Lessons of the Financial Crisis

While I’m on the topic of narratives, Matthew Boudway at dotCommonweal has a post up entitled “They Cannot Fathom Their Failure”.* The post is based on a George Packer column, which basically makes the argument that conservatives “cannot fathom the failure of their philosophy” after the recent financial crisis, and that to deny they have been discredited is a form of self-delusion. This is a charge, I suppose, to be approached with trepidation; false consciousness is notoriously difficult to disprove. That said, it may be worthwhile to offer some thoughts in response. Here is an excerpt from the post:

…“[T]hey cannot fathom the failure of their philosophy.” Not “they will not fathom” it. They cannot. Sure, the response of many conservatives to the bailout and the stimulus package has been opportunistic and cynical. Many of them, though, simply cannot imagine what it would mean — what it now does mean — for the premises of their policy agenda, and indeed of their entire political philosophy, to have failed.  Not even the most spectacular failure can force anyone to learn a lesson he desperately wishes not to learn. Historical events are always complicated and contingent enough to admit of more than one interpretation, and the most plausible interpretation is often not the most attractive.

I agree that the Republican response to the stimulus lends itself very well to a cynical interpretation. But, then, so does the stimulus package passed by Congressional Democrats. When almost half of the spending in a ‘stimulus package’ won’t be spent until 2011, then something is amiss with the design of the purported ‘stimulus’.

Back in September, Megan McArdle wryly remarked in the midst of the presidential campaign: “Isn’t it marvelous how the financial crisis has been caused entirely by things that you were opposed to before the crisis happened?” Ms. McArdle was being facetious, but apparently George Packer and Matthew Boudway believe something similar in all sincerity, and, surprise of all surprises, it validates their pre-existing political philosophy, which I take to be essentially that centralized government regulation is the sure-fire panacea to the problem of free markets. According to Packer and Boudway, any other interpretation of the finanical crisis is basically an attempt to manipulate historical contingency in a desperate (if psychologically understandable) attempt to obfuscate the obvious. Here’s more:

“The financial collapse could mean that our financial industry has been underregulated and overleveraged for many years, and that the power of centralized capital requires centralized public oversight to keep it in check. In that case I and my allies have been fools. Or it could mean that any regulation is too much regulation, and that the market only works when banks are allowed to fail, no one’s money is guaranteed by the government, and everyone must look out for himself. In that case I’m one of a small remnant of brave prophets who are destined to be ignored by all the weaklings now looking to Washington for safety.”

If it were only a matter of rationally evaluating the available evidence, it would be hard at this point not to favor the first of these interpretations. But of course it is never just about rationality; it is also about saving face and even, sometimes, saving one’s very self. What is true of religious conversions is true of ideological conversions: the old man does not yield easily to the new. Even Paul did not leap up from the ground, jump back on his horse, and ride straight to the nearest village to begin evangelizing. He was stunned, blinded, scared; and those fish scales stayed on a while. In any case, there is no shame in silence. It is the normal reaction to disorientation (Alan Greenspan cut a noble figure as he quietly ate three decades of placid reassurance). The shame is in simply raising your voice and yelling the same thing you were saying before, this time with your hands clapped over your ears: “Laissez-faire capitalism has not been tried and found wanting; it has been found wanting and left untried.”

Like the man said — time to put away childish things.

While I give Matthew props for the Chestertonian paraphrase, this summary of the competing explanations for the financial crisis is seriously deficient. Specifically, it completely overlooks the fact that government regulators, no less than market participants, are human beings prone to the same errors in judgment as anyone else (and, in some cases, worse errors in judgment because they have less incentives to be right).

This objection is not just theoretical. Here are some examples from the recent financial crisis: 1)  the Federal Reserve pursued what has been described as a reckless monetary policy, keeping interest rates well below historical levels between 2002-2005. John Taylor of Stanford, for instance, argues that this was the sine qua non of the recent financial crisis. 2) Democrats and Republicans pushed for the relaxation of credit standards for low-income and/or low credit score borrowers, which artificially inflated home prices and dramatically increased the likelihood of foreclosures. 3) Lax regulation of Fannie Mae and Freddie Mac, which together financed around 40% of U.S. mortgages, created a significant moral hazard problem, incentivizing managers to take on excessive levels of risk. When the Bush administration argued that these rules should be modified, the Democrats pushed back, even though these risks were entirely foreseeable at the time.

