/2% short rates encouraged institutions borrow short and loan long in an extremely leveraged fashion in an attempt to boost return into positive real net territory.

"This leads us to the second trend, the greater willingness of both individuals and financial institutions to take on risk..."

In a desperate effort to stay ahead of inflation... There is such a thing as too much stimulation. Inflation was a disaster here, as it forced people to take extraordinary risk in an attempt to keep up with it. Inflation may be directed at unemployment, but it affects others too.

[Bruce Wilder]

"more wealth than investment opportunities"

I think someone doesn't understand the concept of wealth.

[OhNoNotAgain]

"Inflation may be directed at unemployment, but it affects others too."

What the heck is that supposed to mean ? Are you suggesting that wages were one of the reasons for the inflation ? If so, then you're way off the mark.

http://money.cnn.com/2006/09/01/news/economy/state_working/index.htm

[HankP]

"This leads us to the second trend, the greater willingness of both individuals and financial institutions to take on risk..."

Um, I'm pretty sure that there's been an ideological belief for the past thirty years or so that forced individuals to take on additional risk whether they wanted to or not. That same ideological belief was dead set against any kind of socially funded schemes to reduce risk to individuals. So enough of the passive voice in determining causes and apportioning blame.

[Don the libertarian Democrat]

"Most people, including informed insiders, simply did not understand the systematic risk that financial institutions were accepting. ..."

I seem to be alone in this, but I disagree here. I think that people ignored risk because of the implicit guarantee and expectation that the government would intervene in a crisis such as this. That is how I read the reaction of the markets to Lehman.

If we're going to guarantee, either implicitly or explicitly, the government coming to the rescue in a crisis such as this, then, in this case, regulation is the clear problem. Where taxpayer's interests are concerned, the government should regulate a fairly conservative system of investment.

Going forward, we need to decide what to do. If we are going to explicitly have the government intervene, and this should be clearly debated and decided beforehand, we will need a better regulatory system.

If not, then we will still need regulation to prevent crises like the current one occurring, but we won't need to regulate to the extent we would if the taxpayer is on the hook.

For a good debate about regulation going forward, I enjoyed this debate on The Economist:

http://www.economist.com/debate/index.cfm?source=hptextfeature&action=hall&debate_id=14

[mmckinl]

Bruce Wilder has it right on the money ... Many economists and non economists saw this coming for years. The picture of the nations' government, business and consumer debt as a percentage of GDP has been screaming bubble for over 10 years. It started with Reagan and didn't stop.

The leverage scheme was allowed even encouraged as long as the "right" people were benefiting. Sir Alan Greenspan is the poster child for this catastrophe. The even have a name for Sir Alan's generosity to the already rich ... The Greenspan Put.

Tyler Cowen is just another hack economist that earns a living with his apologias for the systemic application of plutocratic greed.

[hari]

TC is an academic clown who is trying to hide his hide from further erosion by claiming no one really knew what was underway! How clever to pass hi street inventions of SVI and rest of the derivatives mess to a global audience.

Aug 2007 Fed/BB admitted there was no policy constraint to economic downturn - he'd control it!

In a nutshell the crisis was cused by American Capitalism gone wild and its increasing greed for *more*! BB/Fed looked the other way. SEC/FDIC and rest of the regulatory mandarins didn't dare challenge the market-makers of derivatives, as Greeenspan argued, the free market is the best balancer of egregious exacerbation.

Academics and other clowns must take a refresher course in political economy and come to grips with the mess they have contributed to by promoting their Libertarian creed for more not less deregulation.

[hari]

What TC and his like don't anticipate - right now - is what follows from the decision Bush/Sarkosy/Borosso agreed last night at camp David. Bretton Woods II is already drafted by Gordon Brown and more or less approved by EU Summit last week. There's no way EU-27 will allow further erosion of their hard earned social security and financial stability under American Capitalism gone mad!

