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Wednesday, November 30, 2011

Crisis Economics: A Crash Course in the Future of Finance

Nouriel Roubini and Stephen Mihm’s book on the great subprime crisis gets off to a good start by dismissing as a red herring the “tired” argument attributing the boom to “greed” and focusing instead on “changes in the structure of incentives . . . that channeled greed in new and dangerous directions.” These included programs aimed at increasing poorer persons’ access to mortgages, the growing moral hazard connected to “too-big-too-fail” (TBTF), and the Fed’s post-2001 easy-money policy. Greenspan, they write, “muted the effects of one bubble’s collapse by inflating an entirely new one,” while the “Greenspan put”—a policy of letting asset bubbles inflate while promising to rescue firms that suffer when they burst—“created moral hazard on a grand scale.”

The authors’ criticisms of the Fed’s response to the crisis are no less trenchant. “In its rush to prop up the financial system,” they observe, the Fed rescued insolvent financial institutions, exposing taxpayers to losses on toxic assets while helping to “sow the seeds of bigger bubbles and even more destructive crises.”

But although Roubini and Mihm draw attention to some ways in which the government contributed to the crisis, they go seriously wrong in claiming that the boom “was primarily underwritten not by Fannie Mae and Freddie Mac but by private mortgage lenders like Countrywide”: Although Fannie and Freddie didn’t originate any subprime loans, they bought and (implicitly) guaranteed plenty of them, including a very large share of Countrywide’s Community Reinvestment Act (CRA) “Best Practice” loans. What Fannie and Freddie didn’t buy other lenders did, to meet their own CRA requirements. Such facts undermine Roubini and Mihm’s conclusion that “the significance of government intervention was dwarfed by the significance of government inaction.”

Roubini and Mihm’s reform proposals also fail to properly weigh government policy’s contribution to the crisis. They start well again by insisting on the need to restore to financial services “the creative destruction that Schumpeter saw as essential for capitalism’s long-term health.” Although Lehman Brothers’ failure revealed the shortcomings of ordinary bankruptcy as a means for resolving large and heavily leveraged financial firms, Roubini and Mihm note how those shortcomings could be avoided by means of “living wills” or by splitting ailing firms into “good” and “bad” parts, so that the latter might be declared bankrupt without raising Cain.

But some of Roubini and Mihm’s other proposals appear useless at best, including their endorsement of a “beefed-up” Glass-Steagall that would forcibly break up enterprises that become too big to fail, with its implicit suggestion that Gramm-Leach-Bliley contributed to the crisis. In fact that 1999 “repeal” of Glass-Steagall merely allowed commercial banks to affiliate with investment banks and played no important part in the insolvency of Lehman Brothers and other independent broker-dealers that was at the heart of the crisis.

A beefed-up Glass-Steagall Act might of course spin a much tighter web of firewalls than the original did. But as Roubini and Mihm themselves suggest, many TBTF firms exist only thanks to “heavy helpings of government largess,” including guarantees and actual bailouts, and could be left to break up naturally once improved bankruptcy procedures are in place. Perversities in executive compensation might likewise vanish on their own once imprudent decisions lead to bankruptcy rather than bailouts.

The most disappointing part of Crisis Economics is the second chapter’s hackneyed history of thought. Here Adam Smith is portrayed as a Walras-Debreu manqué who blinked at capitalism’s “vulnerabilities,” while Marx is credited with the “hugely important insight” that crises are “part and parcel of capitalism”—as if he’d predicted occasional financial panics rather than a steady decline in firm profits. The incomprehensible parts of the General Theory are treated, per usual, as proof of Keynes’s genius rather than of his being, well, incomprehensible. Finally and most disappointingly, by confusing the Mises-Hayek view of the business cycle with Schumpeter’s notion of creative destruction, Roubini and Mihm overlook the one theory of crises that best fits the housing boom-bust story.

Crisis Economics’s occasional references to the Great Depression must also be taken with a pinch of salt. It wasn’t Hoover but FDR who, in February 1933, stood by while “thousands of banks” went under; and it was growth in the money stock rather than fiscal stimulus that fueled the post-1933 recovery. The deflation of 1937–38 was mainly caused not by FDR’s belated attempt to balance the federal budget but by the Fed’s doubling of bank reserve requirements. Finally, corrected statistics show that World War II brought further stagnation rather than sustained recovery.

In short this “crash course in the future of finance” has both strengths and weaknesses. Although it contains much useful information about the subprime debacle, it understates the government’s contribution to the crisis, and although it suggests some desirable reforms, it suggests others that could prove counterproductive. Readers looking for straight A’s are advised to cram with caution.

  • George A. Selgin is the Director of the Cato Institute's Center for Monetary and Financial Alternatives, where he is editor-in-chief of the Center's blog, Alt-M, Professor Emeritus of economics at the Terry College of Business at the University of Georgia, and an associate editor of Econ Journal Watch. Selgin formerly taught at George Mason University, the University of Hong Kong, and West Virginia University.