“Mistakes were made.” As an explanation of the financial crisis, this nebulous phrase offers the advantage of excusing the speaker from assigning blame. It is an accurate statement, given that consumers, governments, central bankers, regulators, banks, academics, and businesses were all culpable. An understanding of the specific errors of each player is necessary, however, if the objective is to reduce the chances of the mistakes being repeated.
Finance professionals need to delve more deeply into the crisis and the impact of the associated policy responses because an important consequence has been the increased effects of government actions on investment returns. The crisis will have long-lasting market reverberations because yesterday’s wrongly learned lessons will guide tomorrow’s failed policy experiments. Markets will continually be tested and stressed as new interpretations of the crisis emerge and policymakers try new solutions.
Two recent works within the ever-expanding universe of books on the crisis—The Financial Crisis Inquiry Report, Authorized Edition: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (FCIR) and In the Wake of the Crisis: Leading Economists Reassess Economic Policy (ITWC)—deepen our knowledge of the key issues.1 Although both suffer somewhat from a myopic viewpoint, together they enhance the finance professional’s understanding of the events and their causes.
FCIR attempts to provide a blow-by-blow account, even though there still seems to be no consensus on exactly what happened. ITWCis a set of perspectives from leading economists who attempt to reconcile past theory with what has been learned and to help future researchers adapt to insights generated by the crisis. Although well written, FCIR offers no theoretical framework. A fascinating compilation of short articles by some of the best U.S. economists, ITWC fails to provide a provocative analysis of the facts, instead settling for a rather antiseptic review of modeling issues. Missing from both books is a sense of indignation about multiple failures through misplaced intentions, unexpected consequences, poor modeling of real economics, and just wrong policies.
The Financial Crisis Inquiry Report
Despite extensive news coverage of the hearings conducted by the National Commission on the Causes of the Financial and Economic Crisis in the United States, the publication of its findings was neither widely nor eagerly anticipated. FCIR emerged with little fanfare except for editorials, which focused on partisan political disagreements among members of the commission. FCIR can be aptly and succinctly described as comprehensive but not definitive, mostly factual but sometimes biased, detailed but not always insightful, useful but not reparative, and exhaustive yet selective. The executive summary will grab the attention of any reader seeking a solid overview of the causes of the crisis. It uses punchy language with strong descriptions and quotes that fairly jump off the page. The main text, however, constitutes a missed opportunity to set the record straight on what actually happened.
FCIR's 576 pages are divided into a majority report and two minority reports, each with its own distinct style. Clearly, a minority report is easier to write because one has the luxury of selecting its topics. The primary minority report is a sound addition that focuses on broader macroeconomic themes not discussed in the majority report. Because events are shaped by the environment, placing blame without providing economic context is unduly simplistic. The secondary minority report is a more focused analysis that provides penetrating insights into the political aspects of the Community Reinvestment Act. As its discussion demonstrates, good intentions can lead to bad economics.
Although commentators are understandably reluctant to blame the housing crash victims, explaining the housing bubble is difficult without pointing out that government policy specifically encouraged increasing homeownership among those least able to afford it. Mortgage bankers and government officials are not immune to pressure. If the government had not wanted capital going into a frothy housing market, it could have sent a signal. But when officials turned a blind eye to excesses in the name of raising homeownership rates, mortgage bankers acted accordingly. Making housing affordable in the long run—but making it less affordable when the goal of financial stability so requires—is complicated. This conflict between policy objectives is a critical issue that is often overlooked.
Many other vital issues have yet to be addressed by legislation or regulation. They are the same issues that receive little attention in FCIR. For instance, although the concepts of “too big to fail” and systemic risk are still not well defined, they will be the linchpins of future policy. Similarly neglected is the very real problem of regulatory capture, which helps the biggest players escape proper supervision. Finally, the political system has not addressed the fact that housing bubbles cannot occur without loose lending standards and loose lending standards cannot arise without loose credit.
Ultimately, solving the riddle of the housing debacle requires an examination of “counterfactual history.” What if there had been a major crackdown on subprime, Alt-A, or adjustable-rate mortgage lending? Would it have been supported by the politicians who control the regulators?
Another question worth posing is whether policymakers should have been willing to make high-risk lending sufficiently expensive to dissuade financial firms from engaging in it. The government’s implicit answer is still no, because making housing affordable remains a policy objective. Unfortunately, taxpayers, savers, and high-quality borrowers must bear the burden of paying for the realization of that objective. That the government works at cross-purposes to the proper functioning of the financial system may be the most important lesson to take from FCIR.
Considering its length, this official report should have delivered more substance. Although it capably reviews the events, it should have produced deeper and more pointed conclusions. Because it was not published until after the passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act, FCIR represents a missed opportunity for proponents of regulatory and legislative action that will haunt the financial markets for years to come.
