What Caused the Financial Crisis

What Caused the Financial Crisis

What Caused the Financial Crisis

What Caused the Financial Crisis


The deflation of the subprime mortgage bubble in 2006-7 is widely agreed to have been the immediate cause of the collapse of the financial sector in 2008. Consequently, one might think that uncovering the origins of subprime lending would make the root causes of the crisis obvious. That is essentially where public debate about the causes of the crisis began--and ended--in the month following the bankruptcy of Lehman Brothers and the 502-point fall in the Dow Jones Industrial Average in mid-September 2008. However, the subprime housing bubble is just one piece of the puzzle. Asset bubbles inflate and burst frequently, but severe worldwide recessions are rare. What was different this time?

In What Caused the Financial Crisis leading economists and scholars delve into the major causes of the worst financial collapse since the Great Depression and, together, present a comprehensive picture of the factors that led to it. One essay examines the role of government regulation in expanding home ownership through mortgage subsidies for impoverished borrowers, encouraging the subprime housing bubble. Another explores how banks were able to securitize mortgages by manipulating criteria used for bond ratings. How this led to inaccurate risk assessments that could not be covered by sufficient capital reserves mandated under the Basel accords is made clear in a third essay. Other essays identify monetary policy in the United States and Europe, corporate pay structures, credit-default swaps, banks' leverage, and financial deregulation as possible causes of the crisis.

With contributions from Richard A. Posner, Vernon L. Smith, Joseph E. Stiglitz, and John B. Taylor, among others, What Caused the Financial Crisis provides a cogent, comprehensive, and credible explanation of why the crisis happened. It will be an essential resource for scholars and students of finance, economics, history, law, political science, and sociology, as well as others interested in the financial crisis and the nature of modern capitalism and regulation.


Jeffrey Friedman

I am privileged to introduce not only the first collection of scholarly essays devoted entirely to the question of what caused the financial crisis of 2008, but a collection that brings us much closer to a comprehensive answer.

As a proxy for the level of scholarly advance achieved in these pages, note that the claims of our distinguished contributors can, in the main, be fit into a larger mosaic with little friction between the pieces. It is true that some of our authors blame the crisis on government action while others blame it on government inaction. But the two types of claim are not mutually exclusive. Both action and inaction can be the result of government policy and, for the most part, that is how our authors treat the causes of the crisis: as policy failures, whether failures of action or of inaction. Thus, it may be said that, for the most part, our contributors agree that this was a crisis of politics, not economics.

Thus, no contributor argues that the Great Recession was just a normal business-cycle downturn or even a normal popped asset bubble: As Steven Gjerstad and Vernon L. Smith point out in Chapter 3, asset bubbles inflate and burst frequently, but worldwide near-depressions are rare. Obviously the crisis took place within “the economy,” but our authors mostly agree that special, noneconomic causal factors were at work—political factors—regardless whether one names poli-

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