I just finished watching the documentary Hank: 5 Years from the Brink and got motivated to flesh out my understanding of the 2008 financial crisis again. The film was largely focused on the response to the crisis, but I thought it interesting that the makers didn't highlight the increase in the interest rate undertaken by the Fed not long before the economy started crumbling. In keeping with typical operations of the Fed, that sort of rate hike would have been in response to a sense that the economy was overheating - in or entering a bubble - and needed to be reeled in before it got too carried away. At that point the rate had been low for years - an enduring response to the bursting of the Dotcom bubble - which fueled the housing boom.
In retrospect we can easily say that it would have been more appropriate had the Fed raised rates much sooner. That gets us into considerations of ego and other interests in Fed operations. Fed chairmen want to reign over a flourishing economy, as do other officials who have influence on them, not least the President. Even the desire to see one's own investments perform well constitutes a conflict of interest. I've actually never seen anyone speak to that, as though Washington decision-makers should be rich enough that their own financial livelihoods wouldn't enter into play in open market operations. It's this fallible discipline and at least potential conflict of interest that lends support to arguments for abolishing the Fed. At the same time, the cause of the crisis was multifactorial. A big issue in responding appropriately to any situation is information, and the way in which subprime mortgages were securitized made it difficult to divine the actual circumstances we faced.
The multifactorial nature of the crisis is covered well in Fault Lines, a book by Raghuram G. Rajan, a former IMF economist. He goes into the distortions in the financial industry, where banks are (still) too big to fail, and the incentives lopsided. Failure goes unpunished, not just at the level of the market, where institutions have been propped up, but within those institutions as well. However, success is, particularly at the higher levels, exorbitantly rewarded. At the same time, Rajan goes into other aspects of the financial system that predispose it to crisis. Freddie Mac and Fannie Mae, complicit in the crisis, are a response to a society with a weak social safety net where that's been compensated for in one of the only political viable ways: promotion of often unsustainable private home ownership. He also points to global aspects, notably the high savings right in China that translated to global capital looking for a place to nest with good returns, such as subprime mortgage-backed investments.
By the end of the documentary, former treasury secretary Hank Paulson asserts that eventually we'll have another financial crisis - this is the nature of markets - but that we now have better mechanisms in place to mitigate the effects. He points to higher capital requirements and Dodd-Frank. The former no doubt cushions the system from calamity but the latter has been described by The Economist as a convoluted piece of legislation -- over a thousand pages long. In keeping with that observation my impression is that it's introduced complexity and hasn't actually made the work of regulators easier or more empowered. That, the historically low interest rates we've had for approaching a decade, and the fact that the banks that were too big to fail are now only bigger fill me with concern. I wouldn't be surprised if the next turn of the market exhibits the same severity of effects as the last crisis. In examining the historical frequency and severity of financial crises, Elizabeth Warren has made a strong argument that the now expired Glass-Steagall Act, which separated commercial and investment banking, played a critical role in staving off disaster. Reinstating that sort of legislation is one of the only options I see available for minimizing the risk of cataclysmic crises in the future.
In retrospect we can easily say that it would have been more appropriate had the Fed raised rates much sooner. That gets us into considerations of ego and other interests in Fed operations. Fed chairmen want to reign over a flourishing economy, as do other officials who have influence on them, not least the President. Even the desire to see one's own investments perform well constitutes a conflict of interest. I've actually never seen anyone speak to that, as though Washington decision-makers should be rich enough that their own financial livelihoods wouldn't enter into play in open market operations. It's this fallible discipline and at least potential conflict of interest that lends support to arguments for abolishing the Fed. At the same time, the cause of the crisis was multifactorial. A big issue in responding appropriately to any situation is information, and the way in which subprime mortgages were securitized made it difficult to divine the actual circumstances we faced.
The multifactorial nature of the crisis is covered well in Fault Lines, a book by Raghuram G. Rajan, a former IMF economist. He goes into the distortions in the financial industry, where banks are (still) too big to fail, and the incentives lopsided. Failure goes unpunished, not just at the level of the market, where institutions have been propped up, but within those institutions as well. However, success is, particularly at the higher levels, exorbitantly rewarded. At the same time, Rajan goes into other aspects of the financial system that predispose it to crisis. Freddie Mac and Fannie Mae, complicit in the crisis, are a response to a society with a weak social safety net where that's been compensated for in one of the only political viable ways: promotion of often unsustainable private home ownership. He also points to global aspects, notably the high savings right in China that translated to global capital looking for a place to nest with good returns, such as subprime mortgage-backed investments.
By the end of the documentary, former treasury secretary Hank Paulson asserts that eventually we'll have another financial crisis - this is the nature of markets - but that we now have better mechanisms in place to mitigate the effects. He points to higher capital requirements and Dodd-Frank. The former no doubt cushions the system from calamity but the latter has been described by The Economist as a convoluted piece of legislation -- over a thousand pages long. In keeping with that observation my impression is that it's introduced complexity and hasn't actually made the work of regulators easier or more empowered. That, the historically low interest rates we've had for approaching a decade, and the fact that the banks that were too big to fail are now only bigger fill me with concern. I wouldn't be surprised if the next turn of the market exhibits the same severity of effects as the last crisis. In examining the historical frequency and severity of financial crises, Elizabeth Warren has made a strong argument that the now expired Glass-Steagall Act, which separated commercial and investment banking, played a critical role in staving off disaster. Reinstating that sort of legislation is one of the only options I see available for minimizing the risk of cataclysmic crises in the future.
