Four Big Reasons for the 2008 Crash

From a new study refered to by Paul Krugman of the NYT, comes four big reasons for the global financial crash:

First, there was irrational exuberance: in both countries buyers and lenders convinced themselves that real estate prices, although sky-high by historical standards, would continue to rise.

Second, there was a huge inflow of cheap money. In America’s case, much of the cheap money came from China; in Ireland’s case, it came mainly from the rest of the euro zone, where Germany became a gigantic capital exporter.

Third, key players had an incentive to take big risks, because it was heads they win, tails someone else loses. In Ireland this moral hazard was largely personal: “Rogue-bank heads retired with their large fortunes intact.” There was a lot of this in the United States, too: as Harvard’s Lucian Bebchuk and others have pointed out, top executives at failed U.S. financial companies received billions in “performance related” pay before their firms went belly-up.

But the most striking similarity between Ireland and America was “regulatory imprudence”: the people charged with keeping banks safe didn’t do their jobs. In Ireland, regulators looked the other way in part because the country was trying to attract foreign business, in part because of cronyism: bankers and property developers had close ties to the ruling party.

There was a lot of that here too, but the bigger issue was ideology. Actually, the authors of the Irish paper get this wrong, stressing the way U.S. politicians celebrated the ideal of homeownership; yes, they made speeches along those lines, but this didn’t have much effect on lenders’ incentives.

What really mattered was free-market fundamentalism. This is what led Ronald Reagan to declare that deregulation would solve the problems of thrift institutions — the actual result was huge losses, followed by a gigantic taxpayer bailout — and Alan Greenspan to insist that the proliferation of derivatives had actually strengthened the financial system. It was largely thanks to this ideology that regulators ignored the mounting risks.