Fred Block, an economic sociologist at UC Davis, explains the political
changes that led to the financial crisis:
Meltdown for Dummies: Defining the Changes We Need, by Fred Block, Dissent:
...[T]he escalating crises of the housing and financial sectors have the
potential to concentrate our minds on the specific reforms that our nation
urgently needs. This requires understanding how our current problems are a
direct result of the policies pushed by Republican Presidents from Ronald
Reagan to George W. Bush.
The story begins with systematic efforts by Ronald Reagan to dramatically
reduce the regulation of financial markets and facilitate a huge transfer of
income and wealth to the highest income households. These policies were
embraced and expanded by later Republican presidents and “succeeded” in
producing a new era of income inequality and out-of-control financial activity.
Starting in 1981, Ronald Reagan set out to deliver on two major changes that
he had promised his business supporters. He significantly rolled back
government regulation of the financial sector... At the same time, Reagan cut
taxes for the very rich, a policy initiative that was replicated by George W.
Bush. Taken together, these steps facilitated a dramatic shift of income...
As the rich grew wealthier, they invested growing amounts in hedge funds
that pursued risky strategies to earn annual returns that were far higher than
those available for ordinary investments... The government never regulated
these funds because they were closed to most people; one had to exceed a
certain wealth threshold to play. The theory was that these already rich
investors could cope if these highly speculative investments turned bad. ...
As hedge funds grew increasingly successful, they produced rate of return
envy among established financial institutions. Pension funds, for example,
wanted a piece of the higher return action and started putting some of their
money into these unregulated funds. The big investment banks, similarly ...
started imitating the strategies pioneered by the hedge funds. Many of them,
like Bear Stearns, were even allowed to create their own hedge funds. ...
This is where the subprime mortgages come in. Starting in the 1990s, some
independent mortgage brokers and mortgage firms figured out how to make money
by lending to poor people who could not qualify for standard mortgages. The
firms acted just like the local pawn shop, appealing to relatively desperate
people who would be willing to pay substantially higher interest rates if only
they could own a home. ...
Since housing prices, even in low income neighborhoods, were rising
steadily, the lenders thought they faced little risk. Even if the borrower
defaulted, the lender could always foreclose and sell the house for an even
higher price... [B]ankers were eager to package large bundles of these
mortgages and resell them to hedge funds and other investors. ... Hedge funds
bought huge quantities..., usually using borrowed money..
This whole house of cards rested on the assumption that housing prices would
continue the rise... But as subprime lending expanded, so too, inevitably did
foreclosures, and as more foreclosed properties hit the market, prices started
heading downward. ... By February 2008, almost nine million homeowners ... owed
more on their mortgages than the house is worth, and that number is bound to
[A] task for a new administration is to reverse the mistaken policies that
created this mess. The right-wing experiment with free market orthodoxy has
been a complete and total failure. It is time to repair the damage by driving
the top 1 percent share of household’s income back down... We also need to
restore effective regulation to all corners of the financial sector, especially
hedge funds. ...
About that regulation:
Hiding behind the invisible hand, by Paul Krugman: Pretty good
on the coming fight over financial regulation. But it lets the Bushies off way
too lightly, by suggesting that lack of coordination between agencies led to
the awesome failure of regulators to take action against the bubble:
Except for the Federal Reserve, all of the federal bank agencies receive funding from fees paid by member institutions, and some specialists have long argued that the agencies competed with each other to woo institutions with lighter regulation.
“There was no federal coordinated oversight, and as a result there was a competition to reach the bottom, both in federal and state organizations,” said Brian C. McCormally, a former enforcement chief at the Office of the Comptroller of the Currency.
Actually, there was plenty of coordination — a
coordinated effort to destroy effective regulation:
Consider the press conference held on June 3, 2003 — just about the time
subprime lending was starting to go wild — to announce a new initiative aimed
at reducing the regulatory burden on banks. Representatives of four of the
five government agencies responsible for financial supervision used tree
shears to attack a stack of paper representing bank regulations. The fifth
representative, James Gilleran of the Office of Thrift Supervision, wielded a
The lack of oversight, in short, was no oversight: it was part of the plan.
Here's some of the "Pretty good story":
In Washington, a Split Over Regulation of Wall Street, NY Times: As
Congress and the Bush administration struggle to contain the housing and credit
crises ... a split is forming over how to strengthen oversight of financial
institutions after decades of deregulation.
The administration and Democratic lawmakers in Congress agree that the
meltdown in credit markets exposed weaknesses in the nation’s tangled web of
federal and state regulators...
But the two sides strongly disagree about whether, after decades of a
freewheeling encouragement of exotic new services and new players like hedge
funds, the pendulum should swing back to tighter control. ...
Given the philosophical differences about the value of government
regulations, some experts were skeptical that Congress and the Bush
administration would agree on more than cosmetic changes.
