Arnold Kling  

Bubble, Bailout, and Cover-Up

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John Taylor writes,


it is very hard to imagine that heavily regulated banks could have engaged in such extreme risk-taking without the support of regulators. Nobel prize-winning economist George Stigler warned long ago about "regulatory capture" -- the tendency for regulated firms to get protection from their regulators -- and the authors provide considerable evidence of it in this book.

He is reviewing the new book by Gretchen Morgenson and Joshua Rosner. I have not yet read the book, but clearly I should.

One way to think about the financial crisis is that it consisted of a bubble, a bailout, and a cover-up, with a consistent set of government players involved in each phase (Geithner, Dodd, Frank). The bubble phase consisted of encouragement of risk-taking by Freddie, Fannie, and large banks. The bailout phase consisted of committing the taxpayers to sustaining those institutions. And the cover-up phase was the demand for financial "reform" culminating in the Dodd-Frank bill. All this hue and cry was really an exercise in promulgating a narrative that the crisis was caused by an "atmosphere of deregulation," when the true narrative would be one of misguided housing policy, crony capitalism and cognitive capture of bank regulators by the large banks.


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COMMENTS (6 to date)
The bubble phase consisted of encouragement of risk-taking by Freddie, Fannie, and large banks

Yeah, just forget Greenspan and co. and the artificially low interest rates.

Where else could Freddie, Fannie, and large banks get the money, Mr. Kling?

Lord writes:

That's right. Government forced banks to make bad loans, kicking and screaming against their will. When confronted Greenspan said they are big enough to know what they are doing and they needn't look into it. Capture, sure. Bush promoted the ownership society, Cox rubber stamped requests to increase leverage, Greenspan looked the other way and the market to take care of it by hiding risk under rocks, and Paulson to do the bailing.

Patrick R. Sullivan writes:

Mattheus, suppose we had the same Greenspan monetary policy, but not the 1992 GSE Act, not the HUD Best Practices Initiative, nor the 1995 CRA amendments. Would we have still had the financial crisis?

If so, how would it have manifested itself?

Lord writes:

None of the other housing bubble countries had those acts, but they were exposed to Greenspan's monetary policy.

That's right. Government forced banks to make bad loans, kicking and screaming against their will.

I didn't suggest the Fed had anything to do with the making of loans per se, just that they provided extremely attractive financing (hence the term "cheap money"). When banks are able to borrow from the Fed at next to nothing, do you think the loans will be more wisely or less wisely given?

If so, how would it have manifested itself?

I'm not sure, honestly. But something's gotta give. Low interest rates will push a bubble SOMEWHERE and it was in housing because of various government programs that pushed homeownership - as you stated. Those policies made building and selling homes profitable, and the extra money found its manifestation in excess homes built.

None of the other housing bubble countries had those acts, but they were exposed to Greenspan's monetary policy.

Probably because low interest rates stimulate the production of higher order capital goods (like homes) and lengthier production processes. It's likely that without the pro-housing policies, we would have still have incentivized the production of homes because that production process is acutely affected by changing interest rates.

Elvin writes:

Bad government policy that encouraged too much home ownership and too much leverage to support it was definitely a major contributer to the crisis. I'd put Roubini's ideas about structural deficits as another cause: we encouraged consumption through trade deficits. In turn, the Chinese kept buying Treasuries which kept interest rates low for the last 18 years. Also, we must not forget a lot of smart people (I can point to college-educated relatives and several neighbors) that just had to buy a house and in some cases two houses. No bank tricked them, they tricked themselves. Finally, I think that oil increases was the straw that broke the consumer's back in the summer of 2008. Up until then, the economy was sputtering, but after that it was in free fall, which eliminated any possibility that banks would get through the crunch.

Lord, my understanding is that the SEC's approval of increased leverage only applied to the broker/dealer subsidiaries and not the overall investment bank. Thus, leverage was unchanged, it was merely transfered around the organization. Overall leverage at investment banks were lower in the late 2000s than the 1990s.

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