“Rotten Institutions” or “Blameless Bubble”?

The report of the US Financial Crisis Inquiry Commission was released last week to controversy and criticism.   The report contains a wealth of information and is interesting reading even for those whose interest is mainly in our own financial crisis.  Much of the story has been about the partisan squabbling since the report’s release, with the Commission failing to agree on the final product.   Republican commissioners issued two separate dissents to the “majority” report (see here for the dissent of Hennessy et al.).    This just underlines how politicised the narrative of the crisis has become.   Strangely enough, though, I find the duelling perspectives actually add a useful analytical edge – otherwise lacking – to the report.  (Update: See here for an interesting discussion at the NYT.)

Anger at our government is probably too raw to have a much of a productive debate until after the election.  But to draw the proper institutional and policy reform lessons, it will be useful to similarly consider the competing extremes of the “rotten institutions” and “blameless bubble” explanations for the crisis, and to explore where the truth lies.  

Some short extracts follow after the break to give a flavour of both the majority report and the dissent.

Extract from the majority report (pp. xvii – xviii):

We conclude this financial crisis was avoidable. The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public. Theirs was a big miss, not a stumble. While the business cycle cannot be repealed, a crisis of this magnitude need not have occurred. To paraphrase Shakespeare, the fault lies not in the stars, but in us.

. . .  

We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts, in no small part due to the widely accepted faith in the self correcting nature of the markets and the ability of financial institutions to effectively police themselves. More than 30 years of deregulation and reliance on self-regulation by financial institutions, championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have helped avoid catastrophe.

 Extract from the Hennessy et al. dissent (pp. 415 – 416)

The majority says the crisis was avoidable if only the United States had adopted across-the-board more restrictive regulations, in conjunction with more aggressive regulators and supervisors. This conclusion by the majority largely ignores the global nature of the crisis. For example:

• A credit bubble appeared in both the United States and Europe. This tells us that our primary explanation for the credit bubble should focus on factors common to both regions.

• The report largely ignores the credit bubble beyond housing. Credit spreads declined not just for housing, but also for other asset classes like commercial real estate. This tells us to look to the credit bubble as an essential cause of the U.S. housing bubble. It also tells us that problems with U.S. housing policy or markets do not by themselves explain the U.S. housing bubble.

• There were housing bubbles in the United Kingdom, Spain, Australia, France and Ireland, some more pronounced than in the United States. Some nations with housing bubbles relied little on American-style mortgage securitization. A good explanation of the U.S. housing bubble should also take into account its parallels in other nations. This leads us to explanations broader than just U.S. housing policy, regulation, or supervision. It also tells us that while failures in U.S. securitization markets may be an essential cause, we must look for other things that went wrong as well.

• Large financial firms failed in Iceland, Spain, Germany, and the United Kingdom, among others. Not all of these firms bet solely on U.S. housing assets, and they operated in different regulatory and supervisory regimes than U.S. commercial and investment banks. In many cases these European systems have stricter regulation than the United States, and still they faced financial firm failures similar to those in the United States.

These facts tell us that our explanation for the credit bubble should focus on factors common to both the United States and Europe, that the credit bubble is likely an essential cause of the U.S. housing bubble, and that U.S. housing policy is by itself an insufficient explanation of the crisis. Furthermore, any explanation that relies too heavily on a unique element of the U.S. regulatory or supervisory   system is likely to be insufficient to explain why the same thing happened in parts of Europe. This moves inadequate international capital and liquidity standards up our list of causes, and it moves the differences between the regulation of U.S. commercial and investment banks down that list.

21 thoughts on ““Rotten Institutions” or “Blameless Bubble”?”

  1. @JMcH
    The “dissenters” like many here see no link between the crisis in the US and our own “home-grown” crisis and other European bubbles. Mainly in the Irish case because the lending here was at the bottom level while in the US the proliferation of derivatives and securitizations helped multiply the effects of subprime lending.
    This is to ignore the source of the massive amounts of credit which were flowing into the banks here. The collapse of Lehman Bros – some say luckily for us but it is hard to see how much worse things could have got if the property bubble gad been allowed to expand even more – the links to the US crisis became obvious.

