The best evidence suggests that the financial crisis was caused in large part by an unprecedented flow of funds into the United States and other developed economies.
Thanks to Michael Barone for the pointer.
Their essay is very well organized and well written. That does not mean that I agree with it. It is true that there is a tendency for large capital inflows to end badly (think of Latin America in the 1980s or Asia in the 1990s). However, we could have used those capital inflows to finance something other than a consumption binge funded by unsound mortgage loans.
One of their arguments is that the financial crisis was more like popcorn (a lot of institutions faltering for the same reason) than like dominoes (one institutional failure leading to another). They say that this argues against case-by-case rescues, and I agree with that. But they say it argues in favor of TARP, which they describe as a systemic solution. But a solution to what? How does transferring the real losses from the owners and creditors of distressed firms to the taxpayers solve anything? They write,
Five years later, TARP and the other policy actions taken during the financial crisis nevertheless remain widely unpopular. This tension between a policy success and intense political unpopularity is a defining feature of the actions taking during the financial crisis.
Of course, we do not have the counterfactual, so they can say that all they want. Just as proponents of the stimulus can say that it saved lots of jobs. Both TARP and the stimulus were followed by horrible economic performance, but you can always argue that it would have been worse without them.
The authors, both of whom were important officials under President Bush in 2008, also defend the GM and Chrysler bailouts.
If [Bush] chose not to extend the loans, he was advised that these firms would likely liquidate within weeks. Private sources of debtor-in-possession financing that would have been necessary to allow GM and Chrysler to continue absent government aid were simply unavailable.
“A solution to what?” Clearly, the way they see it–which involves clearly separating out the “financial crisis” from other related problems, in part so that they can plausibly declare that their administration licked the crisis by the time the next guy came in–what most needed fixing was a total collapse in confidence in various financial instruments and firms. The government remained sufficiently trustworthy that by throwing its weight behind these instruments and firms, their value stopped crashing and, indeed, largely recovered over time–and this was accomplished without huge net transfers from taxpayers when all was said and done.
Now, as you rightly say, if you think the counterfactual wasn’t really that bad, then this doesn’t look like much of an accomplishment. Likewise if you think the current moment of weak growth is just “counterfeit,” and we are just delaying some kind of inevitable reckoning. I tend to think that Hennessey and Lazear’s position is more right than wrong, though.
Well we could have squandered those inflows on military buildup, but no, there was nothing more productive we could have invested them in. We could have maintained lending standards and lowered interest rates below what they are now, made riskier investments less risky, and stemmed the inflows or just rationalized them. Transferring losses to taxpayers does do one thing, if rather inadequately, and that is reduce the amount of money destruction. One would like to believe the Fed is capable of doing that, but we should all be skeptical of them accomplishing that by now.