Was the 2008 Financial Crisis the Result of Market Failure or Government Intervention? Debate

Former head of BB&T and the Cato Institute John Allison and Moody's forecaster Mark Zandi square off on Wednesday, February 20 in New York.

The Soho Forum

"The financial crisis of 2008 was caused mainly by government-induced distortion of markets rather than caused mainly by intrinsic market failure."

That's the proposition under debate at the next Soho Forum, which takes place in New York City on Wednesday, February 20.

The Soho Forum is a monthly debate series that features topics of special interest to libertarians, and the series aims to enhance social and professional ties within the NYC libertarian community. It's moderated by Gene Epstein, the longtime economics editor of Barron's, and tickets, which cost between $12 and $24, must be purchased online and in advance. Reason is proud to be a sponsor of The Soho Forum and all debates are subsequently released as Reason videos and podcasts (go here for an archive). The debates are "Oxford style," meaning that the audience is polled before and after arguments are made and the winner is the person who moves more people in his or her direction.

Here's more information about the evening's debaters.

For the affirmative:

John Allison is an executive in residence at the Wake Forest School of Business. He is a member of the Cato Institute's Board of Directors and chairman of the Executive Advisory Council of the Cato Institute's Center for Monetary and Financial Alternatives. Allison was president and CEO of the Cato Institute from October 2012 to April 2015. Prior to joining Cato, Allison was chairman and CEO of BB&T Corporation, the 10th largest financial services holding company headquartered in the United States. He was recognized by Harvard Business Review as one of the top 100 most successful CEOs in the world over the last decade. He is also the author of The Financial Crisis and the Free Market Cure: Why Pure Capitalism Is the World Economy's Only Hope.

For the negative:

Mark M. Zandi is chief economist of Moody's Analytics, where he directs economic research. He conducts regular briefings on the economy for corporate boards, trade associations, and policymakers at all levels. Dr. Zandi is a cofounder of Economy.com, which Moody's purchased in 2005. He is also the author of Paying the Price: Ending the Great Recession and Beginning a New American Century, which provides an assessment of the monetary and fiscal policy response to the Great Recession. His other book, Financial Shock: A 360º Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis, is described by The New York Times as the "clearest guide" to the financial crisis.

And here are details about the event and venue:

Cash bar opens at 5:45 p.m.
Event starts at 6:30 p.m.
Subculture Theater
45 Bleecker St,
NY, 10012

Seating must be reserved in advance.

Moderated by Soho Forum Director Gene Epstein.

Enter the code "reason" for 25 percent off tickets!

Watch last month's debate, "Government Caused Housing Segregation. Do We Need More Government to Fix the Problem?," which featured Richard Rothstein of the Economic Policy Institute and Howard Husock of The Manhattan Institute. Podcast version here.

Comments

[DaveSs]

I think it would be interesting to know what those two were writing regarding the state of things in 2007 and before, assuming they did write about such things.

[creech]

Obviously, such writings must have gone down the memory hole, along with all the legislation introduced by the Dem controlled congress in 2007 that would have fixed the "Bush Great Recession," as they call it. /sarc

[DajjaI]

Yes it was caused by government intervention. Three main causes:

- Chartered rating agencies - They were once accountable to investors, but after being chartered by the government in the 50's, they were accountable to only the issuers. This resulted in 'pay to play'. (Sweet deal for Moody's, of course.)

- Mortgage Interest Tax Deduction - Implemented to 'nudge' people into buying homes, this created the impossible-to-value 30 year mortgage. This fiscal abomination contributed to the CDO debacle and the financial crisis.

- Local investment regulations - Many municipalities required that pension funds invest only in AAA rated bonds. This created unsustainable pressure on agencies to issue inflated ratings, leading to 'sophisticated' computer programs to essentially assign random numbers and blame the resulting debacle on a 'black swan event'.

[JFree]

Which completely ignores that it was worldwide

[loveconstitution1789]

Foreign markets are heavily tied into US markets?

