For the Concise Encylopedia of Economics. An excerpt:
There can be no single, definitive narrative of the crisis. This entry can cover only a small subset of the issues raised by the episode.
Metaphorically, we may think of the crisis as a fire. It started in the housing market, spread to the sub-prime mortgage market, then engulfed the entire mortgage securities market and, finally, swept through the inter-bank lending market and the market for asset-backed commercial paper.
It is now a decade since I wrote Not What They Had in Mind, which in my opinion still holds up.
In the encyclopedia entry, space was limited, and I had to limit my coverage. I decided that I had essentially no room to cover the many narratives of the crisis that differ from my own.
Wow! Thank you, Arnold, thank you, thank you.
That is the best short summary I’ve seen, and I’ve been watching for awhile (all decade!). Moral hazard, cognitive failure, policy failure.
“In hindsight, within each sector affected by the crisis, we can find moral hazard, cognitive failures, and policy failures. Moral hazard (in insurance company terminology) arises when individuals and firms face incentives to profit from taking risks without having to bear responsibility in the event of losses. Cognitive failures arise when individuals and firms base decisions on faulty assumptions about potential scenarios. Policy failures arise when regulators reinforce rather than counteract the moral hazard and cognitive failures of market participants.”
You are excellent in noting the housing bubble (I would have tried to add The Economist note on the housing bubble in 2003), and the peak housing in 2006.
One thing you don’t mention, like almost all analyses fail to mention, is the complex effects on illegal immigration. A “data failure” of economics. A significant amount of the house construction workers were not-well counted illegals, getting cash payments. They were the first to lose their jobs in 2006, but this doesn’t show up well in the official numbers, and certainly not in the official unemployment numbers. Yet as they lose their jobs, and don’t find replacements, their consumption goes down; many of them even left back to Mexico, or their legal countries. This was part of the reduction of demand, and ensured “over capacity” of production for the first few years after 2008.
“Metaphorically, we may think of the crisis as a fire. ”
“In hindsight, within each sector affected by the crisis, we can find moral hazard, cognitive failures, and policy failures.”
I think the metaphor is right, but the analysis is wrong.The metaphor implies that one failure causes the others. The analysis seems to imply concurrent independent failures.
You can focus on any of the mistakes that made a domino fall, or you can focus on the positioning of the dominoes, which creates a risk of cascading failure. Financial institutions gravitated towards a system of risk management strategies that spreads risk across the system. This protected a firm but left the system prone to cascading risks when the losses were significant enough.
The true test of the system is whether it can contract and absorb failure without wider collapse. The flaw in the system is that the financial institutions have no incentive to wall off and bear more of their risk.
Thanks for the lucid, incisive summary description and explanation of the financial crisis. Your account strikes the elusive balance of fullness and parsimony, and provides insights into key psychological, cultural, and institutional mechanisms.
After the fact, it’s hard to evoke the sense of free-fall and wonder at the seemingly inexorable, yet puzzling cascade of events. I’ve experienced this sort of bystander awe at sudden, massive unraveling a handful of times since I got serious about the social sciences: 1) The collapse of Communism, 1989-1991. 2) The collapse of establishment political parties in Italy during the “Clean Hands” corruption investigations in Italy, 1992-1994. 3) The financial crisis, 2007-2009.