Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 9 November 2017

What really caused the financial crisis

The Global Financial Crisis (GFC) defines how we think about our recent past, our present and our future, yet there is no clear consensus account of why it happened. There have been so many explanations put forward. On the US side these have included the Asian savings glut overwhelming the financial system, a failure of US monetary policy and a US housing bubble (and too much lending to poor people). [1] On the European side the focus has been on excess borrowing by, or excess lending to, the Eurozone periphery, and sometimes on the poor Eurozone architecture. Yet as I have read more and more on this, it seemed to me that we should be focusing on the financial sector in both the US and the Eurozone, and of course the UK. My view has become that the crisis happened because banks in the US and Europe became too highly leveraged, and were therefore a crisis waiting to happen.

It was for this reason that I found Tam Bayoumi’s presentation of his new book so interesting.

He argues that by 2002 almost all the ingredients for the crisis were in place. In Europe we had very large universal banks (combining retail and investment banking) which were far too highly leveraged. In the US retail and investment banking were separate, with tight regulations on retail banks but little regulation on investment banking leading to shadow banking (deposits effectively moved to investment banks, like Lehmans, that again became too highly leveraged). In 2002 these two were separated by geography, but a small regulation change in 2003 allowed linkages between the two to develop, and then it was only a matter of time before we had the GFC, where ‘Global’ here means the US and Europe.

How did these banks become over leveraged? According to Bayoumi in Europe the creation of Universal Banks represented a flawed attempt to create a single European market in banking. There were subsequent failures in regulation that allowed these banks to expand (increase leverage) by manipulating their own risk weighting. This allowed these banks to move into Southern Europe and North America in a big way. In the US investment banks were not regulated because of a firm belief by the Fed that competition provided its own regulation for this type of bank.

Thus the GFC was the story of an over leveraged, interconnected banking system on both sides of the North Atlantic, just waiting for a shock significant enough to bring the whole system to crisis point. The presumption, which history confirms, is that finance is naturally prone to such crises, which is why the sector is regulated, so this story is also one of regulation errors. Bayoumi argues that each one of these errors can be put down to genuine intellectual mistakes, but he did agree with me that it was sometimes difficult to tell to what extent they were also the result of political pressure from powerful financial interests.

Have governments and regulators on either side of the North Atlantic done enough since the GFC to correct the mistakes that were made? The answer is complex, and it is best you read the book to find out Bayoumi's answer. Instead I want to end by making one observation of my own. Whenever a crisis happens, in the immediate aftermath people bring their own biases to understanding why it happened. So those who had been writing about global imbalances re orientated their analysis to explain the GFC. Those who wanted to attack US monetary policy, sometimes as a way of distracting attention from the culpability of the financial sector, did so. Those that had designed the Eurozone in such a way as to avoid profligate periphery governments talked about excess borrowing by those governments.

You can see the same with Brexit and Trump. Although a protest by the ‘left behind’ played some role, the idea that they are the full story suits some narratives but it is simply incorrect, as the new paper by Gurminder K. Bhambra argues. Over time things become clearer. What this analysis by Tam Bayoumi convincingly shows is that finance always has to be carefully regulated, and failures in regulation can have catastrophic consequences.

[1] New evidence suggests that the housing crash may have actually had more to do with lending to property speculators than low income mortgage holders.


  1. The popular belief that banks were over-leveraged is an understatement: the reality is that banks should not leverage AT ALL. At least the clutch of Nobel laureate economists and numerous other economists who back full reserve banking agree that a “zero leverage” system is best.

    Leveraging appears to bring a benefit, namely that more credit / money can be created for a given stock of base money than if leveraging is banned. The flaw in that argument is that creating extra base money costs nothing, thus it is easy under a “zero leveraging / base money only” system to issue whatever amount of base money is needed to bring full employment. Thus not only does leveraging achieve nothing, but it imposes huge costs when banks fail.

  2. whats wrong with mark blyth explanation?

