What really caused the financial crisis?

By Robert Samuelson

It is astonishing that, even though the global financial crisis occurred a decade ago, we do not yet have a clear and convincing explanation of its basic cause. To be sure, theories abound. Liberals blame Wall Street greed and lax government oversight. The conservatives’ villain is the government’s aggressive promotion of homeownership, which flooded the economy with bad mortgages.

Although these ideological explanations have some merit, the real story is more complicated and perverse. What ultimately caused the financial crisis was the economy’s very success. We had, it seemed, entered a new era of less risk. Believing this, Americans embraced more-risky behaviors which, once shunned, suddenly seemed justified by widespread optimism.

The paradox is plain: The faith that economic risk had declined inspired more risk-taking, because it seemed safe.

What prompts these thoughts is a new book, “Firefighting: The Financial Crisis and its Lessons,” by Ben Bernanke, Tim Geithner and Henry Paulson. You’ll recall that these three were major players in halting the crisis. Bernanke was head of the Federal Reserve, Paulson was George W. Bush’s treasury secretary and Geithner was Barack Obama’s treasury secretary.

The book is a CliffsNotes for the crisis. The 129-page text provides a lucid chronology, followed by nearly 100 pages of charts and tables. The authors no doubt hope that their narrative buttresses their reputations. Still, most of their analysis rings true, with one glaring exception: their theory of what created the crisis.

Here’s one passage, “The story of how the crisis happened is … about risky leverage, runnable funding, shadow banking, rampant securitization, and outdated regulation.” A rough translation: Lenders lent too much; borrowers borrowed too much; and arcane financial instruments stymied regulators from stopping the process.

This is the conventional wisdom. It’s also wrong, because it mistakes the crisis’s consequences for its underlying cause. The cause lay in the delusional beliefs that the economy had changed so much that practices that in the past would have been considered risky were no longer so.

Everyone drank the Kool-Aid, so to speak. Economists argued that the business cycle had smoothed. They called this the Great Moderation. Recessions would be shorter and less severe than in the past. This seemed to be confirmed by the decade-long expansion in the 1990s, the longest in U.S. history.

Another positive sign was the decline of double-digit inflation from 13% in 1980 to about 4% in 1982 — a success rightly attributed to then- Fed Chairman Paul Volcker and President Ronald Reagan. This calmed nerves and triggered huge increases in stocks, bonds and home values. In the 1980s, household net worth roughly doubled to $21.6 trillion, according to Fed data. In the 1990s, it doubled again to $42.8 trillion.

In turn, all this wealth creation fueled a consumption boom. Feeling richer, Americans saved less of their paychecks and borrowed more against inflated home values and investment portfolios. From 1980 to 2000, consumption spending rose from 61% of the economy’s output (gross domestic product) to 66%. In today’s dollars, that’s $1 trillion in added consumer spending.

There were other favorable omens. Or so it seemed. Global trade was strong. America was in the midst of a vast technological upheaval around internet technologies. Why not be optimistic about the future? It’s true that lenders lent too much and that borrowers borrowed too much, but the excesses were the new normal and could be rationalized in an economy that stayed close to full employment. Ever-rising housing prices would protect lenders because defaults would be covered by selling the homes.

And the mania extended well beyond housing. “If every subprime mortgage holder defaulted, the losses would be modest and easily absorbed,” says the Bernanke-Geithner-Paulson book. The trouble was that the whole financial system was caught up in a frenzy. Vast sums were to be made in many markets. Banks, borrowers, economists and regulators were all deceived by the same destructive optimism.

If greed (the liberals’ villain) or regulatory mischief (the conservatives’) were the chief cause of the crisis, then reform should be fairly easy. In their book, Bernanke, Geithner and Paulson make some sensible suggestions to reduce the odds of a future financial crisis and to handle it if one does occur. Many, if not most, of these proposals should be adopted.

But we should be realistic. The lesson of the financial crisis is that it wasn’t just the product of overzealous regulators or greedy capitalists. They played a role, but the larger role was played by the convergence of many forces that we understand only in retrospect and can control only with difficulty.

(c) 2019, The Washington Post Writers Group