Was the it the models, the expectations, correlated risks, non-transparency, dangerous financial innovation, or weak regulations?
It was probably all of the above, but recently it has become clear that the banks caused it as well.
While people have long observed that mismatched incentives, poor models, and lax regulation allowed and encouraged the banks to make mistakes, it has only recently become clear that some banks (+ hedge funds, etc) helped create the crisis by stimulating investment that fed the housing bubble so they could bet on it bursting. Specifically, those who were betting on a housing bust enhanced the bubble by creating Collateralized debt obligations (CDOs) they wanted to bet against. By continually creating and buying these CDOs they almost certainly enhanced the bubble, causing a bigger burst and made more money on the bust. The extent to which this actually promoted the bubble has only recently become clear.
The US radio show This American Life has an informative show on how non-transparent couplings between credit default swaps allowed caused the contagion that was critical to the financial crisis – Another Frightening Show About the Economy. You can listen to their show online or download an MP3 file.
Also see economist Paul Krugman on the financial crisis here and with a longer analysis here. He also posts a revealing graph which shows the how the strength of the coupling between the US and the rest of the world’s (ROW) economies has increased over the past thirty years.
The US TV show 60 Minutes has a 12 min. segment on the “Shadow Financial System“. The segment charges the managers of investment banks with criminal incompetence.
Also, the New York Times, a critical look at the deregulation of financial markets under the US Federal Reserve chairmanship of Alan Greenspan. Taking Hard New Look at a Greenspan Legacy
“Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.” — Alan Greenspan in 2004
As John Maynard Keynes is alleged to have said: “When the facts change, I change my mind. What do you do, sir?” I have changed my mind, as the panic has grown. Investors and lenders have moved from trusting anybody to trusting nobody. The fear driving today’s breakdown in financial markets is as exaggerated as the greed that drove the opposite behaviour a little while ago. But unjustified panic also causes devastation. It must be halted, not next week, but right now.
The time for a higgledy-piggledy, institution-by-institution and country-by-country approach is over. It took me a while – arguably, too long – to realise the full dangers. Maybe it was errors at the US Treasury, particularly the decision to let Lehman fail, that triggered today’s panic. So what should be done? In a word, “everything”. The affected economies account for more than half of global output. This makes the crisis much the most significant since the 1930s.
