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.
This is a key paragraph, and there are many key paragraphs, in Arnold Kling, “The 2008 Financial Crisis,” the latest entry in David R. Henderson, ed., The Concise Encyclopedia of Economics.
I thank Arnold for being responsive, and quickly, to suggestions by some referees, particularly Jeff Hummel.
READER COMMENTS
Alan Goldhammer
Dec 21 2018 at 7:32am
I’ve probably read far too much about the 2008 crisis than is healthy. Right now I’m halfway through Adam Tooze’s ‘comprehensive’ history, “Crashed: How a Decade of Financial Crises Changed the World.” Tooze looks beyond just the US, covering China and Eurozone in great detail. For anyone interested in the nuances of how things happened and policy maker’s response this is the book to read. I was unaware of the magnitude of US support within the Eurozone. Most of this was kept very quiet by the Fed as billions of dollars were moved around to help prop things up over there.
Kling’s explanation is a good one but I still think he over rates the role that the Community Reinvestment Act played in the crisis (IIRC this was a point that Wallinson made in his critique of policy as well). While there were loans made under this new direction they were a relatively small number in comparison to the sub-prime offerings. I believe that lax underwriting standards and easy securitization into bundled offerings were far more problematic. Other than this one point, Kling hits all the key issues.
I can remember back when we bought our house in 1985. 20% down payment was expected and if you didn’t meet that threshold you had to take out Private Mortgage Insurance (PMI). We had 15% available for the down payment and ended up paying PMI for a couple of years until the assessed value of the home appreciated enough that the lender allowed us to drop it.
Comments are closed.