Connecting Dots to Financial Crisis

June 10, 2010

By Chidem Kurdas

There are enough books about the events of 2008-2009 to fill a library. Nevertheless, there is no coherent framework that integrates the various factors in the dramatic boom-and-bust cycle that goes back to the late 1990s and may still be with us yet.  Bruce Yandle offers a welcome synthesis in the Independent Review, centered on trust-building devices and their dissolution.

Mr. Yandle identifies several market-generated mechanisms that created trust in credit instruments—ratings, accounting standards, credit default swaps. While  not specific to mortgage-related securities, these were used extensively to back up such securities as the property bubble expanded. Had the real estate market been relatively free from political meddling, the mechanisms would have likely remained intact.

But housing is catnip to politicians of all stripes. Bill Clinton’s “affirmative action” for housing set quotas for Fannie Mae and Freddie Mac to buy poor-quality mortgages given to low-income households. George W. Bush signed a law to channel more money in the same direction. Members of Congress – such as Barney Frank, who now presides over financial “reform” – pressed Fannie and Freddie to loosen mortgage standards.

What a show of bi-partisanship! All to bestow home ownership on families who could not afford it and in the long run would have been better off not overextending their credit, at a cost to taxpayers that boggles the mind.

Mr. Yandle argues that while those intercessions were necessary for creating the boom, they were not sufficient. To accommodate the political push for expanding home ownership, something else had to happen. That was the Federal Reserve’s easy money policy, starting in 2000 in response to the bursting of the 1990s stock bubble—itself arguably encouraged by the Fed’s rate cuts in 1998.

In any event, through 2005 interest rates remained low by past standards. Once the Fed started to tighten, people who had taken out adjustable-rate mortgages found that they made a mistake.  The air started to come out of property prices, mortgage-backed securities wobbled and that undermined ratings and credit default swaps.

Mr. Yandle’s contribution is to show how the policy pieces fit together in inflating the bubble. No single element would have been sufficient on its own, he says—the combination is what led to the financial crash. Among the policies that came to play was the government mandate that empowers the three rating agencies. Another was regulators’ requirement of credit default swaps to offset the risk of mortgage-backed securities held by financial institutions.

As long as money was easy and demand for housing grew in leaps and bounds, there were hardly any defaults—you could always refinance or sell your house for more than you paid. Therefore the danger lurking behind default swaps and triple-A ratings was obscured. These assurance devices, as Mr. Yandle calls them, were politically distorted and once the consequences showed up, trust disappeared.

The result is that government hierarchies and regulations are taking the place of market devices that created trust. Hierarchies and are regulations are blunt, expensive and – as endless examples demonstrate – often ineffective. However, all that may be a minor complaint compared to the damage to our liberty.

This is not a pleasant story and Mr. Yandle offers no help for our current predicament. His version may not be the full story, but it goes a way in knitting together the threads.

25 Responses to “Connecting Dots to Financial Crisis”


  1. Bruce is very solid and I will look at the piece. Thanks for alerting us to it.

  2. chidemkurdas Says:

    This crisis story is not yet an an end. News report today that investors continue to flee assets seen as risky and pile into gold and US Treasuries–
    http://online.wsj.com/article/SB10001424052748703627704575299102785958546.html?mod=WSJ_hps_sections_markets

  3. casuist Says:

    Coming soon to Canada too!—a huge housing bust I mean, only in Canada we have more of a tradition of trust in our beloved political classes.

    http://elenchics.wordpress.com/2010/06/02/canada-british-columbia-and-the-sovereign-debt-crisis-this-time-its-personal/


  4. […] Förlorad tillit Publicerade juni 11, 2010 Uncategorized Leave a Comment ska ha legat bakom finanskrisen, menar Bruce Yandle i detta papper i The Independent Review. Chidem Kurdas kommenterar. […]

  5. chidemkurdas Says:

    The Canadian situation is interesting. In the past year there was a lot about how Canada escaped the financial crisis–many commentators attributed this to greater regulation, others pointed out that Canada, like Australia, benefited from high commodity prices. What’s going on now suggests that the story is more complicated.

  6. chidemkurdas Says:

    Troy–Thanks for the links. just read your posts. One point you’ve made that doesn’t get the attention it deserves:
    “The manipulation of interest rates by the Federal Reserve sent false signals to the financial sector regarding the relative risks being taken by borrowers.”

    False signals were created by various other policies as well. For instance, the SEC endorsed the large rating agencies, giving them a special status that helped blinker investors to the limits of the ratings.


