Arnold Kling  

The Financial Crisis: A Matrix

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Nassim Nicholas Taleb and Mark Spitznagel write,

The core of the problem, the unavoidable truth, is that our economic system is laden with debt, about triple the amount relative to gross domestic product that we had in the 1980s. This does not sit well with globalisation. Our view is that government policies worldwide are causing more instability rather than curing the trouble in the system. The only solution is the immediate, forcible and systematic conversion of debt to equity. There is no other option.

It has hard to reconcile this view with that of Perry Mehrling, which has been receiving so much attention lately. Let me offer some perspective.

Lately, I have started using a matrix to describe the financial crisis, in which there are four main components: bad bets (such as bad housing loans and bad security investments); excessive leverage (what Taleb and Spitznagel are complaining about); domino effects (such as the Lehman bankruptcy creating panic in money market funds); and 21st-century bank runs, as described by Mehrling. Underneath each component are various causal factors.

Bad BetsLeverageDominoBank Runs
Capital regulation
Rating agencies
Housing policy
Tax policy
Capital regulation
Housing policy
Capital regulation
Financial innovation
Shadow banking
Capital regulation
Financial innovation
Shadow banking

I see capital regulation as a major causal factor across the board. It tilted the playing field in favor of securitization rather than old-fashioned lending. It certified credit rating agencies as the arbiters of risk. Thus, capital regulation facilitated bad bets.

Capital regulation contributed to excessive leverage by allowing banks to undertake regulatory capital arbitrage. That is, banks were able to hold the same risk with less capital, with the approval of regulators.

Much of the financial innovation and much of the growth of the shadow banking system was designed to take advantage of regulatory arbitrage. Because the domino effects and bank runs took place largely in the shadow banking system, capital regulation has to be implicated in that component as well.

In addition, we can blame housing policy for some of the bad bets--the government pushed home ownership too hard. It also over-subsidized mortgage indebtedness, helping to promote excessive leverage. In addition, excessive leverage throughout the economy is encouraged by tax policy.

I think that it is helpful to look at the entire matrix, not just at any single component of the crisis.

Comments and Sharing

COMMENTS (2 to date)
John Thacker writes:

State and local housing policy, such as zoning and regional land use controls, contributed as well as the aspects of federal housing policy you mention. Restricting housing supply increases the volatility, which causes bad bets. (It also means that short term price declines, which "never happen," can happen.)

Restricted housing supply causing sharper increases in housing costs led to additional leverage as well because when houses became more expensive, it became necessary to leverage more to buy a house (which seemed worth it since they were going up so fast due to supply restriction.)

E. Barandiaran writes:

In your matrix you distinguish between causal factors and "components". I'd call the latter mechanisms of transmission of the causal factors. But these mechanisms are largely complementary and the critical one is leverage. Without a large accumulation of debt there is no financial crisis. After every crisis, experts claim that too much debt has been accumulated. For example, during the Great Depression, Henry Simons argued for equity and against debt (and in Chile's financial crisis of 1982, I argued that it'd have been better not to be so indebted and the government succeeded in converting debt into equity). It's a pity that people don't know the history of financial crises.

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