[JFree]

Yes. They are NOT however tied into US laws re mortgages. And even the credit rating system was not imposed by the US. It was imposed by the Bank for Intl Settlements (BIS) - the central bankers central bank. Which you can argue is govtl (since most central banks - NOT the Fed - are owned by govts). But that is irrelevant since it is supranational and in fact is accountable almost entirely to big banks and how they choose to do business among themselves and not accountable to any national govt.

Ask yourself - why did much of the Fed bailout go to foreign banks? Why has the US spent a decade subsidizing interest rates and bank balance sheets in order to keep the dollar as reserve/settlement currency?

[DajjaI]

Foreign banks choked on USA issued debt like CDOs.

[JFree]

Yes - and WHY did they buy it and WHO created all that sliced up tranche nonsense and WHO sold it to them.

Answer - because the Basel 1 agreement (which is how BIS 'gets together' to cooperate) created a set of mutual agreements among banks re the risk-weightings of tier 1 capital:
0% risk - cash, bullion, local govt securities
20% risk - securitized debt rated AAA
50% risk - mortgages, muni bonds
100% risk - corporate bonds

IOW - it created an incentive for banks to securitize mortgages because those could be sold at a higher price. And the most lenient country in allowing that - the most market-friendly country - was the US. So Wall St took full advantage.

[JFree]

Oh - and the timing of the 2008 crisis was because Basel 2 was in the process of being implemented in different countries. So prices of those mortgages and securitizations was going to be more volatile and different banks in different countries would be in and out of that market far more frequently.

[DajjaI]

Wall St is in New York, which is in the US. It is not in Europe. You seem confused.

[JFree]

Seriously? You now seem completely moronic. 'Wall St' does not usually mean the asphalt on a physical street. Nor did I mean it that way. Fucking hell. Are you actually this stupid?

[DajjaI]

So... ready for the debate? Should be fun!

[Regrettable]

I think financial asset bubbles can theoretically be a market phenomenon, but we'd hardly be able to test that empirically, since governments have been meddling in the financial markets forever and after each crisis, the solution is "Moar Regulation."

In any case, I think Mr. Zandi's remarks should be preceded by an acknowledgement that his employer is a essentially a government-protected oligopoly (with a poor track record of providing the independent analysis of creditworthiness that is their primary mission). He can hardly be expected to acknowledge the strengths in the debate proposition.

[loveconstitution1789]

"The financial crisis of 2008 was caused mainly by government-induced distortion of markets rather than caused mainly by intrinsic market failure."

The US financial markets are not a free market, so its always government-induced distortion of markets that causes these meltdowns.

The financial market was not free to do what markets do best- decide who the winners and losers are.

When government gets too involved, we're all losers.

[JFree]

The financial market was not free to do what markets do best- decide who the winners and losers are.

Sure. Which is why they won and everyone else lost.

[loveconstitution1789]

Hillary Clinton lost. That is really all that matters.

[John]

I reject the entire assumption that a recession or an asset bubble bursting is a "market failure" whatever that means. Bubbles are something that happen in markets. Once the price of an asset starts to rise everyone who doesn't buy in is missing out on an opportunity to make money. So it starts to feed on itself. The problem is nothing lasts forever and eventually the asset gets so expensive people can no longer buy it in sufficient numbers to keep the price rising and the whole thing goes tits up. It is a product of mass psychology and the nature of short term gains versus long term sustainability.

To the extent the government can be responsible, it is because it either creates artificial incentives that cause bubbles where there would not otherwise have been one or shields people from the consiquences of their investment going south causing bubbles that do occur to be much bigger than they normally would be. So it is wrong to say the government is totally at fault because that implies bubbles would not occur absent the government and that is just not true. It is also wrong to say that bubbles are a failure of the market since every market produces them and trying to stop it does more harm than good. At most you can say that the government made this collapse worse than it need to have been.