Be prepared for a different and substantially restructured global financial superstructure with global regulatory control/audit of financial and other related markets. There is no such thing as a *free* lunch - any more - for hi street!

[hari]

See NYT - Suddenly, Europe Looks Pretty Smart.

[Too Much Fed]

What Caused the Crisis?

How about negative real earnings growth for most people and too much debt?

[Too Much Fed]

"Ben S. Bernanke wrote of a “global savings glut,” particularly from Asia"

Throw most oil producing countries in there too.

Is the “global savings glut,” nothing more than wealth/income inequality on a global scale?

[Bruce Wilder]

Too Much Fed: "Is the 'global savings glut,' nothing more than wealth/income inequality on a global scale?"

It is, at least, three or four things, in combination.

1.) Much of the industrial world is importing large amounts of petro-energy from kleptocratic regimes, and those regimes are accumulating the surplus financial paper as paper; their spending on goods and services from the industrial nations lags.

2.) Japan and the other Asian Tigers are now fully developed, industrial countries, but their consumers still save way too much. Again, there's a huge accumulation of financial paper, as a result. We talk a lot about the People's Bank of China's affinity for dollars, but the Bank of Japan's appetite dwarf's China. Korea and Singapore are no pikers, either.

3. China has adopted the development model pioneered by Japan, of self-financing their own development thru massive domestic savings, combined with a policy of depressing the value of its own currency. Its a disequilibrium policy, and it is aimed at making China the manufacturing workshop of the world. China is both accumulating a lot of dollars, and supplying the U.S. with a lot of manufactured goods cheap -- this is a strategy for China, and not particularly hostile to the U.S., per se, but will be devastating to the U.S. as a whole, because the U.S. "counter-strategy" (such as it is) is basically to enrich the top 1/2 of 1%, and let the bottom 95% fend for themselves. China will use its accumulated dollar hoard to build multinationals, and its currency will rise gradually but steadily relative to the dollar, as the terms of trade change to China's favor. China's products will cost the U.S. more, and China will outbid the U.S. for world commodities. The American 95% will see their incomes decline.

It is number 3, which, more than anything else, depresses investment opportunity in the U.S. Financially, the tilt of the world's forex markets makes all manufacturing investment financially profitable and far less risky in nominal terms, in China. The financial tilt overwhelms all the real considerations.

There are two obvious ways to for the U.S. to challenge the financial tilt. One would be a cheap dollar backed by a credible threat of inflation, but it would involve accepting a much higher price for petroleum. It would also involve a risk of foreign sovereign wealth funds and corporations going on a spending spree, buying up the heights of capitalism in the U.S., or buying the American corporate multinational empire abroad (which is very significant source of income and wealth for the U.S.) The other would be to stop buying and importing oil -- something, which would require at least 10 to 20 years of sustained investment in infrastructure, and increased prices for petroleum fuels.

A strong dollar policy makes petroleum cheap, and prevents Arab sheiks and Chinese multinationals from outbidding America's wealthiest families for control of Corporate America. It also enables corporate America to maintain its multinational dominance in the world economy, expanding globabally even as their foundations in the U.S. wither, an important source of wealth and income for American corporations and their top executives. And, until recently, a strong dollar has enabled the U.S. to build a huge financial industry out of recycling into financial securities these dollar gluts accumulating abroad.

The fact that a strong dollar makes a dustbowl out of rustbelt Ohio doesn't matter, as long as Ohio votes Republican and listens to Sean Hannity and treats high gas prices as the greatest threat to the American dream since Herbert Hoover.

We don't need to protect America from trade. We need to protect America from Wall Street and the corporate plutocracy and the stupid, visionless ignorance of the American suburbanite, for whom politics begins and ends with the price of gas.

[Bruce Wilder]

Too Much Fed: "Is the 'global savings glut,' nothing more than wealth/income inequality on a global scale?"

It is, at least, three or four things, in combination.

1.) Much of the industrial world is importing large amounts of petro-energy from kleptocratic regimes, and those regimes are accumulating the surplus financial paper as paper; their spending on goods and services from the industrial nations lags.