    1. Well... it's hard to take him seriously.

    2. Oi! I resemble that remark. But seriously. Chs. 2 and 3 of my Austerity book basically tells a very similar story. Erik Jones tells that story too. Moreover, that Bhambra paper you linked to at the end is hardly a clincher. Half of it is an opinionated book review. Why did you find that piece convincing Simon?

    3. Mike - I think Bayoumi gives an account that is very similar to Mark Blyth's explanation, and Mark got there first. But given the many alternative claims out there that have ignored Mark's book, its worth making these points again. But I should have acknowledged Mark in this post.

      Mark - His point accords with the research as I looked at it in

    4. The "left behinds" (pro-Brexit/Trump working people) are important because Leave and Trump couldn't have won without them (they "played some role"). Regardless of the bulk of the voters being middle class and/or retired.

      Trump's base is affluent suburbanites, his margin of victory was rural and poor people. If he doesn't keep enough voters of either kind of course he will lose in 2020. And if the Dems don't get them he'll win again.

      Simon was saying in a recent post he wants the left to convince people to accept immigration is beneficial, which may be easier than it seems, and then we can stay in the EU. All I can say is good luck.

    5. The clincher is... neither Leave nor Trump could have won without at least some dissatisfied working people, as both won by slim margins, but the bulk of their supporters were middle class or older people.

      In which case the Democrats can regain the White House or the Remainers can reverse Brexit if they obtain enough votes from, er, either group!

      (I think Mark Blyth would tell us the Democrats are currently still trying to get the votes of Romney to Trump voters as hard as they possibly can, rather than Obama to Trump voters...)

  3. This view overlooks the Governments intrinsic role in unemployment – both in creating unemployment with a tax demand that requires citizens to seek out a specific currency in order to be able to find work, and in mitigating the effects of that tax-created system with a job guarantee programme.

    With a job guarantee people could have kept paying their subprime mortgages rather than defaulting, and so full scale of the GFC was avoidable – had Government better understood its causal role in unemployment.

    The GFC was the CASCADE effect, and that cascade can be halted if people have a job buffer to fall back on.

    By leaving this out, both the book and your post try and join too few dots.

    1. «With a job guarantee people could have kept paying their subprime mortgages rather than defaulting»

      The defaults were mostly not by subprime borrowers on the margins of employment, but by affluent borrowers with good incomes, who speculated on properties whose mortgage payments they could not anyhow afford, using "reset" mortgages with a low teaser rate for a few years, just enough to cash in a big capital gain. The debt bubble was well into the "Ponzi" phase of the Minsky cycle.

      Even so the losses would not have been devastating, merely hideous; they were enormously amplified by "synthetic mortgages", that is huge leveraged bets on custom mortgages indices, designed by the highly creative people at Moody's and S&P, who became hugely wealthy by selling them to speculators.

  4. The contours of the Iraq War, the response to the 2008 economic crisis, and the ongoing Brexit process all seem to have followed or are following the same Conservative political narrative.

    There is a manipulated and predatory description of what the crisis is meant to be, followed by a justification of national struggle that must be undergone is order to remedy this ersatz crisis.

  5. «Bayoumi argues that each one of these errors can be put down to genuine intellectual mistakes, but he did agree with me that it was sometimes difficult to tell to what extent they were also the result of political pressure from powerful financial interests.»

    Whether there were "intellectual mistakes" that were indeed "genuine" instead of "motivated reasoning" or "hypocritical complicity" is a big claim that is hard to prove. Of course the principal instigators of the great debt/derivative bubble had not presented it as "let's create a massive bubble to asset strip the financial businesses in which we work and bezzle as much as we can"; as JK Galbraith wrote in 1954 in "The Great Crash 1929":

    The purpose is to accomodate speculators and facilitate speculation. But the purposes cannot be admitted. If Wall Street confessed this purpose, many thousands of moral men and women would have no choice but to condemn it for nurturing an evil thing and calling for reform. Margin trading must be defended not on the grounds that it efficiently and ingeniously assists the speculator, but that it encourages the extra trading which changes a thin and anemic market into a thick and healthy one.