[DajjaI]

Another big cause of the financial crisis was government backed lending. Mortgage companies like Washington Mutual underwrote completely irresponsible mortgages and then immediately transferred them to Fannie and Freddie (government agencies) to shoulder all the risk. (So why did WaMu fail? Because the process took about a month and they had tons of bad mortgages still in the pipeline. Otherwise they'd be golden!) Also federal mortgage insurance put all the risk on taxpayers instead of the issuing banks. They had nothing to lose.

[John]

That is a huge issue. And we went down this road before in the 1980s with the S&L collapse. There, the FCIC guarantee of deposits up to $100,000. So investors just broke their deposits up into $100,000 bundles and kept pumping money into failing S as the S continued to pay higher and higher interest rates to obtain money. Why worry about the solvency of the S&L is the government guarantees your investment?

Same thing here, why worry about the solvency of the borrower when you can just sell the mortgage off to the government at a profit.

[bevis the lumberjack]

"Was the 2008 financial crisis the result of market failure or government intervention?"

Both.

The initiator of all of it was serial bubble blower Alan Greenspan. He and his obsession with a happy stock market (aka the Greenspan Put) regularly resulted in the Fed funds rate being kept too low for two long, which resulted in a series of bubbles in the markets, the last of which was the housing/real estate bubble of 2005-2006.

The private actors - the mortgage industry and the big investment banks - then took Greenspan's infection and spread it to the four corners of the world. The mortgage industry did their part by loaning money to anybody that was ambulatory enough to walk into an office and fill out an application, then the IBs took those shaky loans and packaged them into securities and dishonestly sold them as safe investments to any mark they could find.

When the defaults started, entities all over the world were in danger of failure, and nobody knew if anyone was solvent or not. Viola, a perfect credit crisis.

[Ron]

The mortgage industry did their part by loaning money to anybody that was ambulatory enough to walk into an office and fill out an application,"

Note though the mortgage industry was required by the government to give out these loans or lose all backing for all loans and banks don't give out loans anymore without government backing.

[loveconstitution1789]

Ninja please!

[Chipper Morning Wood]

Yes, but the private actors were acting rationally, from an economic point of view. If money is available, an investment bank is going to use it. They are not going to sit there and think about the fact that this cheap money will cause over-investment. Because if they do, their competitors will take and use all of it, and they will out-competed into financial loss. There would have to be unanimous agreement between all the market participants not to use the new cheap money, and that would never happen.

It's like if you kept overfeeding your dog, and your dog got fat. Who would be to blame, you or your dog?

[bevis the lumberjack]

"Yes, but the private actors were acting rationally, from an economic point of view. If money is available, an investment bank is going to use it."

In the same way that Madoff was acting rationally, from an economic point of view. Or a bank robber.

Selling CDOs to unwary buyers while either lying about the credit risk of the CDOs or (giving the most charitable interpretation to the IBs) being unaware of the credit risk in the CDOs you're selling is a scam. Are scams not market failures? Is buying houses (or tulips) at valuations far, far above any rational value a market failure?

[Titanian]

"They are not going to sit there and think about the fact that this cheap money will cause over-investment. Because if they do, their competitors will take and use all of it, and they will out-competed into financial loss"

BB&T did. And they came out of it golden.

[JFree]

Fact is they would have gone under as well without the bailout. NO bank can survive on its own. They all require other banks to recognize and settle their checks. Doesn't matter how perfect their own balance sheet is - when the interbank system breaks they all go under.

[Juice]

You think the mortgage industry would have made those loans if not being induced to do so by the Housing and Community Development Act and the Community Reinvestment Act?

[bevis the lumberjack]

"You think the mortgage industry would have made those loans if not being induced to do so by the Housing and Community Development Act and the Community Reinvestment Act?"

Absolutely. They'd have loaned money to dead people if they could have done so. Hell, it's possible they did and we just never heard about it.

There was zero incentive for them to show any concern as to the credit profile of their borrowers because they could immediately sell the loans to big banks so that the big banks could jam 'em into CDOs and sell them at a profit. The HCDA and the CRA don't require loans to people that don't have any source of income.

