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Condescending to the markets

Paul Krugman is not impressed with the efforts to deflect financial regulation by pinning the blame for the crisis on government policy. Government, after all, will make mistakes. Markets can't be so fragile that they're unable to bear them.

[There] is actually a very broad problem with all accounts of the crisis that try to exonerate the private sector and place the blame on the government and/or the Fed: none of the proposed evil deeds of policy makers were remotely large enough to cause problems of this magnitude unless markets vastly overreacted. That is, you have to start by assuming wildly dysfunctional financial markets before you can blame the government for the crisis; and if markets are that dysfunctional, who needs the government to create a mess?

This logic applies, as Brad suggests, to all attempts to explain the crisis in terms of excessively low Fed funds rates for a few years. It applies to John Cochrane’s story that financial markets are efficient, but were terrorized by George W. Bush’s scary speech, and John Taylor’s basically similar claim that policy uncertainty in the couple of weeks after Lehman fell did it. It applies to claims that the Community Reinvestment Act and/or Fannie Freddie somehow led to massive bubbles in high-end housing and commercial real estate.

Put it this way: if our financial system is so high-strung, so manic-depressive, that low rates for a few years can inflate a monstrous bubble, while a few discouraging words from high officials can send them into a tailspin, this doesn’t make the case that policy must walk on eggshells, forgoing any attempt to fight prolonged unemployment. Instead, it makes the case for much, much stronger financial regulation.

It's also worth noting that the markets weren't exactly begging the Federal Reserve to lift interest rates or repeal the Community Reinvestment Act. They were pretty happy with the situation in the late '90s and the mid-Aughts, and they leveraged themselves like mad to take advantage of it.

By Ezra Klein  |  January 14, 2010; 10:34 AM ET
Categories:  Financial Regulation  
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"Instead, it makes the case for much, much stronger financial regulation."

Let's be fair here, it makes the case for less trying to fix the outcomes of markets and better enforcement from the corrupt crew at the SEC to ensure people are playing by rules. If Krugman can't admit that the government was the catalyst for and enabler of the housing bubble, he really is being intentionally misleading. Greedy people made what were effectively momentum trades on houses, tax free, while other people were making trades on mortgage backed securities- crazier people were insuring them and other people were buying CDS on the insurers.

There is certainly a lesson for financial firms here, underpricing counterparty risk in unregulated markets is certainly one of them.

The biggest lessons for government here are that, a) you can't try to fix the outcome of the housing market, b) if you are going to implicitly back mortgages, get 20% down so your collateral is worth something.

Posted by: staticvars | January 14, 2010 11:13 AM | Report abuse

I think both Krugman's argument as well as Ezra yours; we need clarity here. May be my fault, but I cannot make sense out of what is presented here.

The only thing I can agree is what 'staticvars' says that Krugman is on purposes misleading here when he says low interest did not contribute to the problem (why the hell then Bernanke increase those rates afterwards?).

I smell more to this than what meets to eyes - Krugman is indirectly coming to the defense of Bernanke to save his fellow professor. We do not need it.

This country is not going to benifit much and will not be able to re-orient itself by the continued presence of Bernanke at the helm of Fed.

Posted by: umesh409 | January 14, 2010 12:25 PM | Report abuse

I'm pretty sure that the Federal Reserve doesn't have the power to repeal the Community Reinvestment Act, no matter how much anyone begs them to.

Posted by: thehersch | January 14, 2010 12:51 PM | Report abuse

And some people were begging them to get control of the ARM market...

Posted by: staticvars | January 14, 2010 4:34 PM | Report abuse

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