From the preface to Lost Decades, published today (9/19) by W.W. Norton:
The United States … lost the first decade of the
twenty-first century to an ill-conceived boom and a subsequent bust.
It is in danger of losing another decade to an incomplete recovery
and economic stagnation.
In order to not lose the decade to come, the United States will
have to bring order to financial disarray, gain control of a burgeoning
burden of debt, and re-create the conditions for sound economic
growth and social progress. None of this will be easy. The tasks are
made more difficult by the fact, which we have learned to our alarm,
that all too many policymakers and observers cling to the failed
notions that got the country into such trouble in the first place. If
Americans do not learn from this painful episode, and from others
like it, they will condemn the nation to another lost decade.. (p. xvi).
When Jeffry Frieden and I wrote those lines in Lost Decades nearly a year ago, we were still somewhat optimistic that our leaders would rely upon the lessons from history to inform their decisionmaking. However, Republican opposition to funding consumer financial regulation and intransigence regarding revenue increases during recent debt ceiling debate have highlighted the fact that basic economic theory has been trumped by ideology and raw special interest politics.
The Causes of the Crisis
As there have been numerous excellent accounts of the global financial crisis, one might wonder why yet another is of interest. In our view, none have adequately placed the origins of the crisis in a cross-country historical perspective, while highlighting the political economy forces at play. Without a proper understanding of the origins of the financial catastrophe, we are likely to replay the crisis again — but with governments around the world facing a more precarious fiscal outlook.
The origins of the financial crisis of 2008 remains contested territory. Here is a short list of candidates:
- Community Reinvestment Act (CRA)
- The GSE’s: Fannie and Freddie
- Derivatives: MBS’s, CDO’s and CDS’s
- Lax monetary policy
- Global saving glut
- Financial deregulation
- Tax cuts and fiscal profligacy
- Tax policy
Some of these are favorites in conservative circles. The allegedly pernicious effects of the CRA, which required a certain proportion of lending to historically underserved neighborhoods, occupies a particularly prominent place in the fevered imagination of some. The role of the Government sponsored enterprises, Fannie Mae and Freddie Mac, in making the market for securitization of subprime mortgage backed debt is often fingered as well — despite the fact that the vintages of mortgage backed securities that went bad were predominantly private label-issued. These arguments were discussed in this post).
What about derivatives such as mortgage backed securities (MBS’s), collateralized debt obligations (CDOs), and credit default swaps (CDS’s)? As we discuss in our book, these financial innovations certainly exacerbated the magnitude of the crisis. MBS’s and CDO’s certainly gave a mistaken impression of reduced risk even while concentrating it in financial institutions. Credit default swaps certainly gave the mistaken impression that investments in housing related securities were insured against defaults. All of these led to an underpricing of risk, and a transference of eventual costs to the public sector. But housing booms and busts occurred in other countries without these innovations. So in our view these developments exacerbated and widened the geographic scope of the crisis, but did not cause it.
Of the remaining, it would be hard to rule them out completely. Monetary policy was perhaps, in retrospect, looser than it should have been, based on the Taylor rule.  Whether this deviation caused the crisis is unproven in our view. The crisis occurred in other countries as well, some in regions with tighter monetary policy than that in the US (the UK, eurozone).
For us, we find key blame in a toxic and synergistic mixture of ample foreign savings, a profligate fiscal policy (EGTRRA, JGTRRA, Iraq, Medicare Part D), a debt-biased tax code, and most importantly regulatory disarmament.
Government policies enabled, catalyzed, and fueled America’s
crisis. The Bush administration’s tax cuts and spending splurge
drove the federal budget from surplus to deficit, beginning the
most recent cycle of foreign borrowing boom and bust. The Federal
Reserve’s excessively loose monetary policy encouraged households
to take advantage of very low real interest rates to embark on a
debt-financed consumption spree, with much of the debt borrowed
from abroad. Neither the government nor the households that did
the borrowing used enough of the borrowed funds to increase the
nation’s productive capacity and its ability to eventually service the
debt without sacrifice. Lawmakers disarmed financial regulators,
who in turn used few of the weapons left in their arsenals, allowing
financial institutions to develop new instruments that were largely
untested and wholly unsupervised. Financial institutions worked
madly to increase their profits in a low-interest-rate environment by
taking on ever riskier assets, insisting that they had mastered risks
they barely understood.
Any one of these policies might have gotten the United States
into serious trouble. Together they created a financial perfect storm,
driving the American economy to the brink of financial collapse and
dragging much of the rest of the world with it. (pp. 201-02)
Our treatment therefore departs from the Bush Administration’s overly simplistic view that the excess for foreign saving caused us to irresponsibly borrow — that is what I characterize as the “blame it on Beijing (and Seoul, and Riyadh)” view. Rather, as I wrote in Econbrowser on Christmas Day, 2008, there was a synergistic effect between these factors.