[John]

That is a good question and I am not sure what the answer is. I think the bigger issue was the ability to sell these loans to the government or have them guaranteed by the government. Did these banks make some bad loans in bad areas to keep the race hustlers off their backs? I have no doubt they did. But that is not what caused the collapse. What caused the collapse was the conviction that housing prices would always rise and that money could be made on any mortgage by either selling it to the government or bundling it and selling it to larger investors.

If there was a biggest cause of the bubble and resulting crash it was the idea that banks got into their head that if you bundled up enough mortgages from enough areas of the country, the risk associated with any one loan would be canceled out by the others. The idea was that the housing market was going to be rising somewhere at any time. Therefore, if you lost money because someone went underwater on their mortgage in one area, you would make it back and then some by the areas where prices were rising. They never considered the inevitability of prices falling nationwide all at once.

[loveconstitution1789]

The answer is Moral hazard.

[John]

That is part of the answer. But, the big banks honestly believed that bundling mortgages made them a risk free investment. They would have done that and there would have been a bubble even if they hadn't thought the government would come bail their sorry asses out.

[loveconstitution1789]

There was massive fraud too.

To that point, there is massive fraud by companies to overstate their value, assets, and future profit potential. Investors are getting defrauded. When the next market reset happens and huge companies go bankrupt, the response from corporate executives will be "this came as a total surprise".

Facebook is trying to change the definition of users to avoid the financial fact that millions of people are leaving FB, many of the current users are not regularly using FB, and most advertising does not effectively reach or impact FB users.

[LynchPin1477]

But at the end of the day someone was going to be left holding those assets, and you would think that they'd have a pretty big incentive to actually understand the risks on their balance sheets. Maybe the financial instruments were just too complicated for anyone to really understand, but you'd think that in and of itself would set of alarm bells. Maybe this is the result of one group of experts believing in the imprimatur of another group of experts, who relied on the imprimatur of another group of expert, and so on until the whole system just ate itself.

Still, I personally think that the moral hazard caused by past bailouts made it a lot easier to accept and operate within such a system.

[John]

You would think that the people holding those assets would have looked. But the fact is they didn't. And I am not convinced moral hazards created by bailouts were the cause or the only cause of them not looking. I think it was deeper than that and in many ways the nature of bubbles. The fact is that as long as housing prices continued to go up, those bundles made huge amounts of money. They only didn't when the market collapsed. Well, that is the problem with bubbles and why they happen. When a bubble is occurring everyone is making money. That makes it very difficult for investors to not buy in. Banks have to attract capital and have to give a competitive return to their investors. That is pretty hard when your competitors are making huge returns on a bubble. Sure the bubble will burst like every bubble does. But no one knows when. In the mean time, you risk going broke if you don't buy in and keep competitive with those who do.

[LynchPin1477]

I respect that position but based on what I've read and listened to, there were some banks both in the US and elsewhere that did stay out of the riskiest assets. Maybe that just proves that there are different appetites for risk and that the market will meet those tastes as well as those for riskier assets. But like I said, I personally am more sympathetic to some role for moral hazard.

[loveconstitution1789]

John, many Credit Unions were barely affected by the Housing bust.

That system of conservative banking does not return huge profits but they are steady. It also does not face bankruptcy like big banks did.
How Did The Financial Crisis Affect Credit Union Market Share?

It would been perfectly fine for credit unions to buy up super cheap assets from Bank of America, AIG, Chase, etc that ran their businesses the way that they did.

[JFree]

Problem is - that the 'prudence' of those credit unions was only sustainable because they had their own clearing/settlement system. Forget what it was called - but it was absorbed into the Fed clearing/settlement system and so in the next crisis what WILL happen is that that Fed system will be used to eliminate the competition. That is how banking systems actually eliminate competition.

