Fixing the Financial Crisis: Fire, Aim, Ready

No one wants to go through another financial crisis like we had in 2008, so our government is busy writing new regulations to fix things. But how do we know what to fix if we don't know what broke, exactly? To some, it is enough to simply start regulating something, since we know that too little regulation was the problem.

Late-night economist David Letterman summarized the situation: "Republicans in power previously for eight years deregulated banks, and that was a contributory factor."

Key words: Republican, deregulated.

That might be a plausible explanation...if Republicans had deregulated anything. Perhaps Mr. Letterman mixed up Republicans with Democrats. Glass-Steagall's partial repeal was signed into law by President Bill Clinton in 1999 and passed by the Senate with a vote of 90-8, including the votes of Senators Biden, Kerry, Edwards, Schumer, and Dodd.

Or perhaps Mr. Letterman mixed up "deregulated" with "regulated." Sarbanes-Oxley, a major, bipartisan rewrite of corporate regulations in response to the Enron scandal of the 1990s, was signed into law by President Bush in 2002.

The Late Night Hypothesis goes about like this.

Step 1. There was a housing bubble bound to burst. It did in 2007. The cause? Take your pick: the Fed's easy money, greedy lenders, stupid borrowers, government pressure, an incompetent and corrupt Fannie Mae.

Step 2. All those risky mortgages were bundled into credit default swap thingies and traded among big banks without any regulation whatsoever. Obvious cause: unbridled and unregulated greed.

Step 3. From there it was a quick chain reaction. Risky loans started going south. The credit default thingies then became worthless. Then banks took huge losses that left them no money to lend. Then credit froze, and then everything froze.

Step 4. The decline of the U.S. economy caused the economies of Europe and the rest of the world to decline as well, since the U.S. is such an economic hegemon.

That four-step process almost makes sense...except for defying the basic concepts of cause and effect.

First, the housing bubble was not confined to the U.S.; it was global. How could any U.S. housing policy affect house prices in, say, France, Sweden, and Greece? They had their own central banks, which Greenspan did not run. They had their own regulations, which Bush did not undo. Fannie Mae did not make loans on Swedish houses. Houses are not fungible commodities; you can't put them on tankers and ship them through San Francisco harbor.

U.S. housing prices were increasing 12.78% per year in 2006, yet France, Sweden, and Greece all saw steeper increases then. Norway, South Korea, New Zealand, Ireland, and Spain also saw rises of 10% or more in either 2006 or 2007.

And when the bubble burst, house price declines in the U.S. were merely average for 52 countries tabulated by the International Monetary Fund. House prices in the U.S. went down 7% in 2008. Iceland, the U.K., Denmark, Finland, France, Australia, Norway, Ireland, and Spain all experienced even steeper declines.

Secondly, the recession spread to Europe before it spread to the U.S. The Organization of Economic Cooperation and Development provides Gross Domestic Product data for thirty countries. Every one of those countries experienced a decline of GDP starting in either 2007 or 2008.

The peak GDP value (and therefore the onset of the decline) occurred in the 2nd quarter of 2008 for the U.S. Of the thirty OECD countries, fifteen had their GDP peaks either in the 1st quarter of 2008 or sometime in 2007 -- that is, before the U.S. The same is true of the European Union, the Euro Area, the G7, OECD-Europe, and the OECD Total.

Only six countries of the thirty had their GDP recessions start after ours: Australia, the Czech Republic, Finland, Greece, Poland, and the Slovak Republic.

And how severe was the U.S. recession? The drop in real GDP was 3.8% in the U.S. Of the 29 other OECD countries, 21 had deeper drops. Only five countries had a decline of less than 3%:  Australia, New Zealand, Norway, Poland, and Switzerland.

In short, whether talking housing bubble or recession, the U.S. was not unique, not first, and in the better half of the pack in terms of severity.

The scientific method says to find a hypothesis that is not contradicted by the evidence. But any hypothesis that says that our mess was caused by a policy unique to the U.S. is contradicted by the evidence of the mess's global nature. It is also contradicted by the concept of cause preceding effect; the bad stuff did not happen in the U.S. first.

What, then, could it be? We should be looking for something (1) global in nature, (2) connected to housing and banking, and (3) that changed in fairly recent years.

Believe it or not, there is such a thing: a banking regulation called the "Recourse Rule." Jeffrey Friedman and Wladimir Kraus of the American Enterprise Institute provided an extensive discussion of it in the Wall Street Journal.

In the U.S., the recourse rule came from the Federal Reserve and other federal regulators in 2001. For the European Union, it came with the Basel II agreements in 2006. The recourse rule forced large banks to put more of their money into asset-backed securities, such as mortgage-backed bonds, as long as those securities had good bond ratings or were issued by government-backed entities such as Fannie Mae and Freddie Mac (to make sure the banks' investments were more secure, don't you know).

Suddenly, big banks were incentivized, even forced, to buy more mortgage-backed securities. That drove smaller banks to fill that need by making more home loans. And they in turn made it as easy as possible for home-buyers to get loans.

The home-buyers were happy. The lenders were happy. The big banks were happy. The governments were happy. And all this was not just in the U.S., but all over Europe and elsewhere. They all knew it couldn't fail. House prices never go down, certainly not all at once. And who cares, since the underlying loans were all backed by the government?

Ironically, the logic was self-defeating. House prices don't all go down at once, except when they are bid up arbitrarily all at once by every bank everywhere. What goes up for no good reason will come down for very good reason.

So here we had a new regulation happening in the 2001-2006 timeframe. It was global in nature. And it was tied intimately to banking and housing. It meets our criteria for causality.

Do we know that the recourse rule is the culprit? No. But it is consistent with the evidence, and it is about the only hypothesis that is.

Unfortunately, we seem poised to take bold action by regulating something, anything, when we can't even be sure if the real cause of the crisis was too little regulation or too much regulation.

Gene Kranz told us of the first rule of flight control: If you don't know what to do, then don't do anything. The guys who followed that rule put men on the moon and brought them back safely. It's a pretty good rule. 

Randall Hoven can be contacted at or via his website,
If you experience technical problems, please write to