I finished reading Engineering the Financial Crisis fairly quickly. In part, it is because it is only 156 pages. In part, it is because I found the analysis so congenial. Actually, if you did not follow the issues closely back in 2008 and 2009, particularly all of the acronyms, you will find EFC a bit difficult to wade through.
From the conclusion (p. 153:)
"deregulated" capitalist finance did not cause the crisis, but rather that regulatory ignorance and ideology, apparently transmitted to the regulators by modern democracy's most trusted academic experts, may have caused it...a potentially fatal flaw: the mistakes that flow from the cognitive limitations of modern democracy's all-too-human decision makers.
The cognitive limitations of capitalist decision makers are, of course, just as likely to lead to mistakes. But capitalists simultaneously put into practice heterogeneous, competing interpretations of the world...At least some of these interpretations, if not all of them, are very likely to be mistaken, but some may be less mistaken than others.
Society might therefore be well advised to diversify its asset portfolio by allowing capitalist competition to proceed unhindered, rather than by predicting that a single interpretation is best in advance and then imposing it on all capitalists' behavior at once.
Another way to put this is that what experts know today is slight relative to what they have yet to learn. A competitive market system will do a better job of learning than a top-down regulated system. The demand for regulation implicitly assumes that our experts know enough to stop learning. That is ultimately a dangerously wrong-headed view.
More thoughts below.
EFC takes the view that the financial crisis caused the recession. That is, when banks had to mark down the value of assets, they curtailed lending in order to avoid having capital ratios fall below the regulatory minimum. This drop in lending caused real activity to decline.
This "credit channel" that EFC takes for granted is not well established, either theoretically or empirically. As you know, Scott Sumner views the recession as a monetary contraction. I think of it as a recalculation problem. Vernon Smith and others stress balance-sheet issues, as households suffered a tremendous loss of wealth due to the drop in house values.
The credit-channel story might seem to do a better job of explaining the sudden, swift decline from the fall of 2008 through the summer of 2009. However, by the same token, it does a poor job of explaining the sluggish recovery since then. The government did succeed in propping up the banks, but that apparently did nothing to fix the economy. Overall, I am not sold on the credit-channel story.
Speaking of the bank bailouts, EFC implicitly makes a case that the government acted wisely as a speculator of last resort during the crisis. The authors say that many of the exotic mortgage securities were under-valued, so that when the government took on the derivatives of AIG and other distressed portfolios, it actually made good bets and earned a profit.
I was initially quite skeptical of those who argued that mortgage assets were artificially under-valued and that the stress that banks felt was more a problem of liquidity than solvency. However, this view looks increasingly persuasive, and it weakens some of my criticisms of the bailouts.
EFC has two outstanding strengths. One is in its careful weighing of various factors that are thought to have caused the crisis. The authors explain why the behavior of Freddie Mac and Fannie Mae should not be given too much weight, why the behavior of the Fed in keeping interest rates low should not be given too much weight, and so on. They seek to increase the weight placed on the implementation of the Basel capital accords, and I think that this view is correct.
The other strength is in making the case for what the authors call radical ignorance. p. 129:
bankers seem to have been as ignorant of what was to come as other investors were, and as ignorant as the regulators...bankers' preference was for safety before yield. This suggests that bankers were not ignoring risks that they knew about. Rather, they were ignorant of the fact that triple-A securities might be much riskier than advertised.
Correct. Those who instead want to focus on moral hazard would be bound to retort that "Well, they would have been less ignorant if they had known that they were going to suffer the consequences of their ignorance instead of expecting to be bailed out." That is not a falsifiable position, but I personally do not find it persuasive. I think that EFC is right to lay stress on inherent ignorance over incentives.
I think that EFC stands out as by far the best economic analysis of the recent financial crisis. Although a number of economists have come out with books since the crisis, for the most part those books merely serve to promote a pre-existing agenda. I would have to say that none of them illuminates the crisis.
For relevance to the financial crisis, the only two other books by economists that I can recommend are This Time is Different and Manias, Panics, and Crashes. Both talk generically about financial crises, and both have something to offer. But neither goes into detail about the 2008-2009 crisis.
Prior to EFC, I would have recommended some of the journalistic accounts. Fools Gold and All the Devils are Here come to mind. But they lack the analytical focus of EFC. So EFC moves to the top of the list.