  7. Chidem,

    Good point on other false signals. That is an insight worth developing. The SEC led investors to believe it was protecting against fraud when it fact it wasn’t. (Think Madoff.) So investors were less wary than they would have been.

  8. Troy Camplin Says:

    Bottom line: false signals = false information. When people make decisions based on false information, they think they know what they do not know, and they necessarily make bad decisions. The spend when they should be saving, and vice versa. If our most trusted institutions are giving out false information, we will get what we got — and a loss of trust, since those institutions will have proven themselves untrustworthy.

  9. chidemkurdas Says:

    Jerry, indeed, the Bernie Madoff fraud is a dramatic example. The SEC examined the Madoff operation & found only minor, technical violations! Of course that gave the investors a false sense of security. I’ve written about this:
    http://www.thefreemanonline.org/departments/it-just-aint-so/regulation-will-stop-future-madoffs-it-just-aint-so/

  10. chidemkurdas Says:

    Nice summary, Troy. Brings us back to Prof. Yandle’s point that markets function on trust and trust was undermined by policies.

  11. Greg Ransom Says:

    It’s also true that the FBI et al assured investors that they were protecting against mortgage origination fraud when they weren’t.

    On my street in OC mortgage originators were paying criminals to sign $800,000-900,000 mortgage papers and live in the houses until they were repossesed.

    “The SEC led investors to believe it was protecting against fraud when it fact it wasn’t. (Think Madoff.) So investors were less wary than they would have been.”


  12. Greg’s point amplifies on what I wrote about in yesterday’s (6-14-10) Wall Street Journal. Big government is incapable of protecting its citizens.

  13. chidemkurdas Says:

    After all these debacles, you’d think big government would be rejected as the solution to any and all problems. But in fact the we’re getting an even bigger government. I must be missing something.


  14. Chidem — Special interests.

  15. Troy Camplin Says:

    Political power. Politicians regulate things in such a way as to create a crisis that causes them to blame the free market and regulate it some more. This is what they have resorted to when it became clear that violent revolutions didn’t really work.

  16. Pietro M. Says:

    Politics has little to do with efficiency, the common interest and reasonableness. The crisis was caused by wrong policies, and politicians gained power and influence because of their errors: this positive feedback leaves little hope of good policies, especially libertarian policies.

    As Hoover and Roosevelt gained power out of their errors, Bush and Obama got more power thanks to the “errors” of Greenspan, Bernanke, Fannie & Freddie, the SEC, etc.

    Democratic policies are not irrational: from the point of view of the few who are insiders, they are perfectly comprehensible. I don’t mean to believe in conspiracies: most likely Hoover was too ignorant of economics to understand that falling prices and constant wages are the recipe for disaster. But politicians had an opportunity, and seized it.

    Collective choice is a structural source of inefficiencies in our societies, and we have no effective means to limit its dangers except one: too much government destroys societies, thus reducing the amount of political rents the ruling elite can extract out of its political power.

    This internal constraint guarantees a minimum amount of liberty for the citizens in every society, although myopic and insecure elites can sacrifice their long-run rents for short-run stability, as Bush and Obama have been doing in the last years. A new Reagan will probably arrive when the elite will realize they need structural reforms, although at the moment we are accumulating bills to pay.

    External constraints (federalism, constitutions, non-legislated laws, autonomous social powers, economic autonomy and liberty, libertarian moral codes) are far less effective in checking power than the fact that liberty delivers much more than absolute power.

  17. Troy Camplin Says:

    On the latter, you are correct — with the exception of those who end up having the absolute power. We are a power-seeking creature (as studies of other social primates’ hierarchies show, considering having a high social position doesn’t allow monkeys or apes to breed any more than those with low social positions).

    Which leaves us with the ineffectual list you made.

  18. Pietro M. Says:

    I don’t like the German approach to explaining conflict: men seek power because they seek power. It’s methodologically equivalent to explaining business cycles with animal spirits. I think that the problem can be explained in terms of “invisible hand” public choice theory. Bastiat and Pareto reached very similar conclusions without assuming the conclusion.

    The question is why classical liberalism failed despite the inefficiency (and occaionally the horror) of its alternatives. I like to say, somehow drastically, that liberty is a public good and power is a public evil. Rules of the game go against liberty and in favor of political hierarchies. Several forces counter, partially, this process, otherwise we would all live in nazicommunist countries.

  19. chidemkurdas Says:

    ThinkMarkets comments are a great education. They’re always always intellectually stimulating. I love reading them.