    BTW did you “embolden” all the earlier posts when posting this or is it something in my machine?

  2. Institutions in Ireland from the central bank to the regulators and the planning authorities were rotten in that they had a philosophy of supporting the “right” types.

    Standard procedure was that legislation was either not known (I’m not joking) or simply ignored if it was not helpful to powerful of sufficiently connected interests.

    In a bubble these interests become magnified so the rottenness of the institutions magnifies the bubble and certainly in Ireland’s case they are inseparable from it.

  3. History is written by the winners.
    This crisis was caused purely and simply by money lenders – people with way more greed than talent.
    This is a crisis as old as humanity itself. Even the Bible has specific rules re credit. Though they may resist the old-style jubilee is not as far fetched as it might seem – nowadays it’s just called restructuring

  4. AMcG
    Thanks for pointing out the “emboldening”. I am impressed I was able to do that; and even more so that I was able to undo it (or at least I hope I have).

  5. Glad to be of service John. Is this an example of what you economists call the law of unintended consequences?
    Eoin Bond recommended a book by Michel Lewis on the US subprime crisis and the expansion of the CDS and CDO markets. I have read it recently and I suspect it will make more sense than ploughing through many reports.
    The most frightening thing was the lack of understanding many of the sellers and purchasers of these products had. The ratings applied by the agencies in were meaningless. AIG sold CDS on products without any regulation – since it wasn’t classified as insurance – or any understanding of the products they were insuring. The bilout of AIG possibly saved GS from collapse. And the driving force for the big banks was massive bonuses,
    In Fridays Irish Times (Innovation Supplement) William Cohan has a piece called “Bigger, Badder, Bolder – It’s the return of Wall St” where he predicts that since nothing in the bonus culture has actually changed despite a lot of talk, the same thing will happen again and very shortly.


    Yet another scary thing is that the

  6. This moves inadequate international capital and liquidity standards up our list of causes

    But is this in itself not the result of inadequate regulation…?

  7. Ignore that last line.
    I guess one of the common elements between what happened in the US and on this side of the bond, was what was identified by both Michael Lewis and William Cohan as “the bonus culture” . To facilitate this, in the US the big financial partnership were all eventually floated on the stock exchange.
    As here shareholders are bottom of the food chain and TBTF ensured that the top execs loot was protected.

    William Cohan again:

    “The denouement of this unprecedented transformation of Wall Street was the loss of the old partnership ethos – where the fear of financial disaster kept the firms small and the risks by-and-large prudent – and the triumph of a new bonus culture.

    Suddenly, instead of being rewarded to generate pre-tax profits – from which the partners would get paid – Wall Street’s best and brightest were rewarded to generate revenue, from which they would get paid larger and larger bonuses regardless of how the firm as a whole performed. In the new bonus culture, Wall Street firms paid out between 50 per cent and 60 per cent of every dollar of revenue generated in the form of compensation to its employees. “

  8. It’s simple really.

    On issues like this, there is never one factor alone, which triggered an outcome.

    People pick the issue that suits them, as a rationalisation.

    The Fed, the euro, venal politicians, greedy bankers/voters, incompetent regulators, broken systems, accountability and so on.

    There is an old Chinese saying which suggests where the primary focus should be: A fish rots from the head down.

  9. Mr. Hennessy and Als dissent would have more weight if he was not arguing that many european institutions were as rotten as their US counterparts. It is instructive to look at where there wasn’t a property bubble, Germany for example, and then to see what the Germany banks did with their cheap money – they bought rubbish elsewhere, fuelling other bubbles. All ignored by light-touch regulation pretty much everywhere.

