Causes of the Financial Crisis Summarized

There’s an ongoing debate among politically-motivated people about the causes of the bubble and ensuing financial crisis. I’ve long believed that the best summary and explanation is this brief e-book from Russell Roberts of the Mercatus Center. Roberts, being an economist, focuses on incentives. He talks about how various public policies gave people the wrong incentives, or at least incentives to do exactly what they did. Borrowed money due to its ready availability at low interest rates also was a major factor. It’s important to separate the symptoms of the bubble from its causes, and this essay does a good job of that. Read it, and keep it among your favorites so you can refer to it whenever the public debate shifts to politically-motivated causes.

How did this happen? Whose fault was it? Some blame capitalism for being inherently unstable. Some blame Wall Street for its greed, hubris, and stupidity. But greed, hubris, and stupidity are always with us. What changed in recent years that created such a destructive set of decisions that culminated in the collapse of the housing market and the financial system?

In this paper, I argue that public-policy decisions have perverted the incentives that naturally create stability in financial markets and the market for housing. Over the last three decades, government policy has coddled creditors, reducing the risk they face from financing bad investments. Not surprisingly, this encouraged risky investments financed by borrowed money. The increasing use of debt mixed with housing policy, monetary policy, and tax policy crippled the housing market and the financial sector. Wall Street is not blameless in this debacle. It lobbied for the policy decisions that created the mess.