    Wall Street, in recent times, has become, as a learned phrase has it, very "public relations conscious". Since a speculative collapse can only follow a speculative boom, one might expect that Wall Street would lay a heavy hand on any resurgence of speculation. The Federal Reserve would be asked by bankers and brokers to lift margins to the limit; it would be warned to enforce the requirement sternly against those who might try to borrow on their own stocks and bonds in order to buy more of them. The public would be warned sharply and often of the risks inherent in buying stocks for the rise. Those who persisted, nonetheless, would have no one to blame but themselves. The position of the Stock Exchange, its members, the banks, and the financial community in general would be perfectly clear and as well protected in the event of a further collapse as sound public relations allow.
    As noted, all this might logically be expected. However, it did not happen in the go-go years of the late sixties and immediately after -- the years of the performance funds and the conglomerate explosion -- nor will it come to pass.

  6. «sometimes difficult to tell to what extent they were also the result of political pressure from powerful financial interests.»

    As to that, there is a much bigger story that relatively few people seem to have figured out, which is that the startling switch of right wing parties from tory to whig policies, in particular from fiscal restraint to "deficits don't matter", from constraints on debt creation to pushing debt as high as possible, from 1980 to today.

    What I think has happened is that the "leverage industry" lobby has stolen right wing parties from their traditional propertied and business interests. In effect regulatory capture switched from "capitalists" with capital to "capitalists" without capital that wanted access to speculative funds as cheap debt, and bought that access very generously. It has happened previously in the 1920s, and accordingly JK Galbraith in "The Great Crash 1929" wrote:

    Just as Republican orators for a generation after Appomattox made use of the bloody shirt, so for a generation Democrats have been warning that to elect Republicans is to invite another disaster like that of 1929. The defeat of the Democratic candidate in 1952 was widely attributed to the unfortunate appearance at the polls of too many youths who knew only by hearsay of the horrors of those days. It would be good to know whether, indeed, we shall some day have another 1929.

    The fact was that American enterprise in the twenties had opened its hospitable arms to an exceptional number of promoters, grafters, swindlers, impostors and frauds. This, in the long history of such activities, was a kind of flood tide of corporate larceny.

    And all these people leveraged their way to amazing riches.

    «shows is that finance always has to be carefully regulated, and failures in regulation can have catastrophic consequences.»

    As usual our blogger is strongly reluctant to look at the whole picture and in particular at the distributional impact: the "markets" in the years 1980 have been carefully regulated and very successfully indeed, in favour of the "leverage industry", and the consequences have been amazingly awesome for them: people like Cayne, Goodwin, Fuld, ONeil, Lay, and the executives and traders working for them made stupendous riches, and then retired to their immense palaces and their private islands without any negative consequences while governments all over the world covered with public funds the balance sheet holes they had created, and refilled the bonus pools for the next generation of "leverage industry" bezzlers.

    At the same time retail speculators took a bit of a fright in 2008 with a fall in absolute property prices, but then they voted into power governments that did whatever it took to make residential property prices in key constituency areas zoom up again, and are enjoying massive work-free tax-free capital gains on their 3-bed suburban semis.

    The consequences of debt-a-go-go for the past 35 years have not *fabulous*, not catastrophic, for a large number of vested interests. The speculative long wave of the past 35 years has not been a random fluke, but a cultivated, determined policy to enrich the friends of friends of the whig factions that have taken over the centre-right and right-wing parties of the anglo-american countries.

  7. Since I remember the era, I'm inclined to believe the people who predicted the collapse got it right. The general consensus at the time was that the banks had discovered a new way of labeling low quality loan packages as high quality. The idea was to take a portfolio of mortgage loans and slice and dice them, hire amenable rating agencies, and label what would later be called "toxic debt" as a high quality financial instrument. If I remember correctly, each package also included some kind of hedging instrument, but it was rather obvious that this hedging instrument was subject to the same financial forces as the underlying investments it was supposed to be hedging.

    It worked very well. The banks made money originating the loans. The ratings agencies made money rating them. The banks made money selling the mixed product based on the loans. Various investment house made even more money selling spoiled dog meat as prime rib.

