Thursday, July 15, 2010

Causes of financial crisis

This opinion by Raghu Rajan places the blame on skill biased technological change and increased inequality leading to a policy to increase homeownership among low and moderate income as a way to close this gap as the root cause of the crisis. This is a merely a deft way of blaming Fannie and Freddie and the CRA (Community Reinvestment Act).

The CRA and Freddie and Fannie has its passionate (?) defenders, among them:
1. Menzie Chinn,
2. Paul Krugman,
3. Mark Thoma

BTW, Jim Hamilton thinks that GSEs did play a role, albeit not the principal role.

I am thinking of playing a game:
These are as many factors that I could think of that can be the cause of the financial crisis (in no particular order, and I'll update the list as I think of more):

1. Greed (aka rational utility maximizing investment bankers and investors)
2. Lack of regulation and oversight
3. Complexity of securities
4. Media spreading rumors
5. Eliot Spitzer - his removal of Greenberg from AIG coincided with AIG insuring CDS
6. Dr Doom aka Nouriel Roubini, Meredith Whitney, or any or all bearish financial analysts, bloggers and commentators
7. Monetary policy - interest rates were too long for too long and then started rising too quickly triggering defaults
8. Herd behavior among bankers and investors
9. Over-optimisim among bankers and investors
10. Fannie Mae/Freddie Mac and policy to increase homeownership aka Community Reinvestment Act
11. Interconnectedness of financial system
12. Rating agencies
13. Short sellers
14. Securitization
15. Mortgage fraud
16. Inequality caused by skill biased technical change (SBTC)
17. Globalization/free trade possibly causing SBTC
18. And just for the heck of it, global warming.
19. Animal spirits.
20. Financial models & over-reliance on models
21. Moore's law and increase in computing power
22. Mark to market
23. Too big to fail/Moral hazard
24. Pay for performance and the economists who designed lavish pay packages of investment bankers.
25. Leverage
26. Proprietary trading

The name of the game is "causality jenga". We have these factors or building blocks of the crisis on one side and then there is the crisis on the other and for this purpose we can just define crisis as the events of the fall of 2007 beginning with the failure of Bear Stearns. If we start pulling out these building blocks (factors) we would ask ourselves, would the event still happen?

And as we do this, I think analysts need to ask themselves the chain of events that led to the crisis. In other words, a mechanism. Rajan has laid one out above which I think is incomplete. In the parlance of some other social sciences, we need to think clearly about what factors are 'primal' and what others are 'mediators'. If the chain can be broken somewhere could the crisis have been averted?

Or perhaps we can start by identifying necessary and sufficinet conditions. Or perhaps this is asking too much of economists.

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