Blame people for the financial crisis
Jacob Weisberg has written a nice primer on the competing -- and intertwined -- explanations for the financial crisis:
There are no strong candidates for what logicians call a sufficient condition — a single factor that would have caused the crisis in the absence of any others. There are, however, a number of plausible necessary conditions — factors without which the crisis would not have occurred. Most analysts find former Fed Chairman Alan Greenspan at fault, though for a variety of reasons. Conservative economists — ever worried about inflation — tend to fault Greenspan for keeping interest rates too low between 2003 and 2005 as the real estate and credit bubbles inflated. This is the view, for instance, of Stanford economist and former Reagan adviser John Taylor, who argues that the Fed's easy money policies spurred a frenzy of irresponsible borrowing on the part of banks and consumers alike.
Liberal analysts, by contrast, are more likely to focus on the way Greenspan's aversion to regulation transformed pell-mell innovation in financial products and excessive bank leverage into lethal phenomena. The pithiest explanation I've seen comes from New York Times columnist and Nobel laureate Paul Krugman, who noted in one interview: "Regulation didn't keep up with the system." In this view, the emergence of an unsupervised market in more and more exotic derivatives — credit-default swaps (CDSs), collateralized debt obligations (CDOs), CDSs on CDOs (the esoteric instruments that wrecked AIG) — allowed heedless financial institutions to put the whole financial system at risk. "Financial innovation + inadequate regulation = recipe for disaster is also the favored explanation of Greenspan's successor, Ben Bernanke, who downplays low interest rates as a cause (perhaps because he supported them at the time) and attributes the crisis to regulatory failure.
A bit farther down on the list are various contributing factors, which didn't fundamentally cause the crisis but either enabled it or made it worse than it otherwise might have been. These include: global savings imbalances, which put upward pressure on U.S. asset prices and downward pressure on interest rates during the bubble years; conflicts of interest and massive misjudgments on the part of credit rating agencies Moody's and Standard and Poor's about the risks of mortgage-backed securities; the lack of transparency about the risks borne by banks, which used off-balance-sheet entities known as SIVs to hide what they were doing; excessive reliance on mathematical models like the VAR and the dread Gaussian copula function, which led to the underpricing of unpredictable forms of risk; a flawed model of executive compensation and implicit too-big-to-fail guarantees that encouraged traders and executives at financial firms to take on excessive risk; and the non-confidence-inspiring quality of former Treasury Secretary Hank Paulson's initial responses to the crisis
Curiously, Weisberg goes on to dismiss the idea that human nature or Wall Street's financial incentives were ultimately at fault. "Those are weak explanations," he says. "unless you think human nature somehow changed in the final decades of the 20th century to make people greedier or more foolish than they were previously."
That's a bit too flip: Bubbles have been present as long as financial markets have existed, a point that Carmen Reinhart and Kenneth Rogoff pound home in their book “This Time Is Different”. The question is not why this bubble existed so much as why it got so out of hand. The next bubble, after all, will have different features than this one, but the basic process that led to its inflation — money managers will find higher returns by investing, which will force their competitors to do the same, and no one will be able to back off because no single money manager can survive quarter-after-quarter of low returns — will remain the same.
The basic problem during bubbles is that people think that traders worry about the risk of losing money. They do, but more than that, they worry about the risk of falling behind in their careers. As Henry Blodgett has written, the job of money managers is to make money no matter what the market is doing, not to insist that the market is wrong. You can argue that this is really a subcategory of the regulation explanation, as better regulation is needed to align those incentives or prevent them from doing damage, but that gets it backwards, I think: This is the explanation, while better regulation is the solution. The fact that human nature has been the explanation before, too, does not diminish its power now.
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