My review of Jeff Friedman’s edited book, What Caused the Financial Crisis?, was published in Policy Review last week.

Some excerpts from my review:

The most important chapter is the first. This 66-page segment is editor Jeff Friedman’s overview of subsequent chapters, along with his own contributions to the debate. It is by far the densest part of the book, not in the sense of being hard to understand, but in the sense that if you miss even one paragraph, you may miss a lot. Friedman carefully sifts through the other authors’ arguments and evidence. His work would be impressive if done by a Ph.D. economist with twenty years of experience in the profession. What makes it more impressive is that Jeffrey Friedman is not an economist at all but a political scientist (he is a visiting scholar in the Department of Government at the University of Texas at Austin).


And what about the idea of “notional value” of the amounts on which the cdss are written? [Peter] Wallison quotes financier George Soros’ 2008 statement that “The notional amount of CDS contracts outstanding is roughly $45 [trillion] . . . To put it into perspective, this is about equal to half the total U.S. household wealth.”

Wallison’s response? “This is not putting credit default swaps ‘into perspective.'” Wallison shows that each time a CDS is traded, the “notional amount” increases, even though the amount of risk is unchanged. He shows that the “net notional amount” is “actually about 5 percent of the figure Soros used.” The problem with credit default swaps, concludes Wallison, is not their financial effects but their political effects. They can become, he writes, “political piñatas” and “divert scrutiny from the actual causes of problems.”

And finally:

In discussing the high ratings of various bonds, Posner reminds us that we “must be wary of hindsight bias” — that is, seeing as obvious after the fact what was obvious to very few people before the fact. He’s right. But Posner’s own solution for preventing or reducing the probability of future financial crises is a grand example of hindsight bias. Posner recommends more regulation, buying into the Acemoglu view that the financial sector is “unregulated.” But how, exactly, given Posner’s own admission that regulators thought the probability of a collapse was small, are regulators supposed to do better in the future? We, including regulators, never know, except after the fact, that a low-probability event will occur. So isn’t future regulation likely to be closing the barn door only after the horses’ low-probability escape?

Fortunately, Friedman has much of value to say on this issue. He points out that when regulators impose rules, the people they regulate must follow them and that, therefore, the rules homogenize behavior and prevent diversity. The advantage of diversity is that not all participants will walk off the cliff. Friedman notes that Wells Fargo Bank, J.P. Morgan, and Goldman Sachs all became aware of the risks of mortgage-backed securities and took actions to reduce or hedge their risks. Had regulation been even tighter, this would have been impossible. However heterogeneous are the regulators’ opinions of a regulation, he notes, only one regulation becomes law. Diversity among market participants, by contrast, “takes the more concrete form of different enterprises structured by different theories.”