What Caused the Financial Crisis

What Caused the Financial Crisis

Edited by Jeffrey Friedman
Afterword by Richard A. Posner
Copyright Date: 2011
Pages: 376
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    What Caused the Financial Crisis
    Book Description:

    The deflation of the subprime mortgage bubble in 2006-7 is widely agreed to have been the immediate cause of the collapse of the financial sector in 2008. Consequently, one might think that uncovering the origins of subprime lending would make the root causes of the crisis obvious. That is essentially where public debate about the causes of the crisis began-and ended-in the month following the bankruptcy of Lehman Brothers and the 502-point fall in the Dow Jones Industrial Average in mid-September 2008. However, the subprime housing bubble is just one piece of the puzzle. Asset bubbles inflate and burst frequently, but severe worldwide recessions are rare. What was different this time?

    InWhat Caused the Financial Crisisleading economists and scholars delve into the major causes of the worst financial collapse since the Great Depression and, together, present a comprehensive picture of the factors that led to it. One essay examines the role of government regulation in expanding home ownership through mortgage subsidies for impoverished borrowers, encouraging the subprime housing bubble. Another explores how banks were able to securitize mortgages by manipulating criteria used for bond ratings. How this led to inaccurate risk assessments that could not be covered by sufficient capital reserves mandated under the Basel accords is made clear in a third essay. Other essays identify monetary policy in the United States and Europe, corporate pay structures, credit-default swaps, banks' leverage, and financial deregulation as possible causes of the crisis.

    With contributions from Richard A. Posner, Vernon L. Smith, Joseph E. Stiglitz, and John B. Taylor, among others,What Caused the Financial Crisisprovides a cogent, comprehensive, and credible explanation of why the crisis happened. It will be an essential resource for scholars and students of finance, economics, history, law, political science, and sociology, as well as others interested in the financial crisis and the nature of modern capitalism and regulation.

    eISBN: 978-0-8122-0493-3
    Subjects: Business

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-vi)
  3. List of Illustrations
    (pp. vii-x)
  4. Chapter 1 Capitalism and the Crisis: Bankers, Bonuses, Ideology, and Ignorance
    (pp. 1-66)

    I am privileged to introduce not only the first collection of scholarly essays devoted entirely to the question of what caused the financial crisis of 2008, but a collection that brings us much closer to a comprehensive answer.

    As a proxy for the level of scholarly advance achieved in these pages, note that the claims of our distinguished contributors can, in the main, be fit into a larger mosaic with little friction between the pieces. It is true that some of our authors blame the crisis on government action while others blame it on government inaction. But the two types...

  5. Part I. The Crisis in Historical Perspective
    • Chapter 2 An Accident Waiting to Happen: Securities Regulation and Financial Deregulation
      (pp. 69-106)

      The specific missteps that triggered the current financial debacle have been extensively criticized. The easy-money policy of the Greenspan Federal Reserve after 2000, misaligned exchange rates that sustained large global financial imbalances, a housing bubble inflated by Fannie, Freddie, and subprime lenders, forays by insurance companies such as AIG into activities outside the purview of insurance regulators, AAA ratings bestowed by rating agencies on securitized debt obligations, and the comprehensive recklessness of the large banking houses have received their due reproach.

      This chapter looks at some longstanding underpinnings of the crisis: factors that helped turn the recent lapses of bankers,...

    • Chapter 3 Monetary Policy, Credit Extension, and Housing Bubbles, 2008 and 1929
      (pp. 107-136)

      Asset price bubbles have been common for hundreds of years, from the Dutch tulip mania in 1636 to the South Sea bubble in 1720 and on through the years until the recent dot-com and housing bubbles. Indeed, bubbles occur quite predictably in the laboratories of experimental economists under conditions that—when we first studied them in the 1980s—we thought were so transparent that bubbles would not be observed. We were wrong. Even when every trader in an asset market is provided with complete information on the fundamental value of holding an asset, and is provided with regular reminders of...

  6. Part II. What Went Wrong (and What Didn’t)?
    • Chapter 4 The Anatomy of a Murder: Who Killed America’s Economy?
      (pp. 139-149)

      The search is on for whom to blame for the global economic crisis. It is not just a matter of vindictiveness; it is important to know who or what caused the crisis if one is to prevent another, or perhaps even to fix this one.

      The notion of causation is, however, complex. Presumably, it means something like, “If only the guilty party had taken another course of action, the crisis would not have occurred.” But the consequences of one party changing its actions depend on the behavior of others; presumably the actions of other parties, too, may have changed.


    • Chapter 5 Monetary Policy, Economic Policy and the Financial Crisis: An Empirical Analysis of What Went Wrong
      (pp. 150-171)

      What caused the financial crisis? What prolonged it? Why did it worsen so dramatically more than a year after it began? Rarely in economics is there a single answer to such questions, but the empirical research presented in this chapter strongly suggests that specific government actions and interventions should be first on the list of answers to all three. The period from the start of the crisis through October 2008, when market conditions deteriorated precipitously and rapidly, is the focus.

      The classic explanation of financial crises, going back hundreds of years, is that they are caused by excesses—frequently monetary...

