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What Caused the Financial Crisis

Edited by Jeffrey Friedman. Afterword by Richard A. Posner

Publication Year: 2011

The deflation of the subprime mortgage bubble in 2006-7 is widely agreed to have been the immediate cause of the collapse of the financial sector in 2008. Consequently, one might think that uncovering the origins of subprime lending would make the root causes of the crisis obvious. That is essentially where public debate about the causes of the crisis began—and ended—in the month following the bankruptcy of Lehman Brothers and the 502-point fall in the Dow Jones Industrial Average in mid-September 2008. However, the subprime housing bubble is just one piece of the puzzle. Asset bubbles inflate and burst frequently, but severe worldwide recessions are rare. What was different this time?

In What Caused the Financial Crisis leading economists and scholars delve into the major causes of the worst financial collapse since the Great Depression and, together, present a comprehensive picture of the factors that led to it. One essay examines the role of government regulation in expanding home ownership through mortgage subsidies for impoverished borrowers, encouraging the subprime housing bubble. Another explores how banks were able to securitize mortgages by manipulating criteria used for bond ratings. How this led to inaccurate risk assessments that could not be covered by sufficient capital reserves mandated under the Basel accords is made clear in a third essay. Other essays identify monetary policy in the United States and Europe, corporate pay structures, credit-default swaps, banks' leverage, and financial deregulation as possible causes of the crisis.

With contributions from Richard A. Posner, Vernon L. Smith, Joseph E. Stiglitz, and John B. Taylor, among others, What Caused the Financial Crisis provides a cogent, comprehensive, and credible explanation of why the crisis happened. It will be an essential resource for scholars and students of finance, economics, history, law, political science, and sociology, as well as others interested in the financial crisis and the nature of modern capitalism and regulation.

Published by: University of Pennsylvania Press

Title Page

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pp. v-vi


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pp. vii-ix

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1. Capitalism and the Crisis: Bankers, Bonuses, Ideology, and Ignorance

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pp. 1-66

I am privileged to introduce not only the first collection of scholarly essays devoted entirely to the question of what caused the financial crisis of 2008, but a collection that brings us much closer to a comprehensive answer. As a proxy for the level of scholarly advance achieved in these pages, note that the claims of our distinguished contributors can, i ...

Part I. The Crisis in Historical Perspective

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2. An Accident Waiting to Happen: Securities Regulation and Financial Deregulation

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pp. 69-106

The specific missteps that triggered the current financial debacle have been extensively criticized. The easy-money policy of the Greenspan Federal Reserve after 2000, misaligned exchange rates that sustained large global financial imbalances, a housing bubble inflated by Fannie, Freddie, and subprime lenders, forays by insurance companies such ...

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3. Monetary Policy, Credit Extension, and Housing Bubbles, 2008 and 1929

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pp. 107-136

Asset price bubbles have been common for hundreds of years, from the Dutch tulip mania in 1636 to the South Sea bubble in 1720 and on through the years until the recent dot-com and housing bubbles. Indeed, bubbles occur quite predictably in the laboratories of experimental economists under conditions that—when we first studied ...

Part II. What Went Wrong (and What Didn’t)?

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4. The Anatomy of a Murder: Who Killed the American Economy?

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pp. 139-149

The search is on for whom to blame for the global economic crisis. It is not just a matter of vindictiveness; it is important to know who or what caused the crisis if one is to prevent another, or perhaps even to fix this one. The notion of causation is, however, complex. Presumably, it means something like, ‘‘If only the guilty party had taken another ...

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5. Monetary Policy, Economic Policy, and the Financial Crisis: An Empirical Analysis of What Went Wrong

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pp. 150-171

What caused the financial crisis? What prolonged it? Why did it worsen so dramatically more than a year after it began? Rarely in economics is there a single answer to such questions, but the empirical research presented in this chapter strongly suggests that specific government actions and interventions should be first on the list of ...

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6. Housing Initiatives and Other Policy Factors

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pp. 172-182

The current financial crisis is not—as many have said—a crisis of capitalism. It is in fact the opposite: a demonstration that well-intentioned government intervention in the private economy can have devastating consequences. The crisis has its roots in the U.S. government’s efforts to increase home ownership, especially among minority, low-income, and other ...

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7. How Securitization Concentrated Risk in the Financial Sector

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pp. 183-199

There is almost universal agreement that the fundamental cause of the crisis was the combination of a credit boom and a housing bubble. In the five-year period covering 2002–2007, the ratio of debt to national income increased from 3.75:1 to 4.75:1. It had taken the prior full decade to accomplish an increase in debt of this magnitude, ...

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8. A Regulated Meltdown: The Basel Rules and Banks’ Leverage

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pp. 200-227

In trying to identify the immense cluster of bankers’ and investors’ errors that caused the financial crisis, some writers (e.g., the authors of Chapters 3 and 5) have emphasized the role of artificially low interest rates; others have blamed ‘‘animal spirits’’ (e.g., Akerlof and Shiller 2009, chap. 14); still others have identified the deregulation of the ...

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9. The Credit-Rating Agencies and the Subprime Debacle

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pp. 228-237

The three large U.S.-based bond-rating agencies—Moody’s, Standard & Poor’s (S&P), and Fitch—played a central role in the financial crisis that began in 2007. These three agencies’ favorable ratings were essential for the sale of bonds that were securitized from subprime residential mortgages. The sale of these bonds, in turn, was an important ...

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10. Credit-Default Swaps and the Crisis

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pp. 238-248

After the failure of Bear Stearns, Lehman Brothers, and AIG had signaled the global financial meltdown, Securities and Exchange Commission chair Christopher Cox was quoted in the Washington Post as telling an SEC roundtable: ...

Part III. Economists, Economics, and the Financial Crisis

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11. The Crisis of 2008: Lessons for and from Economics

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pp. 251-261

We do not yet know whether the global financial and economic crisis of 2008 will go down in history as a momentous or even a uniquely catastrophic event. Unwritten history is full of events that contemporaries thought were epochal but are today long forgotten. Conversely, much of what we think of as critical was, at the time, considered ...

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12. The Financial Crisis and the Systemic Failure of the Economics Profession

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pp. 262-278

The global financial crisis has revealed the need to rethink fundamentally how financial systems are regulated. It has also made clear a systemic failure of the economics profession. Since the 1970s, most economists have developed and come to rely on models that disregard key factors—including heterogeneous decision rules, revisions of forecasting strategies, and changes in the ...

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Afterword: The Causes of the Financial Crisis

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pp. 279-294

I am honored to have been asked by Jeffrey Friedman to write an afterword to this fine collection of essays that he assembled for a special issue of Critical Review (which he edits), now being published in book form, with some revisions by the authors. Although written within months of the financial collapse that occurred in September ...

Abbreviations and Acronyms

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pp. 295-296


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pp. 297-318


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pp. 319-336


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pp. 337-342


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pp. 343-358


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E-ISBN-13: 9780812204933
Print-ISBN-13: 9780812221183

Page Count: 376
Publication Year: 2011

Research Areas


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Subject Headings

  • United States -- Economic policy -- 2001-.
  • Financial crises -- United States -- History -- 21st century.
  • Finance -- United States -- History -- 21st century.
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