    It is an ideological failure of the FIRE economy. The ignorance that created it dies hard…

  10. The dissenting view quoted is undermined by the obvious fact that poor financial regulation was also at the heart of the European crisis, from Anglo, AIB and BoI to the Landesbanks and Cajas. Our own banking crisis would have been little more than a very big storm in a small teacup if banking regulators across the EU had not been asleep at their posts, or worse, allowing the system as a whole to become extremely fragile.

  11. At the base of this economic and financial debacle in the developed economies is a profound failure in the institutions and procedures of governance and publc representation. I know it’s considered rude to mention the word in polite company, but those at the commanding levels of the capitalist system – and, particularly, those at commanding levels in financial capitalism – proved extremely adept at suborning the state directly and, indirectly, at perverting naive policy desires (e.g., in terms of expanded home ownership) to advance their own interests. In this they were well assisted by many academic theorists acting as ‘useful idiots’.

    Capitalism will do what capitalism is there to do – and that is to make money – loadsamoney – for those who exercise economic and political power. Condemning those who operate within this system for behaving the way they do – or, even worse, naively expecting them to behave differently – is similar to condemning a lion for stalking and killing a zebra.

    Shackling the beast that is capitalism to compel it to generate economically and socially useful outcomes requires effective governance and efficient markets. Capitalists loath both in equal measure – and have succeeded in subverting the former and undermining the latter.

    Citizens in all developed economies were lulled into a false, but very comfortable, sense of security during the ‘Great Moderation’. They are now, very slowly, becoming aware of the ‘Great Deception’ to which they have been subjected as the private debts and losses of the capitalist sytem are being socialised in sovereign debt. But the awakening is partial, because those who retain employment and some measure of their accumulated wealth will strain every sinew to defend these advantages and to ensure that the burden is imposed on those who don’t enjoy these advantages. This is only to be expected.

    There is a long way to go before citizens in the developed economies realise the extent to which they are being oppressed – even if it is a relatively comfortable oppression – and compel the necessary changes in governance and economic organisation. The comfort of the oppression is in stark contrast to the brutal oppression that finally provoked the citizens of Tunisia and Egypt – and may provoke others – to say ‘no more’. It may be that the sense of having too much to lose and political exploitation of divisions among economic and social groupings may suppress the mood for reform, but I sense it will not be suppressed indefinitely.

    This is the narrative that the politicians on the US Financial Inquiry Commission have either sought to suppress (the minority dissent) or to pervert for partisan, factional purposes (the majority report). It’s only a holding job. The truth will out eventaully.

  12. @hoganmahew: “It is … [the] failure of the FIRE economy.”

    Correct response. Economy of words is best, though PH’s longer comment is more explanatory. Lets see what sort of reforms we are ‘permitted’.

    I have a suspicion that the elevated costs of energy will have a far more devastating effect on developed economies. We will simply never be able to service debt beyond a very modest level. Eureka’s comment above, mentioned something that I referred to several times in some of my earlier posts – ‘an olde-style Jubilee’ of debt forgivness. Its inevitable.


  13. Re “Some nations with housing bubbles relied little on American-style mortgage securitization.”

    Although securitisation may have amplified the US bubble, it was an effective form of risk transfer. Investors holding this crap have taken the hit.

  14. I think the failure had many fathers. There were too low interest rates which drove money into riskier assets. There was a cult like belief amongst the elite that a new way of managing the economy away from boom and bust had been found. There were too many naive house buyers with no choice. There was wage stagnation and inequality that turned many people to debt to keep their standard of living up. There was regulatory capture. There was nobody in charge. Above all there was endless expansion of debt. There was chronic mispricing of risk. There was an overdependence on fabulously complicated models that only had data going back 5 or so years. There was the Efficient Markets Hypothesis. There was flogging the dead horse of economic growth to death. There was the exponential function . And ultimately it was the emperor’s new clothes for the internet generation.

  15. People of Ireland – please give the following American video on Ireland a listen (dated February 1, 2011).

    Bill Still actually went to Iceland and advised them on what they should do. But this video is an interview of Karl Denninger (an American blogger) who goes over the ramifications of defaulting, what will eventually happen to the Euro anyway, and why Ireland needs to default on its debts now.


