Unhappy birthday. Five years since the collapse of Lehman Brothers, we still lack a true understanding of what caused the financial crisis and Great Recession. Oh, there are standard stories from left and right. Liberals blame a naive faith in free markets, deregulation and Wall Street greed. Conservatives slam government: lax monetary policy and ruinous home-lending by Fannie and Freddie. These selective narratives are self-serving, intended to advance political agendas and not to illuminate the messier reality.
We were victims of success. The crisis originated from 25 years of prosperity, from roughly the end of 1982 to the end of 2007. This conditioned people — bankers, regulators, economists, almost everyone — to take stable growth for granted. The longer the prosperity continued, the more it inspired the risky behaviors that ultimately wrecked the economy. These included over-borrowing by consumers and financial institutions, housing speculation and loose regulation. The “causes” cited by left and right were usually the consequences of a delusional mind-set: a belief that once-risky practices were prudent in a world of near-perpetual prosperity.
Recall the crucible of this thinking. From 1982 to 2007, the United States suffered only two slight recessions. Gross domestic product adjusted for inflation — the economy’s output — was 125 percent higher in 2007 than in 1982. From 1990 to 2007, unemployment averaged 5.4 percent. Inflation was controlled. Despite the burst “tech bubble” in 2000, stock prices in 2007 were 15 times higher than in 1982. The Federal Reserve, mainly under Alan Greenspan, seemed capable of preventing financial crises from becoming deep recessions. It did so after the tech bubble and the 1997-98 Asian financial crisis. Economists touted “the Great Moderation.”
I concede: I’ve told this story before. It doesn’t take, because it blames faulty ideas more than crooks and scoundrels — the tempting targets of most narratives. But the accumulating evidence suggests that false ideas, not evil people, were the main culprits.
Take the popular notion that banks and investment banks (“Wall Street”) knowingly packaged bad home mortgages in securities that were then sold to unsuspecting investors. The bankers, the story goes, understood that there was a housing bubble — that prices would crash and defaults explode — but peddled bad loans because it made them rich.
Although this happened, it was the exception, not the rule. That’s the conclusion of a study by economists at the University of Michigan and Princeton. They reasoned that if the investment bankers packaging mortgages expected a housing collapse, they would have been careful in their own home purchases. So the economists compared the bankers’ home-buying with that of lawyers and stock analysts who lacked specialized housing knowledge. The study, published by the National Bureau of Economic Research, found that the bankers showed little “awareness of a housing bubble and impending crash.” During the boom, they bought larger homes and second homes. Compared to the lawyers and stock analysts, their housing purchases fared “significantly worse.”
What explains their lapse? Probably this: Before the real estate collapse, there was a widespread belief that housing prices would rise indefinitely, preventing (by definition) a bubble. We now know this belief was mistaken, stupid and suicidal. But for many, it was genuine. An earlier study by economists at the Boston Federal Reserve reached a similar conclusion.
All this is more than ancient history. It matters for two reasons.
One is to understand today’s economy. Because Americans over-borrowed, it’s suggested that when they’ve adequately repaid debt (“deleveraged”), the economy will improve. Well, they’ve deleveraged considerably. Debt payments as a share of disposable income are at their lowest levels since the early 1980s, according to the Federal Reserve Board. Still, the economy barely limps along. The problem transcends debt. The disillusion with the pre-crisis euphoria has led to an opposite post-crisis reaction. Yesterday’s foolish optimism has become today’s protective pessimism. A Pew survey finds 63 percent of Americans feel “no more secure” than five years ago.
People once thought the future was more stable and more predictable; now they fear it’s less stable and less predictable. Their behavior becomes more precautionary. For consumers and companies, there’s a greater bias against spending, lending, hiring and taking economic risks of any kind. The economy, though not crippled, isn’t invigorated either. With changed behavior, economic models based on past patterns frequently over-predict growth.
The second reason to reexamine the crisis involves policy. The “scoundrel” theory of causation suggests that, once defects in the economic system are identified, they can be rectified with “reforms.” The Dodd-Frank financial legislation reflects this philosophy. The true history of the crisis raises a larger problem. Success in stabilizing the economy in the short run fostered greater long-run instability. What are the limits to stabilization policy? Might more short-term upsets minimize long-term calamities? Economists should be wrestling with these and other hard questions. They aren’t.
Read more from Robert Samuelson’s archive.