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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.

By Ezra Klein  |  January 11, 2010; 1:00 PM ET
Categories:  Financial Crisis , Financial Regulation  
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I guess "the market can remain irrational longer than you can remain in a job" is the next adaptation of Keynes' old saw, that "the market can remain irrational longer than you can remain solvent."

Posted by: jesmont | January 11, 2010 1:22 PM | Report abuse

The liberal explanation misses the point. These esoteric financial instruments are for the most part derivatives on housing assets. If there hadn't been a housing bubble (and subsequent collapse), the derivatives linked to housing would have held up. These derivatives collapsed only when the underlying collateral collapsed.

The root of the problem is that housing prices in the US became unhinged from historical norms (median house prices around 3x median income) and this started in the mid / late 90s. The culprit for this was Alan Greenspan who ran the "ease aggressively in the face of financial crisis" play which worked well in the aftermath of the 1987 crash. Unfortunately, he went to the well too many times, easing for the Mexican Peso crisis, the Asian crisis, the Long Term Capital Management Crisis, and the bursting of the dotcom bubble. He even eased in anticipation of a potential crisis - Y2K.

Bubbles have at their root reckless monetary policy. Derivatives didn't cause housing prices to rise.

Posted by: sold2u | January 11, 2010 1:53 PM | Report abuse

Human nature didn't change, human memory did. I remember going to eat out with my grandparents and my grandmother would take all of the leftovers. While my grandparents were not destitute, they were very financially cautious because they lived through the depression. Our generation (I am in my 30s) has never experienced a depression, until possibly now, and our expectations for ever increasing economic opportunity were never popped by reality, until now.

So yes, we were a different type of people in the 1990s and 2000s than the people who lived in the 1960s, 1970s, or 1980s. Their expectations were much different and therefore their likelihood of creating a expectations bubble were much less.

Posted by: lancediverson | January 11, 2010 2:00 PM | Report abuse


I agree that monetary policy was an issue. But your argument placing the blame entirely on monetary policy is incomplete. Without housing-linked derivatives the Wall Street component of the crisis (AIG, Bear, Lehman, Merrill) wouldn't have happened. Credit access wouldn't have seized up as it did. And frankly, without that demand for CDOs, the cost of borrowing probably would have been higher, which would have suppressed the bubble to some extent.

The housing bubble had been deflating for almost two years before the crisis, after all. And it wasn't until Bear and Lehman crashed -because of their derivative holdings- that we had a crisis.

Posted by: jesmont | January 11, 2010 3:11 PM | Report abuse

i'm not a conspiracy theorist, so I don't think this would ever happen BUT ---if China wanted to overcome the United States as the World Super Power, what could be a better way to do it than to send over an economist who would convice us to change the way we invest only later to have our economy collapse as a result? The economist would convice us that we could predict risk as X, when really risk was much greater than X. then China's Soverign Wealth Fund could short sell all that risk in a variety of ways. Once the risk goes bad, the global economy would be brought to its knees, and China would be able to avoid it and even make money. If that happened, we might expect the rogue economist to go back to China and we would never see from him again. Of course, that is exactly what happened with David Lee and his Copula formula.

Posted by: Levijohn | January 11, 2010 3:30 PM | Report abuse

Hmm. Nothing in there about rising income inequality and flat middle class wages for the last 30 years. The pie was constantly growing, but instead of making everyone better off, the piece going to the super-rich got bigger, while the rest of us watched. Enter all the creative new ways of extending credit, so that many people without the means to get the new goodies bought into the illusion that they suddenly had the means, and they got in way over their heads.

Posted by: randrewm | January 11, 2010 7:54 PM | Report abuse

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