Root causes of the financial “crisis”

I attended a conference late last week feature a number of economists, and was surprised to discover a great deal of disagreement about what caused the “crisis” in the financial sector. There was not any Nancy Pelosi- type screed against “deregulation”, as everyone agreed that there hasn’t been deregulation in the financial sector (as this Bloomberg piece breaks down).  What there was disagreement about was which failure of government was the most important.

There were some who blamed the Federal Reserve for loose monetary policy, keeping interest rates too low for too long, then raising interest rates quickly as part of their attempts to manipulate the economy.  Judy Shelton articulates this view in today’s Wall Street Journal, and argues that we should stop our reliance on central banks.  This government failure (in fact current Fed chair Bernanke has admitted the Fed is largely responsible for causing the Great Depression) lends support to those calling for a return to the gold standard, or those calling to replace the Fed with a computer.

Others pointed to the 1977 Community Reinvestment Act (strengthened in 1995), which pushed lenders to target low- and moderate-income families who were otherwise credit risks.  This of course, led to higher rates of default on mortgages.

Finally came the position that Fannie Mae and Freddie Mac, backed by the government, pursued extremely risky lending practices.  Today’s commentary by Thomas Sowell articulates this view very well:

If Fannie Mae and Freddie Mac were free market institutions they could not have gotten away with their risky financial practices because no one would have bought their securities without the implicit assumption that the politicians would bail them out.

It would be better if no such government-supported enterprises had been created in the first place and mortgages were in fact left to the free market. This bailout creates the expectation of future bailouts.

Sowell credits Congressman Barney Frank and Sen. Chris Dodd, specifically, for getting Fannie Mae and Freddie Mac to “push financial institutions to lend to people they would not lend to otherwise, because of the risk of default” and then defending Fannie and Freddie when others were calling for reform and warning of a looming crisis.  Of course Frank and Dodd had numerous ties to Fannie and Freddie, in contributions, lobbying, and romance, but are somehow still given leadership roles in negotiating the bailout.  (Note: Fannie Mae and Freddie Mac announced yesterday that they are facing a federal grand jury investigation of their accounting practices)

As for what should be done now – there was pretty widespread support for the free market approaches supported by many in Congress.