Taxonomy of the Financial Crisis

Tue, 23 Sep 2008 19:14:42 +0000

I do not object to the thrust of the arguments in Barry Eichengreen's post, "Anatomy of the Financial Crisis." But I do object to the language he's using to explain what happened. This passage contains a number of examples, which I have highlighted:

In response, investment banks to survive were forced to branch into new lines of business like originating and distributing complex derivative securities. They were forced to use more leverage, funding themselves through the money market, to sustain their profitability. Thereby arose the first set of causes of the crisis: the originate-and-distribute model of securitization and the extensive use of leverage.

It is important to note that these were unintended consequences of basically sensible policy decisions. It is hard to defend rules allowing price fixing in stock trading. Deregulation allowed small investors to trade stocks more cheaply, which made them better, off other things equal. But other things were not equal. In particular, the fact that investment banks, which were propelled into riskier activities by these policy changes, were entirely outside the regulatory net was a recipe for disaster.

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You can call this Samwick's Second Law if you like (the first is here):

Risky debt does not kill financial institutions. The misuse of risky debt kills financial institutions.

This is not an episode of 24. A nuclear bomb will not detonate in less than an hour if an investment bank fails to pursue yet one more opportunity to borrow short & liquid to invest long & illiquid to make more expected profits. Nobody was forced to do anything. Nobody was propelled into any activity. Choices were made.

The absence of adequate regulation does not excuse the choices or implicate taxpayers or their elected representatives in covering the losses of financial market participants on an ad hoc basis.

Those elected representatives are now listening to experts and taking their cues from what they hear as to how to clean up the mess. Experts need to keep the language clear.