“There is a political will, but I’m not certain that it can overcome
longstanding philosophic objections to dealing with free markets in a crisis
environment,” said Arthur Levitt Jr., the chairman of the Securities and
Exchange Commission under President Bill Clinton. ...
Regulations can make markets work better, so it's not clear to me why those
who believe in the power of markets have such a knee jerk reaction against any
kind of regulatory oversight.
One way regulation can help markets function efficiently is to require that
full and truthful information be made available to all market participants. We see regulations like this so much that we take many of them for granted, e.g. weights and measures
regulations, truth in advertising and labeling, full disclosure rules in housing
markets, and so on. Without government to enforce these rules, markets can break
down or lose efficiency.
One aspect of the problems in financial markets is exactly like this,
information is incomplete or asymmetric, and these problems are pervasive. For
example, complicated financial instruments are difficult to evaluate because
they lack transparency. Currently, with all the financial turmoil, nobody is
sure what they are worth, market participants don't have the information they need to make that
determination, and many markets have broken down entirely. Similarly, there are
also information problems in real estate markets, with real estate agents and
mortgage brokers much better informed about the variety, eligibility, and terms
of loan products than their customers. This made it easy for real estate agents
and mortgage brokers to steer customers into loans that were profitable, but not
always in the best interest of their customers. On the other side, customers don't always reveal truthful information about their situations, e.g. their income, debts, etc., and this can also lead to inefficiencies (and sometimes both sides work together to fool the next person in the chain).
There are many other regulations that are needed besides those intended to increase available
information, one example is increasing capital requirements, and different regulations address
different market failures. Not only do we have information problems in these
markets, we also have moral hazard issues of the type that occur when people do not have
enough of their own money at stake when taking on risky investments using other people's money (borrowed or deposited). Capital requirements will
likely encounter more resistance than measures to increase transparency, but it is a
means of reducing excessive risk taking and the options need to be fully
There's a lot more to do, redefining what a bank is, and then bringing all banks
under a consistent and central regulatory authority, rethinking the
discount window (we are likely headed to a
channel/corridor system anyway, so it's a good time to rethink the whole
operation, what assets can be traded, with whom, etc.), but to emphasize the
information aspect more, here's Tyler Cowen:
It’s Hard to Thaw a Frozen Market, by Tyler Cowen, Economic Scene, NY Times:
Real estate bubbles have burst before, without bringing such trouble to the
financial system. What is distinctive today is the drying up of market
liquidity — the inability to buy and sell financial assets — caused by a lack
of good information about asset values. ... The results have been a form of
If you think that traders have been well informed of late, take another look
at the wild path of Bear Stearns shares: A year ago, the stock was selling for
$170 a share. At the close on March 14, just before the deal by which Bear
Stearns was to be bought by JPMorgan Chase, Bear had a book value of $80 a
share — and a share price of $30. The JPMorgan transaction, arranged two days
later, valued the company at about $2 a share. Since then, the shares have been
trading above $2, which in part reflects the possibility of the deal breaking
Every step of the way, the pricing of the stock has surprised the market —
and yet Bear Stearns is a firm with a lengthy history, not an Internet start-up
or a biotech whose value is based on a new but untried wonder drug.
To understand the depths of the current crisis, let’s go back to an
apparently unrelated episode in economic thought: the socialist calculation
debate. Starting in the 1920s, Ludwig von Mises, the leader of the so-called
Austrian School of Economics, charged that socialism was unable to engage in
rational economic calculation. Without market prices, he reasoned, no one knows
how much economic resources are worth.
The subsequent poor performance of planned economies bore out his point. ... The irony is that the supercharged capital markets of the American economy
are now — at least temporarily — in a somewhat comparable position. ...
Market prices have been drained of their informational value and thus don’t
much reflect the “wisdom of crowds,” as they would under normal circumstances.
Investors are instead flocking to the safest of assets, like Treasury bills.
The absence of trading is a big problem. Financial institutions have been
stuck holding illiquid assets, whose value cannot be easily determined. Who
wants to lend to the institutions holding them? No wonder there is a credit
crisis and a general attitude of wait and see. ...
So what now? Regulators should apply capital requirements consistently to
the off-balance-sheet activities of financial institutions. This will limit
dangerous leverage, contain contagion effects and make the system less
dependent on the steady flow of good information. ...
Update: More on the need for regulation, and on the need to consolidate regulation
under a single authority:
U.S. Financial Regulation 2008, by John Tepper Marlin: In late 1999, the
bulwark bank regulation of 1933, the Glass-Steagall Act - the wall between
investment banks and commercial banks - was torn down. This was a great victory
for creative bankers, who had found the wall irksome and restrictive.
The teardown opened the way for the Bankers Panic of 2008.