Arnold Kling’s Diagnosis of the Financial Crisis
In his paper titled NOT WHAT THEY HAD IN MIND: A History of Policies that Produced the Financial Crisis of 2008, Arnold Kling provides historical context and analysis to explain the symptoms of the financial crisis. He writes, “To ignore these regulatory policies and instead assert that agency ratings were relied on because ‘market discipline broke down’ is to present a distorted view of history.”
Kling effectively denominates the crisis to a combination of four elemnts – bad debts, excessive leverage, domino effects and 21st century bank runs. These four elements, he says, are affected by either one or a multiple of the following areas – housing policy, capital regulations, industry structure/competition, autonomous financial innovation and monetary policy.
Kling gives most weight to capital regulations, however, and says that it was the perverse incentives set up by capital regulations that resulted not only in bad debts and excessive leverage, but also the domino effects and bank runs (as experienced by large financial institutions such as AIG). Kling asserts that capital regulations distorted morgage finance away from traditional lending and toward securitization. He says, “In explaining bad bets and excessive leverage, there are those who place higher weight than I do on the monetary policy of the Federal Reserve.”
Kling also shows that, starting from the 1930’s, the U.S. government has reshaped regulations in the mortgage market to bring reforms such as thirty-year fixed-rate mortgages and the creation of federal deposit insurance resulting in the collapse of savings and loans associations forty years later. But this only brought about more securitization, market-value accounting and risk-based capital, all of which contributed to or exacerbaed the most recent crisis.
Perhaps the only qualm I have with Kling is that he diminshes the importance of increasing money supply by the Federal Reserve in the past. The Fed created inflation that led Americans to bid up real estate prices in the first place. Subsequently, perverse incentives were not only set up by regulations that led to greater risk taking, but also the expectation on behalf of financial institutions to clean up their mess, which again involved Government Sponsored Enterprises such as Freddie Mac and Fannie Mae.