It would be an injustice, however, to relegate the report to the secondhand bin. Portions of FCIR contain some of the most useful material on the crisis published to date. The writing is engaging and the chronological structure is helpful. Unfortunately, much of the content is akin to empty calories. It consists of good description, with appealing packaging, but limited nutritional value in the form of data-driven analysis that addresses the misinformation and biases in other accounts. A lack of deep analysis is precisely what is missing from most of the crisis literature.
In the Wake of the Crisis
The policy failures that contributed to the financial crisis resulted not from government officials’ lacking a mandate but, rather, from their unwillingness to act, especially with respect to systemic risk. Gaining an understanding of systemic risk in order to act wisely, however, requires a solid grasp of the macroeconomic foundation of proposed policy alternatives. Edited by four eminent economists, In the Wake of the Crisis is a start toward building a fresh policy consensus that reflects newly gained knowledge of the ways markets work in extreme conditions.
A majority of the authors provide valuable insights. They lack a sense of indignation, however, over academics’ failure either to warn policymakers of the impending crisis or to recommend new prescriptions for minimizing the macroeconomic fallout. The book conveys an underlying view that the policies were wrong but that, given more flexibility and power, professional economists will get it right in the future.
ITWC focuses on the shifting consensus in six areas: monetary policy, fiscal policy, financial intermediation, capital account management, growth, and the international monetary system. The editors introduce each area by listing questions that should be addressed in the postcrisis world. These provocative questions define a research agenda for academics for the next decade. Unfortunately, a number of the articles fail to answer them.
The monetary policy section concludes that macroeconomic modeling was flawed by virtue of an exclusive focus on inflation targeting as a means of monetary control. But the proposed reform of imbuing inflation targeting with greater flexibility and increased supervision seems too limited a solution for future problems. Identifying macroprudential risk and understanding the credit transmission mechanism are still fundamental challenges that must be met before concluding that more flexible powers can handle crises. Knowledge of the credit transmission process is still in its infancy. The actual link between central bankers pulling monetary levers and bankers making loans remains obscure.
Furthermore, the emergence of an increasingly complex array of institutions beyond traditional banks makes setting monetary policy difficult in practice. Uncertainty about the way financial institutions behave has increased . Interestingly, the central bankers are the ones most humbled by the inability of economists to untangle all the threads of current monetary policy.
ITWC’s fiscal policy section attempts to defend remedial actions that are still not clearly understood. Fiscal policy is an acknowledged stabilization tool, but one with variable effectiveness. In particular, fiscal multipliers are so dynamic that little about the probable impact of a given tax or spending choice can be reliably determined. Multipliers can move from strongly positive to strongly negative on the basis of reasonable assumptions. Consequently, there is no postcrisis consensus on fiscal policy and no reason to expect that one will develop in the near term. Although the two extremes of a country either spending or shrinking its way out of a debt crisis set the boundaries of the policy debate, there is very little uncertainty about the outcome of either choice.
Turning to financial intermediation and regulation, ITWC’s analysis highlights the vast uncertainty that policymakers face in this area. Questions concerning who was at fault in the financial crisis, the social value of the financial sector, and the optimal design and regulation of financial institutions are truly in flux. Accepted views of intermediation may change markedly because both a microstructuralist school and a macro-Minsky school have developed to explain the credit transmission process in greater detail. The possibility of significant advancement exists as research delves into the workings of the financial transmission mechanism. The link between intermediation and monetary policy has the greatest potential for providing a new framework for policy alternatives.
Capital account management is also adapting to the policy establishment’s desire to achieve better control over capital flows. Frustratingly, capital flows can be driven by herd behavior in reaction to a shock or by bond vigilantes pushing to increase market efficiency. In the postcrisis consensus, this is not a range of freedom that policymakers wish to allow. There is a clear impetus toward introducing additional frictions to the global financial system in order to tighten control. Policymakers would prefer not to have to deal with money seeking to exploit policy inconsistencies.
Views on growth have begun to shift in several ways. One key change is a movement away from an ideal of unfettered capitalism to an acceptance of such controlled environments as China’s. Income redistribution and industrial policy are increasingly seen not as causes of but, rather, as solutions to excesses resulting from a system dominated by the financial sector. Although the consensus has long been that government regulation and structure are essential to a well-functioning economy, the pendulum is clearly swinging toward greater centralized control and reduced freedom of economic behavior. It is far from certain where this research trend will lead the global financial system.
Finally, regarding the international monetary system, there is a growing acceptance that monetary policy must be driven by a global consensus. Current account imbalances and the U.S. dollar’s role as the global reserve currency were possibly key contributors to systemic risk in the global financial system. Further cross-border integration, less isolation, and uniformity of policy objectives could ameliorate these problems.
The recurring theme of ITWC is that failures did occur and that the obvious solution is to provide greater technical control of policies through broader mandates and objectives, increased regulatory power, and more global government control. Although these views are well meaning and offer some solutions, they betray an underlying hubris among academics who deny any responsibility for the crisis. The fault, they maintain, was with policy technicians’ limited vision and the insufficient range of options granted to them. It would have been nice to see a humbler set of authors admit that there are limits to both our knowledge and our ability to find solutions to the next crisis.