2.) Japan and the other Asian Tigers are now fully developed, industrial countries, but their consumers still save way too much. Again, there's a huge accumulation of financial paper, as a result. We talk a lot about the People's Bank of China's affinity for dollars, but the Bank of Japan's appetite dwarf's China. Korea and Singapore are no pikers, either.

3. China has adopted the development model pioneered by Japan, of self-financing their own development thru massive domestic savings, combined with a policy of depressing the value of its own currency. Its a disequilibrium policy, and it is aimed at making China the manufacturing workshop of the world. China is both accumulating a lot of dollars, and supplying the U.S. with a lot of manufactured goods cheap -- this is a strategy for China, and not particularly hostile to the U.S., per se, but will be devastating to the U.S. as a whole, because the U.S. "counter-strategy" (such as it is) is basically to enrich the top 1/2 of 1%, and let the bottom 95% fend for themselves. China will use its accumulated dollar hoard to build multinationals, and its currency will rise gradually but steadily relative to the dollar, as the terms of trade change to China's favor. China's products will cost the U.S. more, and China will outbid the U.S. for world commodities. The American 95% will see their incomes decline.

It is number 3, which, more than anything else, depresses investment opportunity in the U.S. Financially, the tilt of the world's forex markets makes all manufacturing investment financially profitable and far less risky in nominal terms, in China. The financial tilt overwhelms all the real considerations.

There are two obvious ways to for the U.S. to challenge the financial tilt. One would be a cheap dollar backed by a credible threat of inflation, but it would involve accepting a much higher price for petroleum. It would also involve a risk of foreign sovereign wealth funds and corporations going on a spending spree, buying up the heights of capitalism in the U.S., or buying the American corporate multinational empire abroad (which is very significant source of income and wealth for the U.S.) The other would be to stop buying and importing oil -- something, which would require at least 10 to 20 years of sustained investment in infrastructure, and increased prices for petroleum fuels.

A strong dollar policy makes petroleum cheap, and prevents Arab sheiks and Chinese multinationals from outbidding America's wealthiest families for control of Corporate America. It also enables corporate America to maintain its multinational dominance in the world economy, expanding globabally even as their foundations in the U.S. wither, an important source of wealth and income for American corporations and their top executives. And, until recently, a strong dollar has enabled the U.S. to build a huge financial industry out of recycling into financial securities these dollar gluts accumulating abroad.

The fact that a strong dollar makes a dustbowl out of rustbelt Ohio doesn't matter, as long as Ohio votes Republican and listens to Sean Hannity and treats high gas prices as the greatest threat to the American dream since Herbert Hoover.

We don't need to protect America from trade. We need to protect America from Wall Street and the corporate plutocracy and the stupid, visionless ignorance of the American suburbanite, for whom politics begins and ends with the price of gas.

says...

hari:

yes, the French (of all nations) have obviously been reading this forum and decided it s about time to fly over to tell the americans a "little secret".

hmmm didn`t they also ship-over the statue of liberty ?
and isn`t there a book on liber-smthing...

It is not Europeans that "look" smart...
It` s the U.S., it`s Nobel "go-go-liber fiscal" and the "15%-is-I think-too-low" and "what-I-thing-trully-happened" and "do-this-do-that" not to forget the "keynes-o-miltoninan" accidental "economists" and with that almost all (well over 99%) of this forum and blogs that IS pretty stupid.

I`m sorry; I truly apologize to all; I just had to post it.

The emperor has NO clothes.

[Too Much Fed]

Bruce Wilder:

about 1) that sounds like wealth/income inequality in those petro-energy countries.

about 2) not sure about the other Asian countries, but I believe that china has a wealth/income inequality problem.

about 3) is china accumulating a lot of dollars or a lot of dollar denominated debt?

"The American 95% will see their incomes decline."

It seems to me that this is greenspan's and the fed's grand plan, lower our wages and standards of living to theirs instead of raising wages and standards of living to ours. In the meantime, the few get rich.

