Causes of the Financial Crisis

If you postulate multiple causes then you have to postulate a synchronization effect.

"The chart does not include monetary policy.."

It's included under the "Housing Bubble" category.

Interesting chart.

“which many people argue was too loose from 2003-2005 (I personally am willing to cut Greenspan more slack, because I think that measures of employment were indicating a slack economy).”

Right on Arnold. However, the problem wasn’t rates were too low, it was they were too high from 2005 to 2007. Remember the “conundrum”? We’re in a conundrum culture right now.

Ultimately, everything boils down to the fact that we have (or we allowed) the output gap to get too wide. Leverage & credit were containing the difference between the economy’s realized growth and its potential fairly well for most of the decade until the Fed misread the conundrum (Feb 2005) and deleveraged the financial sector. Therefore, it wasn’t too much leverage that is to blame, it was not enough!

The economy is now releveraging itself through deflation by allowing real long-term interest rates to press lower over a longer period (say the next 10 years).

Arnold, I agree with your macroeconometric stance to a point (especially when all things are not equal). However, it would behoove you to take a look at the behavior of the Treasury yield curves since 2000 (3mo/10yr & 2yr/30yr). It tells the whole story.

“Without credit, economies cannot grow at their potential, and right now, critical parts of our financial system are damaged.” Treasury Secretary Timothy Geithner Introducing the Financial Stability Plan Tuesday, February 10, 2009

Going through the chart and reading P Allen's comments would have us believe the fault lies in our estimation of future risk, which is credit, an estimation of the future.

If so, then why did banking suddenly, systematically error in its estimation of the future?

Great point Matt-

I again point to the conundrum i.e.long rates coming down at the beginning of a tightening cycle. The banking system “knew” that rates were appropriately priced at low nominal levels for the future. The Fed had other ideas.

It has been said that at its peak in 2007, the creation of leverage (both on and off the balance sheet) was accounting for roughly 20% of the banking sectors’ profits. As we all know, a capitalistic economy (even an imperfect one) will provide incentive through profit to get what it needs. It needed leverage to contain the output gap, without it, the gap widens out beyond “generally accepted” levels and things slow down dramatically.

CEOs are a lot like traders. They sense profit and act on it. Rarely do they rationalize it, putting their faith in their ability and the economy. It is our job as economists to understand the why of profit. In this case we, through the Fed, failed miserably.

Remember it was Greenspan’s irrational fear of unanchored inflation expectations that prompted him to ignore the conundrum. Seems fairly unfounded four years later, I would argue. For a better idea just how far we are from true economic inflation, compare the unemployment rate with long-term interest rates. A completely polar ratio today than in the period from ’65 to ‘82

This reminds me of an engineer trying to describe board by board and brick by brick the sequence of events as a house collapses when the important thing is that the foundation had washed away over the years and the structure was simply unsound. The items listed may be true, but it would have been something else if it were not the housing bubble. We were simply carrying too much debt in all parts of the economy.

So, why did we have too much debt? We have too much debt because congress has only one economic tool and that is to stimulate the economy. A stimulus is no more than a package of incentives that convince people to spend when they know they should be saving. Stimulus after stimulus leaves us with no savings, overleveraged and unable to cope with the next "black swan" that comes along. When economists and politicians try to drive GDP rather than creating and maintaining a healthy economic environment, they set us up for failure.

Economists need to wake up and look at the forest instead of running regressions on the leaves of every bush and tree.

And to that chart you could add zoning regulation and other land use regulation-- something that increased the variability of housing prices in certain areas and made the "unthinkable" general housing price decline happen eventually. (That the models didn't predict because it hadn't happened on a national scale before, though it had happened in regulated California in the 80s and 90s, and in Louisiana and east Texas during the oil bust in the late 80s.)