Moreover, it is far from clear that the last round of regulatory enthusiasm, the Sarbanes-Oxley Act of 2002, was beneficial to the economy. Studies suggest Sarbanes-Oxley has had a chilling effect on risk-taking and investment, resulted in less firms going public, and has substantially increased the likelihood that IPO’s will be conducted in the U.K. rather than the United States. Yale law professor Roberta Romano famously described the difficulties involved in creating effective regulatory legislation in an instructively entitled paper, ‘The Sarbanes-Oxley Act and the Making of Quack Corporate Governance,’ which should be required reading for those with a child-like trust in the efficiency and wisdom of government regulation for its own sake.

It should not be surprising in light of the examples given above that many economists do not share Packer’s and Boudway’s view that market failure is the only real lesson to be drawn from the financial crisis. Here’s Tyler Cowen, for instance: “The crisis represents a massive conjunction of both market and governmental failure.” John Taylor of Stanford goes further, recently stating “my research shows that government actions and interventions — not any inherent failure or instability of the private economy — caused, prolonged and dramatically worsened the crisis.”

My goal here is not to discredit regulation or government intervention. Rather, it is to point out that the financial crisis contains just as many lessons for proponents of government intervention as it does to proponents of free markets. Some honesty and epistemological modesty is in order here. We cannot design perfect regulations to solve every problem, and many regulations are the proverbial cure that is worse than the disease. Similarly, the vulnerability of markets to boom and bust cycles is well-documented at this point. I certainly agree that new regulations are necessary in the housing industry. Of course, I don’t know of any conservatives who disfavor revised regulations in the housing industry.

Conservatives argue, contra Boudway and Packer, that what we had previously is best described not as under-regulation, but rather as poorly designed regulation, with culprits in both parties responsible for that design.  Thus many conservatives urge, along with Prof. Cowen, that effective regulation rather than simply more regulation is necessary. For Boudway and Packer, the problem was simply under-regulation, which they suggest is entirely the fault of the now-and-forever-discredited Republicans. But this, as the examples listed above suggest, is simply nonsense.

Many of the most damaging regulations were initiated, proposed, and defended by Democrats. And the same is true of Republicans. This was a bi-partisan failure in governance and in markets which contains lessons for both parties, not just for the one for which Mr. Boudway and Mr. Packer choose not to vote. In short, I would agree with Mr. Boudway that it is time to put away childish things, but I would suggest that among them is the notion that a massive failure of the public and private sectors only has lessons for one political party.

Update: The original version of this post erroneously attributed a portion of the second block quote to Mr. Packer. This error has been corrected.

* Full disclosure: I knew Mr. Boudway socially a while back and he was (and, presumably, still is) a very nice, very smart guy.

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John Henry

Don't call me Nueman.


  1. If the financial crisis somehow disproved conservative economic policies, then how does one explain the fact that the crisis is even worse in Europe and Japan than it is here?

  2. Well, one could reply that the financial crisis spread from the U.S., but as the links BA provided show, the leading economic indicators in other countries fell off prior to the U.S. crisis. And proponents of regulation and intervention in my view need to offer a compelling reason to believe that the political process is more effective at regulation than the financial markets. Granted, the track record of the latter has been less than stellar recently, but countries with higher levels of regulation generally have much lower economic growth and slower recoveries from economic downturns.

    At a minimum, if one is going to make the strong claim that a political or economic philosophy has been completely discredited, then one should provide evidence for the position.

  3. Sarbanes-Oxley has had a chilling effect on risk-taking and investment, resulted in less firms going public

    Having done contract work for the past three years and doing work for the same company from time to time, I have seen two companies revert back to a private firm and a new one never going public. Sarbanes-Oxley was a major variable in their decisions to revert or remain private.

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