[reason]

Tyler Cohen like much of the economics profession seems to confuse finance and real investment. It is long overdue that academic economists integrated speculative finance into their academic models as at least one academic claims Keynes already did in the General Theory.

[Steven Earl Salmony]

Please consider that which could be a product of arrogance and also shameful behavior.

Our lexicon of business activities is being expanded daily, thanks to the "wonder boys" on Wall Street. We are learning about derivatives, collateralized debt obligations, credit default swaps, recapitalization, puts, short selling and so on. We are gaining a new vocabulary from the recent meltdown of the financial system and expected slowdown of the real economy worldwide.

Where did this debacle begin? Well, it began in the center of human community’s banking and investment houses in the financial district of NYC. Supposedly, the "brightest and best" among us go to Wall Street, know what they are doing and do the right thing. Unfortunately, such assumptions turn out to be colossal mistakes.

How did this calamity occur and why is the human family in such dire economic straits? It appears that grotesque greed and a culture of corruption have come to dominate significant operating systems of the global political economy.

Powerful people in high offices within huge business institutions with access to great wealth are recklessly and deleteriously manipulating the unbridled expansion of the global economy in the small, finite planetary home God blesses us to inhabit.

Self-proclaimed Masters of the Universe have surreptitiously "manufactured" a sub prime "asset bubble" and perversely fostered its uneconomic growth within the world economy. Not unexpectedly, this asset bubble did what bubbles do. The sub prime bubble burst and made a mess. Global credit markets have frozen, stock prices are tumbling and the value of the dollar is gyrating.

Evidently organizers, managers and whiz kids overseeing the global economy, and the unraveling {ie, deleveraging} of the worldwide sub prime swindle, are running the artificially designed financial system of the global economy as a pyramid scheme. This is to say that the international financial system is being operated so that most of the wealth funneled pyramidally into the hands of a small minority of people at the top of the world economy where this wealth is accumulated and consolidated. Note that thirty percent of annual corporate profits end up in the accounts of a tiny number of people. At the same time, the vast majority of people on Earth, near the bottom of the global economic pyramid, are left with very little wealth. Does the economy of the family of humanity exist primarily to provide wealth to the already stupendously wealthy? The "bankstas" among us evidently think so.

In the 1980s, this extremely inequitable method of distributing wealth and arranging business activities was called a "trickle down" economy. We have been repeatedly told how this 'rational' economic scheme is good because it "raises all ships." And yet, from my limited scope of observation, the billion people living on resources valued at less than one dollar per day and the additional 2.7 billion people being sustained on two dollars per day of resources now appear to be stuck in squalid conditions. The 'ships' carrying these billions of less fortunate people {ie, more people than lived on Earth in the year of my birth} do not appear to be lifting them out of poverty.

Steven Earl Salmony
AWAREness Campaign on The Human Population, established 2001

[mrrunangun]

I disagree with the notion that american protectionism is bad for americans at this juncture. Smoot-Hawley was a bad idea in its time, a time when the USA had a trade surplus and was an oil exporting country. Might not be so bad now when our most valuable exports are our jobs. The current global trading system was established after WWII to help our allies reconstruct their economic and military strength for the struggle against the soviet union. The cost of maintaining that system, which has served its purpose, now will include worsening inequality within the USA and consequent social unrest. Industrial workers here will have to compete on wage rates in a world where the international clearing price for semi-skilled factory work is c. $3/hour or accumulate a capital stock in american factories that will multiply tenfold the value of their labor. Right now the government is adopting policies that amount to squandering part of the existing capital stock of the country to prop up the inflated housing market and increasing the taxation of further capital formation. Tariffs on industrial goods look like the most politically practical way of reducing inequality within the US. It will mean much higher prices as well as interest rates here, as the Chinese and Japanese will have no reason to lend us money if we are no longer going to buy their relatively inexpensive manufactures with the loan money.