Best example was the one-week bank holiday of 1933. Does anyone really think that 15,000+ bank balance sheets were carefully audited in that week and 4,000 were deemed insolvent and had to remain closed forever? Of course not. They were threatened. Join the Federal Reserve system and we will provide the interbank clearing that you need to reopen. Or stay in your current (usually state-level) clearing system and we will never honor anything. THAT can get results as quickly as telegrams and letters can be exchanged.

And the more the entire banking system becomes the Federal Reserve system, the more power the too-big-to-fail banks have over everything. THEY are the ones who end up getting to buy assets cheap.

[loveconstitution1789]

That is why the USA should NEVER bailout companies.

It sets a bad precedent and the Lefties tend to twist the actual results of the bailouts into: government bailouts=necessary for markets to work

[LynchPin1477]

That is why the USA should NEVER bailout companies.

That we can agree on for a whole host of practical and moral reasons.

[Bill Dalasio]

If there was a biggest cause of the bubble and resulting crash it was the idea that banks got into their head that if you bundled up enough mortgages from enough areas of the country, the risk associated with any one loan would be canceled out by the others.

This is basically true. With the caveat that you can't ignore why housing prices became highly correlated. The driver was loose money from the Fed in response to the tech crash and 9/11. Rates were kept abnormally low for an abnormally long time. Malinvestment was a predictable consequence.

[Jerryskids]

It's obviously a market failure when banks are required to issue mortgages to anybody with a pulse including people you wouldn't otherwise trust to pay you Tuesday for a hamburger today and they default on the mortgages. As long as you define "market failure" as the failure of the market to provide free healthcare, free college, free guaranteed minimum incomes, free beer and free blowjobs as the Left tends to do. By that metric, sticking your hand up a lion's ass to see if there's a bag of gold hidden inside can be defined as a lion failure when rather than getting a bag of gold you get your head ripped off.

[$park? is the Worst]

sticking your hand up a lion's ass to see if there's a bag of gold hidden inside can be defined as a lion failure when rather than getting a bag of gold you get your head ripped off.

You're the best, hands down.

[Longtorso, Johnny]

The Cause of the 2008 Mortgage Crash
Revised 8/21/2011
Revised 12/23/2011
Revised 12/31/2011
Revised 1/8/2012
Revised 5/19/2012
Revised 9/2/2012
Revised 11/23/2012
Revised 12/25/2012
Revised 2/17/2013
Revised 4/14/2013
Revised 4/21/2013
Revised 11/17/2013
Revised 1/2/2015
Revised 9/4/2015

[loveconstitution1789]

Johnny got it.

[Sevo]

Anyone who confuses the mortgage market with a 'free market' is either painfully dense or lying.

[Tony]

I thought it was uppity negroes who caused it.

[loveconstitution1789]

You Lefties sure do hate Black folks.

[Diane Reynolds (Paul.)]

It was Russians.

[Dillinger]

more racism before noon than most people all day?

[Enjoy Every Sandwich]

It was uppity strawmen.

[Dillinger]

government intervention. Jimmy Carter's fault.

[JFree]

Govts gave the banking system a monopoly over debt creation and based our money system on that debt. Banks and the financial system did as always - mismanage their balance sheet to point of fraud. Then extorted govt into fixing their balance sheets by holding money itself hostage.

Can never prevent future market failures in banking cuz the business model can never perfectly predict the future or prevent the sort of fraud that the model encourages. Financial crises are that industry's form of recession. Nor is preventing that sort of market failure a job that govt need be concerned with.

Govts concern is ensuring a stable monetary system. For ITS currency - for which only it can provide a solution.

For ITS currency - that means the govt has to introduce a govt-money system that competes with itself - one for the leveraging part of a cycle (prob bank-based as current), one for a deleveraging part (prob commodity-based - when surpluses need to be monetized - see Say's Law), one that externally arbitrages the two (a foreign-based money that imposes its own intermarket discipline re exchange rates, intl trade, and capital flows). Unfortunately, neoclassical economics ITSELF whored itself out to bank-based money so is a corrupt academic discipline that can't be used to model shit.