Regarding monetary policy, there seems to be a widespread consensus that it was too lax in 2002-04, this is a viewpoint made with the benefit of hindsight. As Orphanides and Wieland (2007) [pdf] have pointed out, according to the Greenbook forecasts, monetary policy was not — according to a Taylor rule framework — overly lax.
On the regulatory front, I think it’s important to not indict all deregulation (eliminating the Glass-Steagall barriers makes sense to me, while the Phil Gramm-sponsored Commodity Futures Modernization Act exemption of regulation of CDS’s does not). I outline some empirical research on what factors were important in this crisis in this post.
But clearly, regulatory disarmament/nonenforcement and “criminal activity” were important. Office of Thrift Supervision under the Bush Administration “helped out” IndyMac  , and how deregulatory zeal   metastatized over into criminal activities on the part of regulators and the regulated.
Fiscal profligacy is important because it pushed the economy more into a boom exactly at a time when not needed (i.e., near full-employment), and the tax cuts made people feel like they had more discretionary income than justified, thereby adding extra fuel to the asset boom.
Chart C: from Irons, Edwards and Turner (2009).
Finally, tax policy clearly provided incentives to borrow and leverage. In particular, I have been thinking about the tax deductibility on second homes, a provision dating back to 1997   . (Mortgage deductibility on a second home never made sense to me, let alone on a first home); see Capital Games and Gains, who highlighted this provision, citing a NYT article). I suspect that on its own, this provision wouldn’t had a big impact, but in combination with the other forces and distortions, it might have.
Typically, for ordinary phenomena, I would think of these factors adding up in a linear fashion, so that each of the impulses would sum to the total effect. But I think it’s worthwhile to think about lax monetary policy, deregulatory zeal and criminal activity/regulatory disarmament, and tax cuts and tax policy changes, all combining to lead to the “bubble” (in a nontechnical sense) or episode of Akerlof-Romer “looting”, and subsequent collapse we’ve witnessed.
Consider one example of a pernicious synergy: the 2001 and 2003 tax cuts were aimed at higher income households, while the second home mortgage deductibility benefited mostly higher income households ; with regulatory oversight absent, and low interest rates, the stage was set.
So, despite the outward trappings that seemingly differentiated the last crisis from previous ones, we can interpret the recent episode as yet another capital flow cycle: We borrowed from overseas, not only because of ample supplies of capital, but because government profligacy and the distortions in the purportedly “deep and liquid” (but actually under-regulated) financial markets.
Looking Forward, But Ignoring the Past?
Viewed through this historical lens, the hazards for policymakers are all too clear.
First, in our view, we are very much in danger of repeating the experience of 1937 , when monetary and fiscal authorities prematurely withdrew stimulus, and threw the US economy into a contraction of 3.5%.
Figure 1: Real GDP growth (y/y, log differences). Source: Johnston/Williamson, Measuring Worth and author’s calculations.
So in the short term, it’s essential that we maintain aggregate demand by not further cutting discretionary spending, especially since the fiscal problems we face are at the longer horizon involving the Bush tax-cut induced revenue shortfall and growing entitlement spending. That was the point of CBO Director Doug Elmendorf’s statement the other day before the deficit reduction supercommittee. In addition, we need to increase monetary stimulus, perhaps along the lines that Bank of England MPC member Adam Posen has argued: “…we cannot take our foot off the pedal….The outlook is grim — the right thing to do now is engage in more monetary stimulus.”
Second, turning to the longer horizon, we see equally daunting obstacles to preventing a replay of financial crisis. If one believes that highly leveraged and unregulated financial institutions and households were important, then one want to implement tighter standards and higher capital requirements. However, some have argued for a “just say no” approach to further bailouts. We believe that that approach will work as well in financial regulation as it did in drug policy, and really just covers for the naked self-interest. (See how finance was powerful enough to force Republicans to delete all references to Wall Street in the Financial Crisis Inquiry Commission report. ) As we note:
None of the changes necessary to avoid a repeat of this disaster
will be easy. At every turn there are major political obstacles. Financial
interests resist regulations that shift the burden of risky behavior
back onto them and off of taxpayers. Beneficiaries of government
programs fight against attempts to curb their benefits. Taxpayers
refuse to pay the taxes needed to pay for the programs they want.
Partisan politicians block reasoned discussion, suggesting absurd
pseudo-solutions instead of realistic alternatives. Ideologues and
political opportunists encourage Americans to cling to the childish
things that have served them so poorly in the past: a mindless
belief that markets are perfect, that tax cuts solve every ill, that borrowing
is to be encouraged. Despite the great trouble these policies
have caused, their attractions continue to be touted and spouted by
unprincipled pundits. (p. 221)
Hence, the challenge of avoiding a second lost decade is still a very real one.