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Causes of the Financial Crisis: Many Responsible Parties

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  • Zeckhauser, Richard

    (Harvard University)

Abstract

This analysis argues that blame for the financial crisis falls specifically and heavily on a broad range of the private players and public regulators in our financial sector. Wall Street and the government joined hands in a situation of contributory negligence. Even recognizing the triggering event of the collapse of the subprime market, a key question arises: How did a relatively small loss--$1 billion in subprime mortgages--initiate such a gigantic loss amounting to $20 trillion? By contrast, the NASDAQ swoon of 2001-02, though entailing equal direct losses, had virtually no reverberating consequences. The novel aspect of this crisis was the tremendous inter-penetration of the various affected sectors, notably due to financial engineering. Assets were put in place that were both unfamiliar and opaque. This enabled Firm B's shortfalls to become A's losses, and similarly for Firm C's impositions on B and hence A. This was a cascade of risk that A had not perceived. Such engineering, like nuclear weapons will be with us forever. Unfortunately, they are very difficult to regulate, since critical elements of secrecy provide some of their value, and creative new products are always around the corner. In the critical race between effective regulation and innovation, innovation will win at least some of the time. A modest proposal is made for a mechanism that will provide better information about the security of financial institutions and the financial system as a whole. It is also recommended that we have a financial intelligence agency, and that that agency bear no regulatory responsibilities lest it be subject to political pressures to shield its eyes or use rose-colored glasses.

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Bibliographic Info

Paper provided by Harvard University, John F. Kennedy School of Government in its series Working Paper Series with number rwp10-016.

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Date of creation: Apr 2010
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Handle: RePEc:ecl:harjfk:rwp10-016

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