One school focuses primarily on "greed" and places the blame well and truly on the private sector. This school of thought inevitable avoids as much as possible any mention of fanny may or freddy mac and instead seems to focus on regulating financial instruments.
Type 1 cares more about why people bought dodgy financial instruments and not why the instruments were dodgy in the first place. The reason for this distinction appears to be that it allows them to claim that the inefficient actions of participants belie the efficient market hypothesis and as such provide an obvious invitation to increase centralised control. They promote the idea that more intrusive regulation would have saved us from the calamity.
The second school of thought places the blame well and truly on the shoulders of regulators. this school of thought focus more on the genesis of the crisis rather than contagion. In particular it draws attention to a long history in the US of monetary expansion, making interest rates too low and the moral hazard associated with shielding investors from the normal ups and downs of a business cycle. The argument is that investors had access to artificially cheap money and also lacked the skills to properly manage risk. All of which feed into a spectacularly huge housing bubble in the US.
Alongside easy money was a bizarre push by government to promote housing mortgages on a welfare basis. This school often draws attention to fanny mae and freddy mac (both government sponsored entities) and the legislative changes made by Bill Clinton.
Put these two things together and BAM one subprime crisis coming up. And its this subprime crisis that made all those financial instruments dodgy.
At the end of the day
At the end of the day the truth probably lies somewhere between the two extremes of type 1 and type 2.
The following abstracts were lifted from the most recent version of Critical Review. This addition of the journal is dedicated to the crisis and I thought there would be value in reproducing the abstracts as they are illustrative of the breadth of argument regarding the cause of the recession.
Along with the mandatory economic haters they also represent the opinions of some very well respected economists including nobel laureates Smith and Stiglitz (ps I love the way Stiglitz cant help himself from putting forward a highly politicised viewpoint).
Its worth noting that those that spend their time knocking down markets never present a viable alternative, and those that call for regulation never seem to consider that the financial sector is already regulated at an extremely high level. So while the market may have produced an outcome they don't like, they should also acknowledge that the vast body of regulation all ready in place failed to stop the correction.
INTRODUCTION: A OF POLITICS, NOT ECONOMICS: COMPLEXITY, IGNORANCE, AND POLICY FAILURE
ABSTRACT: The financial crisis was caused by the complex, constantly growing web of regulations designed to constrain and redirect modern capitalism. This complexity made investors, bankers, and perhaps regulators themselves ignorant of regulations previously promulgated across decades and in different “fields” of regulation. These regulations interacted with each other to foster the issuance and securitization of subprime mortgages; their rating as AA or AAA; and their concentration on the balance sheets (and off the balance sheets) of many commercial and investment banks. As a practical matter, it was impossible to predict the disastrous outcome of these interacting regulations. This fact calls into question the feasibility of the century-old attempt to create a hybrid capitalism in which regulations are supposed to remedy economic problems as they arise.
THE CRISIS OF 2008: LESSONS FOR AND FROM ECONOMICS
ABSTRACT: The financial crisis is, in part, an embarrassment for economic theory. Economists tended to think that severe business cycles had been conquered; that free markets require no regulations to constrain self-interest; and that large, established companies could be trusted to monitor their own behavior so as to preserve their reputational capital. These three beliefs have proved to be inaccurate. On the other hand, economists justifiably believe that as a process of creative destruction, capitalism requires institutions that allow for innovation and the reallocation of resources toward firms that have successfully innovated. This suggests that we should not condemn wholesale even the financial innovations that played a role in the crisis, which have been remarkably productive and will continue to be, given the right regulations. Nor should economists hesitate to say that political reactions to the crisis that hamper such innovation and reallocation may do far more harm than good.
CAUSES OF THE FINANCIAL CRISIS
Viral V. Acharya and Matthew Richardson
ABSTRACT: Why did the popping of the housing bubble bring the financial system—rather than just the housing sector of the economy—to its knees? The answer lies in two methods by which banks had evaded regulatory capital requirements. First, they had temporarily placed assets—such as securitized mortgages—in off-balance-sheet entities, so that they did not have to hold significant capital buffers against them. Second, the capital regulations also allowed banks to reduce the amount of capital they held against assets that remained on their balance sheets—if those assets took the form of AAA-rated tranches of securitized mortgages. Thus, by repackaging mortgages into mortgage-backed securities, whether held on or off their balance sheets, banks reduced the amount of capital required against their loans, increasing their ability to make loans many-fold. The principal effect of this regulatory arbitrage, however, was to concentrate the risk of mortgage defaults in the banks and render them insolvent when the housing bubble popped.