    The limiting supply was the number of loans issued, so banks dipped deeper and deeper into weaker and weaker loan prospects. They suborned fraudulent loan applications. They applied high pressure sales practices to push loans. By the time the bottom of the barrel was wearing thin, a lot of loans were issued with extremely favorable terms, but only for an introductory period.

    People watching this were appalled, but there was too much money to be made issuing bad loans, packaging them, then reselling them with a premimum label. No one was going to rock the boat. The financial watchdogs had been neutralized. The banks had paid off both their traditional allies and their opposition. Any regulator who wanted to rock the boat was reminded of the limits of civil service protection.

    Needless to say, each packaged product increased the effective leverage, and the decreasing quality of the product increased it ever more quickly. It was rather obvious that at the first hiccup, the entire system was going to fall apart, and without Glass-Steagall, it was going to hit the banking system proper, not just the investment houses. It didn't really matter what caused the hiccup. It could have be an extrinsic slowdown that cut cash flows. It could have been the timing of those short term loans. It could have been simply running out of new borrowers.

    We had an old fashioned financial cycle of boom and bust. I'm guessing people are still surprised at this, but that's what lightly regulated financial systems do and have done throughout history. I'm glad to see people reviewing the crisis and trying to get the lessons learned, but we had already learned those lessons, but willfully discarded them since there was good money to be made doing so.

  8. I would place a large amount of the blame on the center left like Bill Clinton who reappointed Alan Greenspan who in turn felt the new shadow banking system didn't require regulation b/c the market is magic. Center left parties made a deal with the devil, helping finance deregulate in order to use some of the proceeds to fund the welfare state. Well the financial crisis helped ignite a populist revolt and now Robert Rubin is in favor of government job guarantees.

  9. I have trouble with the notion that "intellectual errors" play any roll at all. The system of private enterprise is to create profits. There is no upper bound on what level of profits are desired, so whatever stands in the way of higher profits are only laws which restrict them.

    Gov't is thus "persuaded" by the fact that they are controlled by those with the most capital (rationale therefore equated to "employment") to remove "some" legal restrictions to enable greater profits. And then "some" more for yet greter profits, etc.

    This is not an "intellectual mistake" but an inevitable and repetitive nature of the ever desired more and more 'for profit' system.

    This is Icarus repeated over and over again.

  10. Perhaps you are paraphrasing too loosely, but a couple of seeming factual errors. Glass-Steagall was repealed in 1999 I think (it had already been reduced to nothing by salami tactics) so I-banks were no longer ring fenced. Not sure 'deposits' moved to I-banks since they are not depository--but in a sense the rise of repo could be described this way. Not sure the Fed chose to not regulate I-banks--they didn't have statutory authority since I-banks weren't BHCs or FHCs which was their choice. SEC regulated them. Sorry for the pedantry.

    I do think this narrative overlooks the structural contradictions in the neoliberal model of capitalism that expressed themselves in the financial sphere, but I'll have to read the book!

    1. I wanna know more about the structural contradictions please

    2. Perhaps the decoupling of real wages and productivity, combined with the tendency of financialization to disincetivize investment so that the rising share of profits/CEO compensation expresses itself in a bloated financial system and asset bubbles. Something like that...

    3. OK, thanks for replying.

      I think it was probably a rising ratio of private debt to GDP in recent decades until it couldn't grow anymore following Steve Keen and Hyman Minsky. This hurts aggregate demand because credit creation is newly created money but it's no longer coming in. This would make derivatives, subprime mortgages etc just the proximate cause, really the tip of the iceberg. Also seems to explain the Great Depression in the US, as the debt to GDP ratio rose massively in the 20s.

  11. There were numerous policy mistakes which exacerbated the GFC. But the real-estate boom/bust had its roots in the DIDMCA of March 31st 1980. The Act created the legal basis for the addition of 38,000 commercial banks to the 14,000 we already had, and in the process, the abolition of 38,000 intermediary financial institutions (non-banks).
    It started with the non-member banks holding a part of their legal reserves in the form of interbank demand deposits (IBDDs) in correspondent member banks; the S&Ls, as IBDDs in the Federal Home Loan Banks; and the Credit Unions, as IBDDs in the National Credit Union Administration Central Liquidity Facility (pass through accounts). Presumably in order to prevent the pyramiding of reserves, the Act required all institutions holding these particular IBDDs to redeposit the funds in Federal Reserve Banks. Unfortunately, pyramiding wouldn’t be eliminated unless the Fed imposed a 100 per cent reserve ratio on these accounts. But the Act specifically exempted all except correspondent member banks from any reserve requirements.

