Share

Beltway Confidential

Illuminating observations on the financial crisis

By |
Beltway Confidential,Michael Barone,2008 Financial Crisis,Ben Bernanke

Two Bush administration appointees, Director of the Economic Council Keith Hennessey and Council of Economic Advisers Chairman Edward Lazear, have prepared an interesting paper with 19 observations on the financial crisis. You can access their summary or the PDF of the paper.

I found a couple of their observations particularly interesting. They link the financial crisis to a large inflow of capital into the United States in the mid-2000s --- a contrast to the usual pattern in which capital flows out from rich countries to poorer countries. As a result, they write, "cheap credit made risky investment seem profitable." Risky investment, particularly in mortgage-backed securities, which government regulations treated as low-risk investments --- incorrectly, as it turned out.

Another interesting point. They contrast what they call the "domino theory" and the "popcorn theory" of financial shocks. The two theories produce different government responses. If you believe in the domino theory, you rescue one financial institution lest its failure lead to loss of confidence in others or to the failure of its counterparties. If you believe in the popcorn theory, you believe that the cause affects all or many financial institutions, and saving one does nothing to prevent the failure of others. The key government officials --- Fed Chairman Ben Bernanke, Treasury Secretary Henry Paulson, New York Fed President Timothy Geithner --- acted as if they believed in the domino theory, and then were stuck when they had no legal authority to prevent the failure of Lehman Brothers. With the benefit of hindsight, Hennessey and Lazear believe mostly in the popcorn theory.

I am not sure I agree with everything in the paper. But it's a short and interesting read for anyone trying to understand what happened --- and what policies should be in the future.

View article comments Leave a comment