More than a bubble

Ten years ago, massive uncertainty roiled financial markets. Major firms collapsed or teetered on the edge of insolvency. Asset values plunged. Every TV show and news story speculated about bankruptcies and bailouts. It seemed like the beginning of another Great Depression.

We did not get a repeat of the 1930s, but there was a serious recession in most nations. Moreover, many of those countries have not enjoyed strong recoveries, which some argue is a characteristic of downturns caused by bubbles and debt.

That economic hangover is augmented by a political hangover – at least to the extent that one believes that populism in various countries is driven by economic angst. Trump and Brexit could be interpreted as the most visible signals, but voters in many nations rebelled against the establishment.

At the very least, the financial crisis presumably was the most meaningful economic event since the stagflation and malaise of the 1970s. Perhaps even since the Great Depression.

Causes and consequences

Unsurprisingly, there is not agreement on the consequences of the financial crisis. And there definitely is not agreement on the causes of the crisis.

We are contributing to the debate in this magazine, with articles by Bill Stacey, chairman of the Lion Rock Institute, and “Hamilton,” which is the pen name of a senior Washington economist who must remain anonymous.

They identified some of the key issues that have not been resolved.

Monetary policy – To what extent did central banks create the conditions for the housing bubble? Perhaps more important, did they learn from that mistake, or are we currently still in the midst of a period of artificially low interest rates? Everyone likes the sugar high when excess liquidity is being created. But it is never fun when the party comes to an end.

Housing subsidies – The United States has numerous policies designed to boost residential real estate. There are preferences in the tax code, as well as spending programs that funnel money to the sector. But Fannie Mae and Freddie Mac were the most important drivers of last decade’s housing bubble. For what it is worth, those two government-created entities still exist and there are concerns that they are repeating their mistakes.

Rating agencies and regulatory standards – What is the point of having the government mandate the use of firms like Moody’s when such firms have a less-than-impressive track record? On a related note, what is the value of Basel standards that inaccurately rank the safety and soundness to mortgage-backed securities and government bonds?

Risk perception – The private sector also deserves a portion of the blame. Did individual investors and financial institutions rely on poorly designed models that understated risk and/or failed to capture important variables? Did they blithely assume that everything was okay so long as they could point to the credit-rating agencies and/or technically comply with regulatory standards?

Our authors suggest some answers to these questions, though it is not clear that regulators and policy makers are listening.

If you look at the response from Washington and other national capitals, the knee-jerk response to the crisis started with panic, then shifted to finger-pointing, and eventually ended with either the status quo or more regulation.

Very little attention was given to structural reforms to remove housing subsidies. And there has been even less discussion of whether it is a good idea for central banks to engage in Keynesian-style monetary policy.

A debt bubble?

When we think about whether lessons have been learned, it is important to understand that not all bubbles are created equal.

If someone’s home doubles in value, that does not necessarily mean volatility and instability. At least if the homeowner is prudent and doesn’t decide to take on a large amount of new debt. If home prices come back down, our prudent owner simply shrugs. A paper gain is offset by a paper loss.

But what happens if the owner responds to higher home values by refinancing? Perhaps lured by the temptation of a low-rate mortgage, what if the owner decides to borrow against the additional value, based on the assumption that the home’s value will stay high, or even keep rising? This is the person who can wind up underwater, owing more than the property is worth. And if this happens often enough in an economy, it becomes a crisis.

The point of this simple example is to underscore that the problem is not necessarily the existence of a bubble. Instead, what we should worry about is a leveraged bubble.

Which brings us back to the issue of central banks keeping interest rates at artificially low levels. It raises the concern of tax codes that tilt the playing field in favor of debt over equity. And it should lead us to wonder about the wisdom of TARP bailouts and IMF bailouts that may lead to even more mis-priced debt because of the perception that there may be future bailouts.

Demographics and government debt

Last but not least, should we incorporate demographic projections into our analysis? What is going to happen as baby-boom generations in various nations leave the workforce and put additional strain on public finances?

This may not seem directly connected to the financial crisis, but it is worth noting that almost all governments incurred a lot of debt because of how they responded to insolvent financial institutions and/or sputtering national economies.

And it is also important to remember that the crisis in Greece (and less extreme debt crises in Spain, Portugal, Italy, and Ireland) could be considered part of the crisis. Especially since bailouts for those governments may have been indirect bailouts for the financial institutions that held large portfolios of government bonds.

So what happens when the next recession hits? Will bond vigilantes descend upon Italy? Other Club Med nations may be vulnerable as well. Perhaps even France and Belgium. At some point, investors are going to realize that debt levels in Europe are far higher than they were 10 years ago.


The history of the financial crisis is far from settled. People in financial markets understandably want to understand more about what happened because they have a bottom-line incentive to be aware of factors that may affect financial markets and asset values.

People in public policy, by contrast, care about political effects rather than economic effects. Advocates of more state intervention want the history books to teach that the financial crisis was the result of untrammeled greed, capitalist instability, and excessive deregulation (the same story they successfully – but inaccurately – told about the Great Depression).

The proponents of economic liberalism want historians to tell a story of misguided intervention and subsidies. They want the history books to talk about policies enforced by entities such as the Federal Reserve, Fannie Mae, and Freddie Mac (in large part because they have only recently had some success in correcting the record about the Great Depression).
It hardly matters, though, which side wins the battle to “control the narrative” if the underlying problems remain unsolved.