Financial Crisis Inquiry Commission

The short story of The Financial Crisis Inquiry Report is that some rather intelligent and sophisticated people got in over their heads in an attempt to make a lot of money that eventually backfired and nearly took down the entire world economy.

The longish story is that not long after September 11 a credit bubble began forming in the U.S. as a result of the Federal Reserve Bank's efforts to stave off a recession. This credit bubble eventually morphed into a housing bubble after millions of subprime mortgages were extended starting around 2005 based on a faulty assumption that house prices could only continue to go up or that any fall in house prices would be localized to just a few locations. The negative ramifications of the bursting of the housing bubble were subsequently spread throughout the economy via the process of securitization of mortgages and the issuance of collateralized debt obligations, repurchase agreements, and derivatives that were facilitated by off-balance sheet investment vehicles. And all the while that this was going on the state and federal regulatory agencies that were supposed to be making sure nothing bad happened were effectively asleep at the wheel or, even worse, knew what was going on but did not consider it to be dangerous.

The Financial Crisis Inquiry Commission (FCIC) claims that this was an avoidable situation. In a sense the FCIC commissioners are right. The specific causes of the crisis could have been avoided. But, in another sense, that is wrong, and this is where I think the FCIC report comes up short. In a large sense, this report gets lost in the weeds of details instead of focusing on the real reason why the crisis occurred: complexity. The U.S. financial system and the larger economy are simply too complex for any group of people, no matter how smart, to "regulate" as if they were merely watches that need periodic winding to make them run smoothly. Given the overwhelming complexity of the financial system, financial crises are inevitable. The only question, then, is how often do they occur and whether their occurrence bleeds into and causes major problems for the larger economy.

As such, what policymakers should be doing is not trying to figure out how to stop financial crises from occurring, which is the ultimate goal of this report, but instead trying to figure out how to keep financial crises from spreading to the larger economy. That is, they should be trying to figure out how to keep illnesses on Wall Street from spreading to Main Street. It might not be possible to do so, but the FCIC report provides a pretty good history of why we should at least try.… (més)