But What Caused It?

A lot has been written about the financial crisis - what caused it, why was it so bad, and how do we get out. I hear that the best written explanation of the mechanics of the housing financial tools that played a part in the collapse is The Big Short by Michael Lewis (certainly Moneyball and Liar's Poker were well written). Too Big to Fail (think Game Change for the financial crisis) describes what everyone did and said as the crisis was unfolding, but is not as great at explaining the mechanics.

But for good detailed economic analysis of this recession, I have been relying mostly on Paul Krugman. His latest piece in the New York Review, co-authored with Robin Wells (the two are married) is probably the best analysis I have read about what really caused the financial crisis.

Krugman and Wells explore the four most common theories for the cause of the collapse.
- Low interest rate policy of the Federal Reserve
- Global savings glut
- Complicated financial products
- Government policy (ie Fannie Mae / Freddie Mac / CRA)

You might be surprised to hear that Krugman and wells say that the global savings glut is the primary cause of the real estate bubble and subsequent collapse. I just had an argument with one of the few conservatives I know about this, and I had come down decidedly on blaming Wall Street and complicated financial instruments. My conservative friend clearly blamed the government.

Krugman and Wells dismiss the low interest rate policy due to a real estate bubble that existed in Europe as well, where central banks were not keeping rates as low. They dismiss complicated financial products because all European real estate and American commercial real estate also had bubbles, and neither of those used these American products. And they dismiss government policy, which they have been dismissing for a long time, because Fannie and Freddie made less of the really troubled loans than other private institutions and there is no link between CRA-qualifying loans and high rates of default.

The global savings glut is explained as follows:

Historically, developing countries have run trade deficits with advanced countries as they buy machinery and other capital goods in order to raise their level of economic development. In the wake of the financial crisis that struck Asia in 1997–1998, this usual practice was turned on its head: developing economies in Asia and the Middle East ran large trade surpluses with advanced countries in order to accumulate large hoards of foreign assets as insurance against another financial crisis.

The authors say that this savings glut lead to low long-term interest rates (different from the short-term rates controlled by the Fed) and the low rates were primarily directed into real estate.

If I read the article right, the authors do blame financial institutions for letting a bubble take down the entire economy. Financial institutions were able to borrow much more than they could really back up through lax government rules and borrowing through repurchase agreements that were not government guaranteed, subjecting the firms to crises of confidence. Krugman and Wells say that loans like Repo agreements accounted for 60 percent of the banking system yet was largely unregulated.

If their analysis is correct, the next questions are how do we get out of the recession and how do we prevent this from happening again. Their next article in the NY Review will tell us how to get out. I need to learn more about the Wall Street reform to see if we are preventing this from happening again.