Reasons for the economic crisis of 2007-????

I’ve mentioned before that, for the last couple of months, I’ve spent the time I would have spent on blogging instead getting my head wrapped around the economic crisis. During that time, I’ve put together some summary documents just to help my thinking. Here’s one of those summaries listing the reasons for the economic crisis.

Of course, this situation is a complex tangle, but we can certainly weight factors. Obviously liberals and conservatives will assign different weights – government vs. the private sector, generally speaking. Then the issue becomes presenting evidence to back up those weightings. And fighting the perceptual and political battles.

I’ve not included a lot of links because I’ve consulted many sources. If you want to ask a question about something specific, just let me know. Also, in some places I indicate that no actions have taken place so far – like addressing the housing market. I know the Obama administration has released a variety of plans, but these aren’t really underway yet.

Here we go…


Leading up to the crash:

1. It was the lack of prudent regulatory supervision – regulatory capture by the financial services industry

  • Federal Reserve – Greenspan – belief of let bubbles pop then clean them up – even if it is hard to spot a bubble, they can still be spotted
  • The Commodities Future Modernization Act – it barred regulation of derivatives markets
  • CDOs were exempted from regulatory scrutiny specifically
  • Fed allowing loose lending standards
  • Over-leveraging by financial firms – SEC could have stepped in
  • We didn’t have enough market transparency – SIVs, shadow banking sector

2. It was the implicit government guarantee of “too big to fail” and “systemic risk” – moral hazard

  • Allowing institutions that are “too big to fail” to believe so
  • Financial services firms got whatever they wanted for years

3. Loose Fed monetary policy

4. Global macroeconomic imbalances – cheap capital from Asian countries, especially China

5. Policy of keeping dollar strong, regardless of fundamentals

6. Household debt and federal budget deficits, low savings rate – “Go shopping”

7. It was the government incentives, distortions and promotion of housing

  • Mortgage interest tax deduction
  • Fannie Mae, Freddie Mac
  • General push for homeownership

8. It was NOT the Community Reinvestment Act

Since the crash:

1. Slow response to deteriorating conditions

2. Lehman collapse

3. What HASN’T exacerbated it this time is monetary policy – as conservatives argue during the Great Depression – the Fed has been cutting like crazy – zero percent interest rates – quantitative easing

4. Poor response to bank sector insolvency so far

5. No response to housing crisis so far – altering foreclosure and bankruptcy efforts

6. Mediocre efforts to stimulate the economy so far

Private sector:

Before the crash:

1. Irresponsible, immoral, incompetent, and/or foolish business people, households, and individuals

2. Bad incentives for executives, who could pocket bonuses and pay without proving that they had created real value – agency problem (failures of corporate governance)

3. Over-leveraging by financial firms and private households

4. Securitization

  • Mortgage lenders sold off the loans to securitizers
  • Securitizers sold the loans to investors
  • Breach of the train of responsibility for the results – moral hazard

5. Risk-assessment models and overconfidence in them – Black Swans

6. Complexity that could not be comprehended by businesses (or regulators)

7. The growth of the shadow banking sector

8. Credit ratings agencies and their bad incentives

9. Global macroeconomic imbalances – cheap capital from Asian countries, especially China

10. Housing bubble

11. Outright mortgage-writing fraud – both originators and customers

12. Household debt and federal budget deficits, low savings rate

13. Journalistic and media cheerleaders and aiders and abettors

14. Outright accounting fraud

Since the crash:

1. Deleveraging – debt-deflation

2. Continuing housing crash

3. Lack of credit due to lack of trust and lack of real economic prospects

4. Crash of the real economy

5. Crash in business and consumer sentiments and prospects


Before the crash:

1. The ideology of free markets as self-correcting and perfect

  • “rational expectations” and “the efficient market hypothesis”
  • Poor view of economic man – rational, self-interested actors vs. actual human beings
  • Abhorrence to prudent government regulation

2. Income concentration

3. Values

  • Household propensity to save and avoid debt
  • Morality at top of financial services firms (looting by the Masters of the Universe)
  • Morality of mortgage originators and customers
  • Morality of politicians serving special interests

4. Psychological effects

  • Emotions – greed and fear
  • Everyone thought that housing prices would always go up
  • Herd mentality

Since the crash:

1. Psychology

  • Trust has collapsed and fear has moved in
  • Need to revivie Keynes’ “animal spirits”

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