Felix Salmon says Larry Summers is stupid for not thinking that the financial crisis was caused by new-fangled financial instruments. Brad DeLong leaps to Summers' defense, arguing that Summers said no such thing. Instead, Summer said that other notable financial crises -- the Japanese, Nordic, and EU debt crises -- did not arise from new-fangled financial instruments.
I think that Salmon is right about this: I think Summers was implying that new-fangled financial instruments did not cause this crisis, or at least there is no overwhelmingly-convincing evidence that they did. After all, Summers says "I am in less of a hurry to condemn the [financial] innovation as the cause of the crisis than many." I think Salmon is wrong, however, in saying that Summers should be scoffed at for saying such a thing.
Rather than denying that Summers said what he said, DeLong should have said that Summer is right: we did not have a financial crisis because of new-fangled financial instruments. We had a financial crisis because home prices rose by more than 100% from 1999-2006 (pic above), and then dropped 35% from 2006-2008 (pic below). Indeed, given the size of that bubble and the quickness of the correction, a financial crisis was inevitable.
So the question should be: why did we have a such a large bubble? One answer could be "new-fangled financial instruments created a bubble". But that is not obviously true, which is Summers' point. Other countries have had real estate bubbles without new-fangled financial instruments recently, and the U.S. has had real estate bubbles without new-fangled financial instruments in the past, so there is no a priori reason to think that new-fangled financial instruments were responsible for this particular bubble. More precisely, there is no causal mechanism that links new-fangled financial instruments to the housing bubble, much less the crash*.
(I would argue that the same is true of regulation: there is no causal mechanism that links deregulation, or more precisely "unregulation", to the crisis. But then I'm weird that way.)
Plausible causal mechanisms are important if we are to improve future outcomes. Thomas provided a pretty good one recently. Without them, we are in Underpants Gnomes territory:
1. New-fangled financial instruments
That isn't helpful.
* Jeffrey Friedman has tried to make such a case -- that securitization that could be highly-rated was rewarded by the Basel Accords, which then led banks to do more lending that could be turned into highly-rated securities -- but I don't think Salmon had this in mind.
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Monday, April 18, 2011
Posted by Kindred Winecoff at 4:53 AM . Monday, April 18, 2011