Leijonhufvud writes,

The financial structure inherited from the 1930s divided the system into a number of distinct industries: commercial banks, savings and loan associations (S&Ls), credit unions, and others. It also divided it spatially. Banks located in one state could not branch across the line into another. This structure of the financial sector gave it great resilience. On another occasion I used the metaphor of a ship with numerous watertight compartments. If one compartment is breached and flooded, it will not sink the entire vessel.

This is directly the opposite of what Calomiris and Haber argue. They say that American cultural hostility to large banks produced an overly fragmented system, and that this fragmentation is the root cause of the peculiar instability of American finance.

Leijonhufvud elaborates,

At the time, the abolishment of all the regulations that prevented the different segments of the industry from entering into one another’s traditional markets was seen as having two obvious advantages. On the one hand, it would increase competition and, on the other, it would offer financial firms new opportunities to diversify risk. Economists in general failed to understand the sound rationale of Glass-Steagall. The crisis has given us much to be modest about.

In other words, economists championed open competition without thinking about how this would turn idiosyncratic risk into systemic risk.

The thing is, I was following these regulatory issues at the time, and I do not think that economists were as influential as we would like to believe. I think that the driving factors were computer technology, inflation, and massive lobbying. With high inflation, the regulatory ceilings on deposit interest rates that were a vital part of the regulatory structure became untenable. Moreover, with computer technology, it became easy for Wall Street to “disintermediate” banks using money market funds and securitization. These forces produced an inevitable turf battle between commercial banks and investment banks, which took years to resolve, as everybody lawyered up on the lobbying front. There were multiple possible political/regulatory outcomes, but hanging on to Glass-Steagall was not one of them.

Another Leijonhufvud quote:

Deregulation. . .allowed the great investment banks to incorporate and one by one they all did so. . .Incorporation meant limited liability for the investment bank and no direct liability for its executives. The incentives for executives in the industry changed accordingly. . .Now they are seen as jet-setting high rollers. Economists in general failed to predict this change in bankers’ risk attitudes. We have much to be modest about.

I cannot disagree with that.

However, I would instead put most of the emphasis on the regulations that directly affected housing finance. The pressure to lend with little or no money down and the designation of highly-rated mortgage securities as low risk for bank capital purposes are the main villains in the story as I tell it.

Various politicians and pundits seized on the Amtrak derailment as a narrative of failure to spend on infrastructure. Then it turned out that at 100 miles per hour the train was going twice the speed limit in the area.

Similarly, when the financial crisis struck, politicians and pundits seized on it as showing an excess of greed and exploitation by banks and an “atmosphere of deregulation” that allowed the banks to run amok. In my view, this is as misleading as the narrative about the train derailment.

Some further comments.

1. Perhaps in the end both misleading narratives will dominate. Maybe that is just the way things work in matters where what matters is the political orientation of most journalists and historians.

2. Perhaps the misleading narrative of the train derailment will not stand. Perhaps the facts will stand in the way. On the other hand, the complexity of the financial crisis makes it difficult to sift through the facts, and by the same token makes it easy to impose a dubious narrative.

3. Perhaps eventually historians will look more carefully and objectively at the financial crisis, and the misleading narrative will be set aside.

As of this writing, my money is on (1).

That is the title of a new NBER working paper by Robert McDonald and Anna Paulson (ungated versions). They conclude,

Much of the discussion about the crisis has focused on liquidity versus solvency. The two cannot always be disentangled, but an examination of the performance of AIG’s underlying real estate securities indicates that AIG’s problems were not purely about liquidity. The assets represented in both Maiden Lane vehicles have experienced write-downs that disprove the claim that they are money-good. While it may seem obvious with the benefit of hindsight that not all of these securities would make their scheduled interest and principal payments in every state of the world, the belief that they could not suffer solvency problems and that any price decline would be temporary and due to illiquidity was an important factor in their creation and purchase.

My random comments:

1. This is valuable work. I am really glad to see a retrospective audit of this important bailout.

2. I view the conclusion as saying that this truly was a bailout. The Fed was not acting as a hedge fund of last resort, buying temporarily undervalued assets that otherwise were just fine.

3. This also throws Gary Gorton under the bus. Gorton said that AIG’s problems were collateral calls, meaning illiquidity rather than insolvency. Note that Gorton is not included in the list of references, at least in the ungated version. Note also that the authors write that AIG’s problems were both liquidity and solvency.

4. Bob McDonald and I shared an apartment our first year as MIT grad students. He has written a treatise on derivatives.