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March 2015 – Hidden in Plain Sight – What caused the financial crisis

March 20, 2015

Hidden in plain sight:

What really caused the world’s worst financial crisis — and why it could happen again


AEI Portraits - (Photo by Jay Westcott/for AEI)

Peter J. Wallison, AEI’s Arthur F. Burns Fellow in Financial Policy Studies.


Because of the government’s extraordinary role in bringing on the crisis, it should not be treated as an inherent part of a capitalist or free market system, or used as a pretext for greater government control of the financial system.  On the contrary, understanding the financial crisis for what it was will permit the debate we should have had about the Dodd-Frank Act.

Note: The following is the preface of Peter J. Wallison’s book “Hidden in Plain Sight: What really caused the world’s worst financial crisis — and why it could happen again,”  published in January, 2015.

Far from being a failure of free market capitalism, the Depression was a failure of government. Unfortunately, that failure did not end with the Great Depression. . . . In practice, just as during the Depression, far from promoting stability, the government has itself been the major single source of instability. — Milton Friedman

Political contests often force the crystallization of answers to difficult political issues, and so it was with the question of responsibility for the financial crisis in the 2008 presidential election.  In their second 2008 presidential debate, almost three weeks after Lehman Brothers had filed for bankruptcy, John McCain and Barack Obama laid out sharply divergent views of the causes of the financial convulsion that was then dominating the public’s concerns.  The debate was in a town-hall format, and a member of the audience named Oliver Clark asked a question that was undoubtedly on the mind of every viewer that night:

Clark: Well, senators, through this economic crisis, most of the people that I know have had a difficult time. . . . I was wondering what it is that’s going to actually help these people out?

Senator McCain: Well, thank you, Oliver, that’s an excellent question. . . . But you know, one of the real catalysts, really the match that lit this fire, was Fannie Mae and Freddie Mac . . . they’re the ones that, with the encouragement of Sen. Obama and his cronies and his friends in Washington, that went out and made all these risky loans, gave them to people who could never afford to pay back . . .

Then it was Obama’s turn.

Senator Obama: Let’s, first of all, understand that the biggest problem in this whole process was the deregulation of the financial system. . . . Senator McCain, as recently as March, bragged about the fact that he is a deregulator. . . . A year ago, I went to Wall Street and said we’ve got to reregulate, and nothing happened. And Senator McCain during that period said that we should keep on deregulating because that’s how the free enterprise system works.

Although neither candidate answered the question that Clark had asked, their exchange, with remarkable economy, effectively framed the issues both in 2008 and today: was the financial crisis the result of government action, as McCain contended, or of insufficient regulation, as Obama claimed?

Since this debate, the stage has belonged to Obama and the Democrats, who gained control of the presidency and Congress in 2008, and their narrative about the causes of the financial crisis was adopted by the media and embedded in the popular mind. Dozens of books, television documentaries, and films have told the easy story of greed on Wall Street or excessive and uncontrolled risk-taking by the private sector — the expected result of what the media has caricatured as “laissez-faire capitalism.” To the extent that government has been blamed for the crisis, it has been for failing to halt the abuses of the private sector.

The inevitable outcome of this perspective was the Dodd-Frank Wall Street Reform and Consumer Protection Act, by far the most costly and restrictive regulatory legislation since the New Deal.  Its regulatory controls and the uncertainties they engendered helped produce the slowest post-recession US recovery in modern history.  Figure 1 compares the recovery of gross domestic product (GDP) per capita since the recession ended in June 2009 with the recoveries following recessions since 1960.

Unfortunately, Dodd-Frank may provide a glimpse of the future. As long as the financial crisis is seen in this light — as the result of insufficient regulation of the private sector — there will be no end to the pressure from the left for further and more stringent regulation.  Proposals to break up the largest banks, reinstate Glass-Steagall in its original form, and resume government support for subprime mortgage loans are circulating in Congress.  These ideas are likely to find public support as long as the prevailing view of the financial crisis is that it was caused by the risk-taking and greed of the private sector.