Hayek denationalization of money can work in theory. In practice, every single private currency will base itself on some govt currency cuz currency isn't just about issuing notes.

[John]

Private currencies just beg the larger problem which is the moral hazards created by government bailouts. Private currencies only solve the problems you list if the government lets those currencies fail. All a "private currency" is is a promise from someone, usually a bank to make good on the note. If the entity that backs the currency goes tits up, the currency goes with it. That is okay. It should go tits up. What is not okay is the government stepping in to make good on losses such that people don't pull their money out of entities that are for whatever reason undeserving of investment.

In a sense, bank deposits and checks/debit cards are a form of private currency. I loan my money to the bank and my ATM card is nothing but the bank's promise to pay it. Sure it is measured in "dollars", but it could be measured in bitcoin or anything else and the underlying transaction would be the same. The problem is federal bailouts and deposit insurance. Give people a reason to care about the solvency of where they keep their money and banks that deserve to fail fail more quickly and cause less damage when they do.

[JFree]

That's why my post is about how the govts own currency system is structured. All private or semi-private currencies will require either a bailout at some point or will subject the country to extreme volatility where markets itself can no longer really function well.

'US dollars' ARE the govts own currency. But we privatized out the creation of them when we established the Fed. Just to give an easy example of how we could eliminate deposit insurance almost overnight. A post office bank purely for checking-type accounts - deposits backed entirely by short-term T-bills (no other lending AT ALL) - and a GIRO-type transfer (similar to the debit-card type transfer so no overdrafts). There is never a 'bank run' - cuz T-bills ARE money. So FDIC would be seen for what it actually is - a bailout for private banks with the liability squarely on taxpayers. Course it would need to be set up BEFORE the next crisis cuz it can't literally be set up onvernight. It would however provide competition to banks for their short-term money needs at the Fed window.

[chemjeff radical individualist]

Sounds interesting. I will have to check this one out.

[Bill Dalasio]

The Crisis was a consequence of government intervention. Specifically, monetary policy. Rates were kept so low for so long, at the same time as the U..S. was on the receiving end of record financial inflows, that investors were pushed to the extreme ends of the risk-reward spectrum.

[JFree]

Why do you think 'govt' sets interest rates?

[Bill Dalasio]

Federal Reserve Board. Ever heard of it?

[Bill Dalasio]

And you can try pretending that the Fed isn't part of the government all you want. The Board is nominated by the government.

[JFree]

The Federal Reserve SYSTEM is the entity that the US govt granted a monopoly to over the creation of money. The FRS is owned by the private banks that choose to be in that system. The US did not grant a monopoly to any specific private bank. They gave the monopoly to that private SYSTEM. And yeah - the Board of Governors is nominated by govt. Golly - hell of an exchange for granting a monopoly over money.

But the Board of Governors does not 'set' monetary policy the way you think. The Open Market Committee in fact sets monetary policy. And the FOMC is not the FRS is not the FRB Governors.

If the FRS didn't exist, the banking system would still have created that function. Before the FRS that function was carried out by JP Morgan PERSONALLY - which wasn't really what the other banks wanted - esp after 1907. The entire purpose of Jekyll Island was to create a successor system. JP Morgan dies in Mar 1913 (not unexpectedly). The FR Act is passed in Dec 1913. Complete coinkydink by a suddenly powerful federal govt imposing itself on the banks - ya sure ya betcha.

[rballan]

Considering that the market is heavily regulated, it's pretty much a given that govt meddling in the market was the cause of the problems, not market forces. In order to blame the market, you would have to disentangle it from all the govt regulations distorting the market. I doubt that would be possible. We have not had anything resembling a free market in over 100 years.

[JFree]

'Blame' is meaningless anyway.

Are financial crises inevitable?

If you believe that then in effect it is the market causing them and the only role of govt is to figure how to minimize their effect or ensure that the effects are quarantined to that industry.

If you believe that they aren't inevitable, then it is the govt causing them when they happen