    Then the boom was jump-started, the outcome of the S&L crisis and the July 1990 –Mar 1991 recession, by Alan Greenspan (1) dropping legal reserve requirements by a whopping 40 percent (rendering DFIs non-e-bound by c. 1995) as well as by (2) sweep accounts.

    Since the housing boom was primarily a velocity phenomenon, and economists define velocity as income velocity (a contrived metric), indeed the Board discontinued its longest running time series, the G.6 release, the boom went undetected and uninterrupted. Bank debits reflect both new & existing residential & commercial real-estate sales/purchases.

    Bankrupt-u-Bernanke (who thinks money is neutral), initiated a contractionary monetary policy for 29 contiguous months (one where the rate of change in the proxy for inflation was negative, less than zero). This coincides perfectly with the reversal in real-estate prices, turning otherwise safe assets, into impaired assets, or upside down / underwater.

    As predicted in May 1980: “One of the principal purposes of the Act was to provide the housing industry with a reliable source of funds. That may be achieved through various governmental and quasi-governmental corporations (according to Henry M. Paulson, eventually ½ of all residential mortgages were owned or guaranteed by the GSEs, FNMA and GNMA, or “a stunning $4.4 trillion worth at the time”). But the role of the S&Ls in housing finance will probably diminish significantly.”

    1. The answers are obvious, as I've repeatedly explained.
      POSTED: Dec 13 2007 06:55 PM |
      The Commerce Department said retail sales in Oct 2007 increased by 1.2% over Oct 2006, & up a huge 6.3% from Nov 2006.
      10/1/2007,,,,,,,-0.47,... -0.22 * temporary bottom
      11/1/2007,,,,,,, 0.14,,,,,,, -0.18
      12/1/2007,,,,,,, 0.44,,,,,,,-0.23
      1/1/2008,,,,,,, 0.59,,,,,,, 0.06
      2/1/2008,,,,,,, 0.45,,,,,,, 0.10
      3/1/2008,,,,,,, 0.06,,,,,,, 0.04
      4/1/2008,,,,,,, 0.04,,,,,,, 0.02
      5/1/2008,,,,,,, 0.09,,,,,,, 0.04
      6/1/2008,,,,,,, 0.20,,,,,,, 0.05
      7/1/2008,,,,,,, 0.32,,,,,,, 0.10
      8/1/2008,,,,,,, 0.15,,,,,,, 0.05
      9/1/2008,,,,,,, 0.00,,,,,,, 0.13
      10/1/2008,,,,,,, -0.20,,,,,,, 0.10 * possible recession
      11/1/2008,,,,,,, -0.10,,,,,,, 0.00 * possible recession
      12/1/2008,,,,,,, 0.10,,,,,,, -0.06 * possible recession
      Trajectory as predicted:

  12. What does Rational Expectation theorists have to say about the fact that they can LEARN about the crisis?

  13. "All The Devils are Here" by Nocera and Maclean does a pretty good job of giving the detail.

    My interpretation is that governments were ramping credit to drive growth i.e. creating a bubble in order to generate a feel-good factor and get elected. They systematically removed barriers to lending to avoid the inevitable economic dip that would occur on bursting the bubble. The boom inevitably ended when there was no-one left to lend to.

    Two examples of this are allowing self-certified mortgages allowing banks to choose their regulator. This latter example made regulation competitive and so encouraged lax regulation.

    It is easy to be critical of participants but again from the book a lender (I believe Nationwide in the USA) announced it was not going to do sub-prime lending. After two weeks of having no-one come into their offices they went all-in on sub-prime. In a highly competitive and leveraged market all the business takes place at the margin which is set by the government of the day.


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