AN ACCIDENT WAITING TO HAPPEN
ABSTRACT: Banks provide a valuable but inherently unstable combination of deposit-taking and lending functions that were successfully held together for several decades after the New Deal by tough banking rules. The weakening of the rules after the 1970s promoted the displacement of traditional relationship-based banking with securitized, arms-length alternatives that encouraged banks to undertake activities about which bankers lacked deep relationship-based knowledge of the risks. Ironically, this risky behavior, encouraged by loosened regulation, was reinforced by progressively tightened securities regulation, which promoted stock-market liquidity but also deprived large banks (and other publicly traded companies) of oversight by investors with “insiders’” knowledge. Both the underregulation of banking and the overregulation of securities were underpinned by economic theories that favored blind diversification in liquid, anonymous markets, and that ignored the value of relationship-based knowledge and case-by-case due diligence.
THE FINANCIAL CRISIS AND THE SYSTEMIC FAILURE OF THE ECONOMICS PROFESSION
David Colander, Michael Goldberg, Armin Haas, Katarina Juselius, Alan Kirman, Thomas Lux, and Brigitte Sloth
ABSTRACT: Economists not only failed to anticipate the financial crisis; they may have contributed to it—with risk and derivatives models that, through spurious precision and untested theoretical assumptions, encouraged policy makers and market participants to see more stability and risk sharing than was actually present. Moreover, once the crisis occurred, it was met with incomprehension by most economists because of models that, on the one hand, downplay the possibility that economic actors may exhibit highly interactive behavior; and, on the other, assume that any homogeneity will involve economic actors sharing the economist’s own putatively correct model of the economy, so that error can stem only from an exogenous shock. The financial crisis presents both an ethical and an intellectualchallenge to economics, and an opportunity to reform its study by grounding it moresolidly in reality.
MONETARY POLICY, CREDIT EXTENSION, AND HOUSING BUBBLES: 2008 AND 1929
Steven Gjerstad and Vernon L. Smith
ABSTRACT: Asset-market bubbles occur dependably in laboratory experiments and almost as reliably throughout economic history—yet they do not usually bring the global economy to its knees. The Crash of 2008 was caused by the bursting of a housing bubble of unusual size that was fed by a massive expansion of mortgage credit—facilitated, in turn, by the longest sustained expansionary monetary policy of the past half century. Much of this mortgage credit was extended to people with little net wealth who made slender down payments, so that when the bubble burst and housing prices declined, their losses quickly exceeded their equity. These losses were transmitted to the financial system—including banks, investment banks, insurance companies, and the institutional and private investors who provided liquidity to the mortgage market through structured securities. It seems that many of these institutions became insolvent; it is certain that they became illiquid. Liquidity loss and solvency fears created a feedback cycle of diminished financing, reduced housing demand, falling housing prices, more borrower losses, and further damage to the financial system and eventually the stock market and the real economy. There are important parallels with the housing and financial-market booms that led up to the Crash of 1929 and the Great Depression.
THE REGULATED MELTDOWN OF 2008
Juliusz Jablecki and Mateusz Machaj
ABSTRACT: Capital regulations stemming from the Basel accords created incentives for banks to securitize mortgages, even risky ones; hold them at a correspondingly low Basel risk weight; or shift them off of banks’ balance sheets to obtain even greater leverage. Securitization was praised by economists and regulators for dispersing risks to investors across the world, providing greater resilience to the financial system. However, since in reality banks tended to hold onto securitized assets—either on their balance sheets or off of them, in off-balance-sheet entities—the accumulated credit risk remained with the banks, especially in the “shadow banking sector.” This explains the heightened vulnerability of the financial system to a sudden collapse.