For that reason, the question of what caused the financial crisis is still very relevant today.  If the crisis were the result of government policies, the Dodd-Frank Act was an illegitimate response to the crisis and many of its unnecessary and damaging restrictions should be repealed.  Similarly, proposals and regulations based on a false narrative about the causes of the financial crisis should also be seen as misplaced and unfounded.

Figure 1

Sources: Bureau of Economic Analysis; Census Bureau; authors’ calculations. Adapted from Tyler Atkinson, David Luttrell, and Harvey Rosenblum, “How Bad Was It? The Costs and Consequences of the 2007–09 Financial Crisis,” Staff Papers (Federal Reserve Bank of Dallas) no. 20 (July 2013): 4.
Note: The gray area indicates the range of major recessions since 1960, excluding the short 1980 recession.

As demonstrated by Dodd-Frank itself, first impressions are never a sound basis for policy action, and haste in passing significant legislation can have painful consequences.  During the Depression era, it was widely believed that the extreme level of unemployment was caused by excessive competition.  This, it was thought, drove down prices and wages and forced companies out of business, causing the loss of jobs.  Accordingly, some of the most far-reaching and hastily adopted legislation — such as the National Industrial Recovery Act and the Agricultural Adjustment Act (both ultimately declared unconstitutional) — was designed to protect competitors from price competition.  Raising prices in the midst of a depression seems wildly misguided now, but it was a result of a mistaken view about what caused the high levels of unemployment that characterized the era.

In the 1960s, Milton Friedman and Anna Schwartz produced a compelling argument that the Great Depression was an ordinary cyclical downturn that was unduly prolonged by the mistaken monetary policies of the Federal Reserve.  Their view and the evidence that they adduced gradually gained traction among economists and policy makers.  Freed of its association with unemployment and depression, competition came to be seen as a benefit to consumers and a source of innovation and economic growth rather than a threat to jobs.

With that intellectual backing, a gradual process of reducing government regulation began in the Carter administration.  Air travel, trucking, rail, and securities trading were all deregulated, followed later by energy and telecommunications.  We owe cell phones and the Internet to the deregulation of telecommunications, and a stock market in which billions of shares are traded every day — at a cost of a penny a share — to the deregulation of securities trading.  Because of the huge reductions in cost brought about by competition, families don’t think twice about making plane reservations for visits to Grandma, and we take it for granted that an item we bought over the Internet will be delivered to us, often free of a separate charge, the next day.  These are the indirect benefits of a revised theory for the causes of the Depression that freed us to see the benefits of competition.

We have not yet had this epiphany about the financial crisis, but the elements for it — as readers will see in this book — have been hidden in plain sight. Accordingly, what follows is intended to be an entry in a political debate — a debate that was framed in the 2008 presidential contest but never actually joined. In the following pages, I argue that but for the housing policies of the US government during the Clinton and George W. Bush administrations, there would not have been a financial crisis in 2008. Moreover, because of the government’s extraordinary role in bringing on the crisis, it is invalid to treat it as an inherent part of a capitalist or free market system, or to use it as a pretext for greater government control of the financial system.

I do not absolve the private sector, although that will be the claim of some, but put the errors of the private sector in the context of the government policies that dominated the housing finance market for the 15 years before the crisis, including the government regulations that induced banks to load up on assets that ultimately made them appear unstable or insolvent. I hope readers will find the data I have assembled informative and compelling. The future of the housing finance system and the health of the wider economy depend on a public that is fully informed about the causes of the 2008 financial crisis.

– By Peter J. Wallison

AEI’s Arthur F. Burns Fellow in Financial Policy Studies.

This article is excerpted from “Hidden in Plain Sight: What really caused the world’s worst financial crisis — and why it could happen again,” published by Encounter Books.

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