    • Chapter 6 Housing Initiatives and Other Policy Factors
      (pp. 172-182)

      The current financial crisis is not—as many have said—a crisis of capitalism. It is in fact the opposite: a demonstration that well-intentioned government intervention in the private economy can have devastating consequences.

      The crisis has its roots in the U.S. government’s efforts to increase home ownership, especially among minority, low-income, and other underserved groups, through hidden financial subsidies rather than through direct government expenditures. Instead of a government subsidy, say, for down-payment assistance to low-income families, the government used regulatory and political pressure to force banks and other government-regulated or -controlled private entities to reduce lending standards, so...

    • Chapter 7 How Securitization Concentrated Risk in the Financial Sector
      (pp. 183-199)

      There is almost universal agreement that the fundamental cause of the crisis was the combination of a credit boom and a housing bubble.

      In the five-year period covering 2002–2007, the ratio of debt to national income increased from 3.75:1 to 4.75:1. It had taken the prior full decade to accomplish an increase in debt of this magnitude, and it had taken fifteen years to do the same thing prior to that. Moreover, from 2002 to 2007, house prices grew at an unprecedented rate of 11 percent per year.

      When the “bubble” burst, a severe economic crisis was bound to...

    • Chapter 8 A Regulated Meltdown: The Basel Rules and Banks’ Leverage
      (pp. 200-227)

      In trying to identify the immense cluster of bankers’ and investors’ errors that caused the financial crisis, some writers (e.g., the authors of Chapters 3 and 5) have emphasized the role of artificially low interest rates; others have blamed “animal spirits” (e.g., Akerlof and Shiller 2009, chap. 14); still others have identified the deregulation of the financial system, or at least the failure to impose regulations on new financial instruments, as the major cause (e.g., the authors of Chapters 2 and 4; Posner 2009). While we generally find ourselves in agreement with the first explanation, we are somewhat skeptical about...

    • Chapter 9 The Credit-Rating Agencies and the Subprime Debacle
      (pp. 228-237)

      The three large U.S.-based bond-rating agencies—Moody’s, Standard & Poor’s (S&P), and Fitch—played a central role in the financial crisis that began in 2007. These three agencies’ favorable ratings were essential for the sale of bonds that were securitized from subprime residential mortgages. The sale of these bonds, in turn, was an important underpinning of the U.S. housing boom of 1998–2006—a self-reinforcing price-rise bubble. When house prices stopped rising in mid-2006 and then began to decline, the default rates on the subprime mortgages underlying the bonds rose sharply, and bonds that the three rating agencies had proclaimed...

    • Chapter 10 Credit-Default Swaps and the Crisis
      (pp. 238-248)

      After the failure of Bear Stearns, Lehman Brothers, and AIG had signaled the global financial meltdown, Securities and Exchange Commission chair Christopher Cox was quoted in theWashington Postas telling an SEC roundtable:

      The regulatory black hole for credit-default swaps is one of the most significant issues we are confronting in the current credit crisis . . . and requires immediate legislative action. . . . The over-the-counter credit-default swaps market has drawn the world’s major financial institutions and others into a tangled web of interconnections where the failure of any one institution might jeopardize the entire financial system....

  7. Part III. Economists, Economics, and the Financial Crisis
    • Chapter 11 The Crisis of 2008: Lessons for and from Economics
      (pp. 251-261)

      We do not yet know whether the global financial and economic crisis of 2008 will go down in history as a momentous or even a uniquely catastrophic event. Unwritten history is full of events that contemporaries thought were epochal but are today long forgotten. Conversely, much of what we think of as critical was, at the time, considered insignificant; in the early stages of the Great Depression, for instance, many people belittled its import.

      Regardless whether the second half of 2008 will be featured in history books, however, it is a critical opportunity for many in the economics profession—unfortunately,...

    • Chapter 12 The Financial Crisis and the Systemic Failure of the Economics Profession
      (pp. 262-278)

      The global financial crisis has revealed the need to rethink fundamentally how financial systems are regulated. It has also made clear a systemic failure of the economics profession.

      Since the 1970s, most economists have developed and come to rely on models that disregard key factors—including heterogeneous decision rules, revisions of forecasting strategies, and changes in the social context—that drive outcomes in asset and other markets. It is obvious, even to the casual observer, that these models fail to account for the actual evolution of the real-world economy. Moreover, the current academic agenda has largely crowded out research on...

    • Afterword: The Causes of the Financial Crisis
      (pp. 279-294)

      I am honored to have been asked by Jeffrey Friedman to write an afterword to this fine collection of essays that he assembled for a special issue ofCritical Review(which he edits), now being published in book form, with some revisions by the authors. Although written within months of the financial collapse that occurred in September 2008, these essays will, I predict, pass the test of time with flying colors and thus stand as durable contributions to our understanding of the crisis.

      There are twelve essays in all, including Friedman’s introductory Chapter 1, and I will try to touch...

  8. List of Abbreviations and Acronyms
    (pp. 295-296)
  9. Notes
    (pp. 297-318)
  10. References
    (pp. 319-336)
  11. List of Contributors
    (pp. 337-342)
  12. Index
    (pp. 343-358)
  13. Acknowledgments
    (pp. 359-360)