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 While the business cycle cannot be repealed, a crisis of this magnitude need not have occurred.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.