Financial Crisis – Market Failure or Government’s Mistake

Mr. Rajan has made some further comments here and he had some original entries on his (young) blog here. Do I agree with everything he says, no, but the overall summary is similar enough. Instead I want to take up “bruce”’s comment:

• Jun-7 - bruce —

  Very interesting but you ask why "the financial system suddenly took such a deep dive into lending to low-income housing" and conclude it must have been due to government pressure, but ...

  these subprime mortages were being resold as components of AAA-rated securities, right? The lenders were getting the profit and offloading the risk. That was new, right?

  Without analyzing the data (which I'm not qualified to do anyway), the latter explanation seems more plausible than the former Unless, of course, you're claiming that the GSE's were the major buyers (suckers) for these securities. But I seem to recall that not only the GSE's but also Lehman Brothers, Bear Sterns, Merrill Lynch, AIG, washington Mutual, and other institutions were all caught in the same mess. Can you explain that? Or is it

 

In this case we tend to confuse root causes and symptoms. That an economy can be very good at “we play along, because there is money” is nothing new. We just have to remember the dot-com crash. During the late 90s there were companies that were highly rated and traded on Wall Street, while having a ROI of almost zero, because they just did something with the internet.

You can view subprime mortages and their packaging from a similar angle. And you can still conclude that with all their mischievous and stupid actions, they only worked inside the regulatory barrier-ridden market they had to and followed incentives by the government. There wouldn’t probably have been this kind of a mess in a freer market without bad incentives. The incentive to get poor people into houses as homeowners has been there since the early 2000s. The very existence of the Maes is a good example for this belief.

Then there is the problem with leverage. They wouldn’t (and couldn’t) have bundled those securities in the way they did. Also, in the free market, the crisis would have been less pronounced and quicker. Government shouldn’t have bailed-out enterprises that made really stupid decisions.