THE ANATOMY OF A MURDER: WHO KILLED AMERICA’S ECONOMY?
Joseph E. Stiglitz
ABSTRACT: The main cause of the crisis was the behavior of the banks—largely a result of misguided incentives unrestrained by good regulation. Conservative ideology, along with unrealistic economic models of perfect information, perfect competition, and perfect markets, fostered lax regulation, and campaign contributions helped the political process along. The banks misjudged risk, wildly overleveraged, and paid their executives handsomely for being short-sighted; lax regulation let them get away with it—putting at risk the entire economy. The mortgage brokers neglected due diligence, since they would not bear the risk of default once their mortgages had been securitized and sold to others. Others can be blamed: the ratings agencies that judged subprime securities as investment grade; the Fed, which contributed low interest rates; the Bush administration, whose Iraq war and tax cuts for the rich made low interest rates necessary. But low interest rates can be a boon; it was the financial institutions that turned them into a bust.
ECONOMIC POLICY AND THE FINANCIAL CRISIS: AN EMPIRICAL ANALYSIS OF WHAT WENT WRONG
John B. Taylor
ABSTRACT: The financial crisis was in large part caused, prolonged, and worsened by a series of government actions and interventions. The housing boom and bust that precipitated the crisis were enabled by extraordinarily loose monetary policy. After the housing boom came to an end, the Federal Reserve misdiagnosed financial markets’ uncertainty about the location and value of risky subprime mortgagebacked securities as being, instead, a liquidity problem, and it took inappropriate compensatory actions that had side effects that included raising the price of oil. Finally, in mid-September 2008, the government’s ad-hoc bailouts, and the unpredictable terms of the proposed TARP legislation, appear to have caused a sharp spike in uncertainty in the financial markets.
CAUSE AND EFFECT: GOVERNMENT POLICIES AND THE FINANCIAL CRISISPeter J. Wallison
ABSTRACT: The underlying cause of the financial meltdown was much more mundane than a “crisis of capitalism”: The real origins lay in mostly obscure housing, tax, and regulatory policies of the U.S. government. The Community Reinvestment Act, the affordable-housing “mission” of Fannie Mae and Freddie Mac, penalty-free refinancing of home loans, penalty-free defaults on home loans, tax preferences for home-equity borrowing, and reduced capital requirements for banks that held mortgages and mortgage-backed securities combined with each other to create the incentives for both subprime lending and the housing bubble that eventually led to the financial collapse.
CREDIT-DEFAULT SWAPS ARE NOT TO BLAME
Peter J. Wallison
ABSTRACT: Though accused by critics of helping to cause the current financial crisis, credit-default swaps are blameless. The accusation is understandable, however, given misunderstandings about how a credit-default swap actually works. A careful look into its mechanism shows that it is not only simpler than thought, but that it is also vital to keeping the financial system strong by enabling financial institutions to better manage their risks. The risk taken on in a credit-default swap (CDS) is no different from the risk of making the underlying loan. CDSs allow risks to be spread more widely instead of being concentrated at vulnerable points, but they do not add to the total amount of risk.
THE CREDIT-RATING AGENCIES AND THE SUBPRIME DEBACLE
Lawrence J. White
ABSTRACT: By means of the high ratings that they awarded to subprime mortgagebacked bonds, the three major rating agencies—Moody’s, Standard & Poor’s, and Fitch—played a central role in the current financial crisis. Without these ratings, it is doubtful that subprime mortgages would have been issued in such huge amounts, since a major reason for the subprime lending boom was investor demand for high-rated bonds—much of it generated by regulations that made such bonds mandatory for large institutional investors. And it is even less likely that such bonds would have become concentrated on the balance sheets of the banks, for which they were rewarded by capital regulations that tilted toward high-rated securities. Why, then, were the agencies excessively optimistic in their ratings of subprime mortgage-backed securities? A combination of their fee structure, the complexity of the bonds that they were rating, insufficient historical data, some carelessness, and market pressures proved to be a potent brew. This combination was enabled, however, by seven decades of financial regulation that, beginning in the 1930s, had conferred the force of law upon these agencies’ judgments about the creditworthiness of bonds and that, since 1975, had protected the three agencies from competition.