    The key question in this thread: Why has classical liberalism failed? Of course, one could take a step back and ask whether it has failed or in what ways it failed. After all, it looked triumphal when the Soviet Union & satellite states collapsed. Now we have crony-nanny states and state capitalism.

    In any case, major forces undermine the object of limited government:
    Special interests — as Jerry reminds us
    Grab for political power by insiders — Troy’s point
    Lack of effective means to control that — Pietro M. points out

  20. Troy Camplin Says:

    It’s not the German approach — what I explained was what primate researchers have learned about primate politics. It’s all about power, nothing more and nothing less. They don’t get more food and they don’t get more mates. They just get the right to bully.

    Now, if we’re talking conflict, there certainly is more to it than power. But we weren’t talking conflict, we were talking politics. They’re not unrelated, but they’re not the same, either.


  21. […] Connecting Dots to Financial Crisis, by Chidem Kurdas […]

  22. Pietro M. Says:

    Troy: I said “German” because vitalistic ideas are found in Nietsche, Morgenthau, Schmitt, a literature I don’t know very well, however.

    My point is that society tends to excessive power instead of liberty because of public-choice problems. I agree that there are also instincts, cognitive biases, etc, making the outcome even more likely.

    Human instincts are pro-rape, pro-power, pro-socialism, pro-collectives and pro-war, I know. But this doesn’t prove much. We have culture to go beyond ferality. We have created institutions and morals to check our instincts. We have the benefits of cooperation to exploit and force on us the unnatural discipline of legality, tolerance and openness.

    True, centuries of civilizations can be wiped out by decades of propaganda, but as long as peoples’ interests are for security we shall assume that on average there are strong incentives to constrain our instincts and reap the benefits of social cooperation.

    Besides, humans usually remain calculative also when they are utterly amoral: Stalin was great in realpolitick. Masses are often mad, leaders are much more seldom so: masses have no incentives to be rational in politics (as argued by Caplan), but leaders have: political rents are their profit systems. Arabs often learn about Jewish world conspiracies since childhood, but because Arab leader need antisemitism for their interests. Hate propaganda is often a rational investment in mass irrationality (I must admit that Hitler wasn’t that rational in some cases).

    Decades of propaganda are necessary to justify savagery once moral principles have been introjected. Germans needed to be exposed from the early childhood to jew-hatred to learn how to hate them properly. A huge mythology of conspirations was needed, fear of aggression and extermination were raised to stop the prefrontal cortex from constraining human behavior and numbing moral sense.

    A theory of society which can’t explain how society can work is not a theory of society.

  23. chidemkurdas Says:

    The rationality question is complicated. Individuals may be motivated by an instinct to pursue power as an end in itself. But they go at that pursuit more or less rationally. “More or less” is the operative term.

    In retrospect some of the choices made by historical figures look crazy. Why did Napoleon invade Russia? What was he thinking? It destroyed most of his army. But in the political setting he had created and benefited from, it must have looked like a reasonable, if bold, decision.

  24. Troy Camplin Says:

    I disagree that human instincts are “are pro-rape, pro-power, pro-socialism, pro-collectives and pro-war”. Rape is a mating strategy for individuals with less-than-desirable personalities to begin with. We are a social mammal, not a social insect, so we are not really pro-socialism and pro-collective in our instincts — even though our pro-social instincts (which are anti-rape, btw) can be directed toward socialism and collectivism. And humans are not necessarily pro-war so much as pro-protect-my-people-and-territory, which may involve preemptive strikes (as chimpanzees and G.W. Bush demonstrate(d)). I do agree that we are still pro-power, but that can be directed in many ways. One of the worst and most destructive is politics.

    It is out social nature that resulted in our “legality, tolerance and openness.” Darwin himself talked about how this happens, that our family- and tribal-feelings get applied to ever-larger groups of people. Our brains are also generalist in nature, allowing us to adapt to a wide variety of natural environments, and also to larger social groups as well. We accept people into our “tribes” as we get to know them, people who look like them, etc. The same neurotrasmitter that creates group conflict also creates social bonds (oxytocin, as revealed in the most recent Science). If people present themselves as nonthreatening to ourselves and our group, we tend to trust them and, eventually, accept them into our group. As Matt Ridley pointed out in “The Rational Optimist,” this oftentimes comes about via trade.

    So human sociality is an instinct as well. We are full of instincts — some apparently contrary to each other. the good news is that the pro-social (which are opposite of pro-socialist) instincts keep winning out. Mostly.


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