Chinn and Frieden, and Posner on Origins of the Fall of 2008 Financial Crisis

I find substantial agreement about the origins of the fall of 2008 financial crisis between Menzie Chinn and Jeffry Frieden and Richard Posner.  I do not agree with all their conclusions, but I respect their analysis and give it serious consideration.  They find that large budget deficits during the Bush era, high leverage by firms in the financial sector, financial innovation and lax regulatory control were the culprits.  Chinn and Frieden write in "Reflections on the Causes and Consequences of the Debt Crisis of 2008," La Follette Policy Report, Vol. 19, No. 1, Fall 2009 (see also Chinn's post, "Reflections on the Causes and Consequences of the Debt Crisis of 2008" on Econbrowser) that

In late 2008, the world's financial system seized up. Billions of dollars worth of financial assets were frozen in place, the value of securities uncertain, and hence the solvency of seemingly rock solid financial institutions in question. By the end of the year, growth rates in the industrial world had gone negative, and even developing country growth had declined sharply.

This economic crisis has forced a re-evaluation of deeply held convictions regarding the proper method of managing economies, including the role of regulation and the ideal degree of openness to foreign trade and capital. It has also forced a re-assessment of economic orthodoxy that touts the self-regulating nature of free market economies.

The precise origin of this breathtaking series of events is difficult to identify. Because the crisis is such an all-encompassing and wide-ranging phenomenon, and observers tend to focus on what they know, most accounts center on one or two factors. Some reductionist arguments identify "greed" as the cause, while others obsess about the 1990s era amendments to the 1977 U.S. Community Reinvestment Act that was designed to encourage banks and other financial institutions to meet the needs of the entire market, including those of people living in poor neighborhoods. They also point to the political power of government-sponsored entities such as Fannie Mae and Freddie Mac, agencies designed to smooth the flow of credit to housing markets.

In our view, such simple, if not simplistic, arguments are wrong. Rather, we view the current episode as a replay of past debt crises, driven by profligate fiscal policies, but made much more virulent by a combination of high leverage, financial innovation, and regulatory disarmament. In this environment, speculation and outright criminal activities thrived; but those are exacerbating, rather than causal, factors.

In Posner's book, "A Failure of Capitalism," that I commented on here, he writes

So the market can be blamed for recessions, which without government intervention would often turn into depressions, as they often did before the government learned (we thought) in the aftermath of the Great Depression how to prevent that from happening.  But it doesn't let the government off the hook.  It failed to take timely and coherent measures to check the downturn.  The seeds of failure were sown in movement to reduce the regulation of banking and credit, which began in the 1970s.  They germinated during the Clinton Administration, when the housing bubble began and the deregulation of banking  culminated in the repeal of the Glass-Steagall Act (which had separated commercial banking from investment banking and it was decided not to bring the new financial instruments, in particular credit-default swaps, under regulation even to the limited extent of moving trading in swaps to exchanges, which would have given the public information about the scope, risks, and value of these investments.  Greenspan, Ruben, and Summers, the dominant figures in U.S. economic policy during the Clinton era, allowed the head of steam to build up that would eventually blow the housing and banking industry sky-high. 

But there might not have been a depression if not for the Bush Administration's mismanagement of the economy.  Bush cannot be criticized for having reappointed Greenspan as chairman of the Federal Reserve in 2004.  Greenspan had a towering reputation; it is only in hindsight that we can see that his reputation was inflated and after seventeen years in the post he had overstayed his welcome.  And Bernanke looked like a superb choice to succeed Greenspan in 2004, and probably was, though he went on to make grave mistakes...

Another mistake of the Bush Administration's management of the economy, though one the gravity of which is apparent only in hindsight, is the budget deficits of the Bush years, which so increased the size of the national debt.  So great was the national debt before the financial crisis hit that the economy will be hard-pressed to absorb the enormous expenditures that are being made in an effort to spur a recovery, without doing serious long-term damage to the U.S. economy. 

I accept the argument that the Fed's easy money policy contributed to the financial crisis.  I also accept the argument that the Bush administration's profligate spending contributed to the severity of the crisis and increased the difficulty of an effective fiscal response now.  The Bush deficits are even more egregious for those who believe that war expenditures were easily observed as unnecessary as the campaigns in Afghanistan and Iraq began.  Many liberal and libertarian economists warned of the difficulty of building democracy in those countries based on good empirical data.  It is hard to deny that high leverage contributed to greater insolvency of financial institutions as default rates increased.  I would like to read more about the role that new credit default swaps played; I simply don't understand it well.   

My largest disagreement with Chinn and Frieden, and Posner is their dismissal of active government regulation of Fannie and Freddie designed to increase home ownership.  Posner calls the government involvement, "pushing through an open door," meaning that the mortgage industry would have made these loans without government help.  They may be right but I would like to see an event study investigating changes in bank lending behavior as the Congress put pressure on the agencies to increase nontraditional lending.  I also believe that local practices authorizing building permits and building codes were at least an "exacerbating" factor in the crisis.  Many local governments limited permits and stiffened codes in ways that tended to increase the inelasticity of housing supply, setting the stage for large price increases and subsequent decreases in many of the cities that experienced the largest bubbles.

Before I draw a stronger conclusion about root causes of the financial crisis, I would like to see more evidence in several areas.  My prior beliefs make me doubt that the repeal of the Glass-Steagall Act had a negative impact.  Likewise, I would like more evidence linking weak enforcement through the SEC under the Bush administration to the financial crisis.