    A Canadian friend.

  16. The extract from Henessy et al relies on faulty logic. It is possible for similar events to occur without all the conditions are identical. Therefore I believe that it is entirely possible & in my opinion correct to say that securitisation (passing on the Malus) was a significant factor in the US.

    Bonus was given to the issuer of the loan while the issuer passes on all the risk (Malus) for a share of the profits. That behaviour could, should & probably did make some buyers of subprime-debt vary. Enter economists who believe (-s or-d?) they can accurately model the economy & suddenly there is risk-free profits available! Investors (people) like the idea of getting money for nothing and when someone wants to believe they are easily deceived. Consequently they were deceived (or deceived themselves) and therefore they bought something they shouldn’t have.

    As long as it is possible to get a bonus for an action taken without risking malus for the same action then there will be a strong likelihood that the action will be taken. Game-theory would indicate that the action should (& probably will) always be taken.

    -> in the US that led to lots of loans being issued
    -> more resources were funneled into the bubble
    -> as long as resources are being fed into the bubble it won’t deflate
    -> bubble inflating even more
    -> the bigger the bubble, the bigger the fallout when it bursts
    -> securitisation was a major factor in the US.

    With securitisation it is possible to separate bonus from malus. Without securitisation then anyone issuing a loan has to carry all the risk. If the issuer of the loans believes in the formulas used to price risk then the issuer can of course base his/her lending decisions on that formula & get all the profits for themselves (& also all the losses).

    As long as there is securitisation there will be an arms race between issuer & buyer: -The issuer wants a high price -> high complexity to hide the bad stuff using complex models.
    -The buyer wants a low price -> want to find the bad stuff the seller is trying to hide using the complex models.

    The only winner is the ones supplying the arms – The finance & economic professionals (& firms) specialising in complex & ultimately unverifiable (until after the fact) models.

  17. Did the Republican minority dissent really claim it was a “blameless bubble.” If so, wow! The freshwater tradition lives on in the Republican Party.

    To be fair it is also notable how the main report (synopses that I have read) gives so little mention of the key destabilizing role of aggressive policies by government and quasi-government agencies to push minority and low-income mortgage growth that was unsustainable and unwise. I disagree with Krugman on this point; he also underplays it.

  18. We learn from history that we learn nothing from history (Hegel or Shaw – Google can’t make up it’s mind!
    The Davos economists are nothing if not hubristic:

    ““The whole world’s going to be rich by the end of this century,” according to Edward Prescott a senior monetary adviser to the Federal Reserve Bank of Minneapolis who shared the 2004 Nobel Prize for analysis of business cycles and economic policy. ”

    Maybe he means the last few standing after armageddon!

  19. Failure to understand was everywhere because, as the quote goes ” it is extremely difficult to make someone undertand something when their livelihood depends upon their not understanding”….

    We can blame governments that failed to regulate but then we say but government was captured by financial interests. We can blame the structure of banks that limited losses and shifted the bonus culture to revenues and away from profits. But if you believe that risk has been offloaded efficiently through efficient market instruments, how can that model be wrong? We can blame economists, most notably Keynes who said that “in the long term we are all dead” but failed to point out that, while correct for individual people he was badly wrong for nations. I think it was Tallyrand that said that while individuals can often escape the consequences of their sins in this life we must hope that they are trwated with justice in the next. Nations always pay for their sins in this life because they survive longer and the consequences of their mistakes come home to roost on them,

    Finally, paper money is to blame..the gold standard was suspended in the early 1970’s and within less than half a generation, world governments were printing more money than the real economy needed, we see that is falling interest rates and while economists can point to falling inflation to deny this, they can only do that credibly if they ignore asset prices.

    We are witnessing the death of an economic model with all of the philosophical confusion that surrounds it. The days when we could print money and regulate away the barriers to more debt are ending. I wish I had a clue about what the next framework will be.

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