(Dear Reader: This post is in response to requests that we have received from some of my younger readers to summarize my views on the causes of the financial crisis of 2008 and 2009. I have already commented on many of these factors but I have never pulled them together into a single narrative. That is the point of this blog. This material may be obvious to some of my readers, particularly those who, like me, lived through the financial crisis and the bubble era that preceded it. In addition, because this is a huge subject and because I have elaborated individual arguments elsewhere, this will also be a more “flyover” approach than my typical posting. With these small caveats, I hope you find this helpful.)
Let me start by debunking some popular myths: these things certainly didn’t cause the financial crisis:
Greed is a meaningless explanation. As I have commented before, blaming the financial crisis on greed is like blaming airplane crashes on gravity. Greed and gravity are always present. The real question is why greed (or self-interest), which is normally channelled into productive activity by a free-market economy, periodically becomes pathological. This is almost always due to the malign influence of the government. This is not to say that private actors are incapable of stupid actions. But in order to generate the type of widespread stupidity that can cause a crisis, we must look for an equally widespread cause. This is almost always the government.
De-regulation did not cause the financial crisis. As I describe in the Martin O’Malley section of this post, there was no real deregulation and, in any case, the repeal of Glass-Steagall was a complete non-event for the financial crisis. This is a pure figment of the liberal imagination. Also, as I argued in “Doping and Banking,” regulation is almost always too little and too late to have any real deterrent effects, particularly when it focusses on an easily gamed rule book instead of focussing on incentives.
But, then, what did cause the financial crisis? It was a combination of the following factors:
Federal Reserve interest rate policy was the foundation. The Federal Reserve followed extremely lax monetary policy following the emerging markets crisis of 1997-1998, the “Y2K” scare of 1999-2000 and the collapse of the dot-com bubble in 2001-2002. The response of the Fed to each of these events was a “hair of the dog that bit you” policy that maintained artificially low interest rates for extended periods of time. In addition, this period saw a tremendous expansion of globalization. This opening of new sources of world supply would have naturally created a benign retail price deflation had not the Fed resisted it through expansionary monetary policies, adding more fuel to the fire.
The end result of these policies was to create a “stretch for yield” and a “wall of money,” two phrases widely heard in the period before the crisis (as they are, sadly, now), that overrode the normally prudent behavior of investors. Many have blamed Wall Street for creating and selling risky products such as sub-prime mortgages, CDOs, HELOCs, and the rest of the menagerie. These critics ignore the demand side of the equation. If investors had not been made desperate by the artificially depressed rates offered by safer investments and the need to invest large monetary inflows, they would not have purchased these investments en masse. I witnessed this in person from my seat on the trading floor. (This argument is made, in a more recent context, in The Fed Decision section of this post.)
The fragility of the banking sector was a major factor. Once the bubble started to pop, its effects were greatly magnified by the weaknesses in the banking sector. This can be seen in the differential impact that the bursting of the dot-com and the real estate bubbles had on the real economy. The dot-com bubble had only a minor impact compared to the bursting of the property bubble because the banking sector was only slightly involved with the former.
The weaknesses in the banking sector are also largely the result of bad government policy. As I have argued in “Jamie and the Whale,” the fragility of our banking system is not a free-market phenomenon. Our system of Federal Reserve backstops, deposit guarantees and the reality of “too big to fail” create the conditions for excessive risk-taking, excessive leverage and insufficient liquidity in our banking system.
Once the banks got into trouble, the problems were exacerbated by the poor legal system for dealing with insolvent or bankrupt banks. As I have argued in “It Is Risen: A Dead Bank, Revived,” we need a more rational system of insolvency and bankruptcy for banks, one that quickly separates the “good bank” (including most of the routine banking and payment activities) from the “bad bank.” This will avoid the interruption of services to the public but will, unlike the bailouts practiced during the financial crisis, suitably assign losses to the shareholders and creditors of the bank. Knowing that they will bear the consequences of bad decisions, shareholders and other investors will exercise greater control over bank management. A clearer system of insolvency and resolution will also help avoid the “freezing” of the interbank markets that was a major feature of the financial crisis.
Bad government regulation and policy was a major contributor to the sub-prime bubble. This took many forms. Fannie Mae and Freddie Mac, both quasi-governmental entities, were under huge political pressure to expand mortgage lending, including to borrowers who were fundamentally unsound; they were the buyer for a large percentage of the sub-prime loans that were created and, through their enormous size, set the competitive tone for the entire market. Other regulations (such as the Community Reinvestment Act) pushed in the same direction, particularly for banks that were expanding rapidly and required government merger approvals. The outsized role of the rating agencies, which completely failed as gatekeepers, was also largely the result of government regulations which required their use and gave them an undeserved credibility. Finally, tax policies such as the deductibility of interest strongly encouraged over-indebtedness through the economy, including the mortgage sector.
The financial crisis is a tremendously complicated subject and there could very well have been other factors involved. Each of these factors is also debatable, although I think their opponents would lose the debate. If I could claim a certain answer to this question, I would have already visited Stockholm to pick up my Nobel Prize. However, these are the elements that I would emphasize. I certainly feel that this is a far more compelling explanation of the crisis than the one that is commonly given.
Weybridge, United Kingdom
 The best writer/speaker on this subject is Peter Wallison of the American Enterprise Institute. Wallison was a member of the Financial Crisis Inquiry Commission, a commission set up Congress to investigate the causes of the crisis, but he dissented from its final report. Here is a podcast that he did with Tom Woods on this subject and here is a review of his book, Hidden in Plain Sight, which discusses both the financial deregulation point and the point about how government housing policy produced risky lending. The Cato Institute also has a very good analysis of this subject entitled “The Repeal of the Glass-Steagall Act: Myth and Reality.”
 Another factor was that the wealth effect of the bursting of the property bubble was much more widespread than the bursting of the property bubble. This was particularly dramatic because, due to the mortgage market (including second mortgages), the borrowing capacity of property wealth was significantly higher than for stock market wealth. These two factors meant that the bursting of the property bubble had a much bigger impact on personal consumption.
 The Financial Times has just published an article entitled “Do lenders of last resort actually make the financial system safer?” Short answer: no.
 For example, a common apologia of the central bankers is that the housing bubble was caused by an excess of world savings and not monetary policy and credit creation. Libertarian economist Bob Murphy does a good job of discrediting this argument here.