Causes of the Crisis

“The financial crisis was caused by excessively low interest rates, heavy-handed market interventions and over-indebtedness. Are we seriously to believe that the right therapy involves even lower interest rates, stronger market interventions and more debt?”

- Rainer Zitelman “The Power of Capitalism.”

This is correct. The low interest rates were set by central banks, notably the Federal Reserve, in order to cushion shocks such as the Korean crisis and the Dotcom bubble. Alan Greenspan acted to prevent a stock market collapse in response to outside shocks. He smoothed what would have been corrections. He acted to ‘steer’ the economy using easy credit to prevent contractions, the business collapses, and the unemployment that would have followed.

The low interest rates created a housing bubble, seeing huge increases in the average price of US houses. First under President Carter, then much more under President Clinton, government acted to ensure that mortgages could be obtained by low income people, including minorities. With the aim of extending home ownership lower down the income scale, the qualifying rules were slackened, and mortgages given to some who could not afford to make the required payments. These ‘sub-prime’ mortgages were packaged with others into securities, many of which were bought by Fannie Mae and Freddie Mac, the two quasi-public housing agencies. The degree of risk these packages contained was unquantified and uncertain.

Investors, faced with easy credit and the assumption that the Fed would act to prevent a stock market collapse, bought stocks and shares with less caution than they would otherwise have shown. Moreover, with low interest rates, returns on more conventional investments were low, leading many investors to pursue the higher returns offered by riskier shares, bonds and real estate, whose prices rose in consequence.

When the housing bubble burst, the fall in the value of houses left many institutions and individuals, including banks, unable to meet their obligations. Mortgages were foreclosed, and homes were repossessed and sold at a fraction of their former value. The Financial Crisis of 2007-08 took the world by surprise, but in retrospect its causes could have been discerned. Queen Elizabeth perplexed economists by asking why none of them had seen it coming. The answer might have been, “Because none of us was looking.”

The Financial Crisis was wrongly described as a “failure of capitalism,” and has led some to seek alternatives. In fact the roots of the crisis were political, representing the desire of legislators and bankers to keep the economy on a smooth, upward-sloping curve, rather than subject to the bounces and corrections that the economy would otherwise experience. A real economy is subject to the rough and tumble of trial and error, with mistakes being made and corrected, with businesses going under and capital redeployed elsewhere. Legislators dislike its roller-coaster ride, however, especially at election time, and intervene to attempt to smooth it.

An important lesson of the Financial Crisis is that government and its bankers should not try to steer the economy, but allow it to be steered instead by investors, businesses and banks responding to price signals and perceived risks, and making the individual decisions that will cumulatively determine its shape. Whether that lesson will be learned is still uncertain.