Tuesday, April 14, 2009

Roots of the Financial Crisis

Many conservative people share a concern about the recent level of borrowing, and blame excessive borrowing and lax credit standards for the current financial crisis. What seems to trouble them is not just the borrowing itself, but the lack of prudence suggested by the vast increase in borrowing from historical standards. The underlying suggestion is that a greatly increased flow of credit means that there's something seriously wrong; probably, that someone isn't watching the store. But this reading of the data is mistaken. It doesn't take into account the fact that there are excellent reasons why both lenders and borrowers can now expect repayment with far more good reason than was the case a generation ago, and accordingly lend and borrow more than used to be possible. Both lenders and borrowers today enjoy a vastly improved ability to predict financial behavior and to reduce the risk of failure.

It probably sounds idiotic to say this now, but the reality is that even the improvements that make a greater flow of credit reasonable, even those improvements, cannot overcome the kind of faults that created the current mess. Those faults come down to 3: the improper alignment of financial incentives within the financial industry, particular the part dealing with mortgages; the massive growth of key financial institutions, which renders them at the same time "too big to fail" and too big to govern; and the decline of regulation for ideological reasons since Reagan's presidency, culminating of course in the ideologues of W. Bush.

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