If you ask most people today what caused the 2008 financial crisis and the subsequent “Great Recession,” my suspicion is that the answer would be something like “untrammeled and unregulated financial markets.” At the time, I and others argued that a combination of mistaken monetary policy, government interference in American housing markets, and a firm belief on the part of large banks and Government-Sponsored Enterprises (GSEs) that they would get bailed out by the federal government if they ever faced colossal losses were the primary precipitating factors. I still consider this diagnosis to be correct. Alas, there is little doubt, however, that the “it-was-the-fault-of-unregulated-markets” thesis triumphed in the public imagination.
That is all the more reason for this interpretation to be challenged, not least because it will better equip us to understand the next major economic crisis, whether it comes in 10 or 50 years’ time. It is also necessary for any analysis of the events of 2008 to consider what the aggregate data accumulated since then tells us, and to examine the role of institutions like the Federal Reserve and GSEs such as Fannie Mae and Freddie Mac in the crisis.
This is the task undertaken by Todd Sheets in his 2008: What Really Happened—Understanding the Great Financial Crisis. A seasoned investment banker and economic historian, Sheets begins by observing that it invariably takes a long time before we acquire anything like an accurate understanding of the causes of major economic crises: “A lengthy delay,” he writes, “from an economic crisis to an understanding of what really happened tends to be the rule rather than the exception.”
Whether it is the economic impact of President Andrew Jackson’s decision to close the Second Bank of America or the causes of the Great Depression, the time lag between the event and any definitive explanation of what happened can range from decades to even a century. Part of the delay owes something to the time it takes to accumulate and then explain relevant data. But Sheets notes that it invariably takes a very long time to overcome whatever has the established narrative, much of which is constructed by participants with a strong interest in promoting a story that puts them in the best light possible and their opponents in the worst. Such is human nature.
Unpacking a Crisis
Sheets begins with a brief overview of the 2008 financial crisis and makes the case that understanding it means beginning with the housing bubble whose origins can be traced to the late 1990s. He goes so far as to say that, minus the housing bubble, “there would not have been a financial crisis in 2008.” Sheets is not the first to make this claim. He does, however, lay out a clear cause-and-effect for 2008. Sheets also goes into considerable detail when explaining the different phases of the housing bubble and how its growth quickened over time. He notes that prior to 1997, “real home prices declined by an average of 0.2%,” and then shows how real home prices increased during the period of liftoff (1988–2001) at an average annual rate of 4.7% before magnifying again at an average annual rate of 8.3%, “reaching a peak of 10.4%” during the period of 2002–5.
These are striking numbers but, Sheets states, they cannot be attributed to a single factor, whether loose monetary policy or the activities of Fannie Mae and Freddie Mac. What is needed, he maintains, is “a plausible theory” that can “explain the sudden onset and the distinct phases of the bubble.” Sheets then builds such a theory in which factors like uncertainty play a leading role, as does failure across the regulatory spectrum (rather than just regulatory oversight of investment banks), whether it was that of GSEs, commercial banks, or brokerage firms.
Sheets proceeds methodically through the housing bubble, the liftoff phase of the bubble, and its acceleration phase before turning to 2008 and the specific role played by investment banks and money market funds throughout that year. In doing so, he provides a convincing refutation of the gradual deregulation narrative that still maintains considerable traction in academic and popular discourse.
Sheets makes a point of not demonizing or caricaturing the regulators. Nonetheless, he does demonstrate the extent to which the dominant narrative “is largely constructed from anecdotes, the accounts of talented but biased insiders, and selected facts.” As a theory, Sheets shows that the gradual deregulation interpretation is also “inconsistent with the aggregate data on the housing bubble and the financial crisis.”
To support his argument, Sheets examines an impressive array of data such as the financial statements of major investment banks as well as longer-term trends in price levels. His book is, however, much more than a compilation of numbers. Sheets integrates data analysis into attention to the choices made by some of the most important players in this story during the decade before the crisis and throughout the crisis itself. He also weighs into some of the debates between these individuals about topics like the role played by monetary policy, highlighting the strengths and weaknesses of their respective positions.
Especially instructive in this regard is Sheets’ analysis of the stances taken by Stanford economist John B. Taylor (famous for prescribing the Taylor Rule as a guide for interest-rate policy) and former Federal Reserve chair and Nobel Prize–winning economist Ben Bernanke vis-à-vis the Fed’s role in the crisis. In doing so, Sheets shows the enduring strength of Taylor’s guidance but also how Bernanke posed good hypotheticals about what the Fed could and could not have been reasonably expected to do as it sought to realize the employment and inflation goals spelled out in its official mandate while simultaneously seeking to moderate the housing bubble. Some circles are difficult to square.
Could the Crisis Have Been Avoided?
This raises the issue of whether the crisis could have been avoided. Is it the case that particular actions might have prevented the worst financial and economic meltdown since the Great Depression? Or did it become unavoidable once longer-term dynamics were firmly in place?
Like the proverbial run on banks, economic and financial trends are often difficult to stop once underway, especially if incentives are aligned in particular ways and policy institutions have become complacent or inattentive to what is going on beneath the surface of everyday market activity. As Sheets observes, however, the Fed was not utterly out of touch. He also believes it made one crucial mistake:
A financial crisis was avoidable even with the housing bubble. The financial markets were stressed but not panicked from the onset of the huge mortgage-driven write-downs that began in the fall of 2007 and extended through the bailouts of Bear Stearns and the GSEs. A full-blown panic did not arise until the authorities, under intense political pressure, allowed Lehman to fail.
Sheets’ point is less about the specific decision to let global financial-services firm Lehman Brothers fail than the fact that the choice contradicted “the long string of often-unprecedented financial market rescues engineered by the Committee to Save the World dated all the way back to the 1987 stock market crash.” These include the Fed’s bailout of hedge-fund Long-Term Capital Management in 1998 and its actions to address the tech stock bubble collapse in the early 2000s. “By 2008,” Sheets states, “the markets had more than twenty years of experience in seeing the Fed (with frequent assists from the Treasury) step in to rescue lenders and even equity investors from one crisis after another.”
It is not that Sheets thinks it is always a mistake to let a bank fail. Rather, it was that allowing Lehman to fail against a background of bailouts and rescues meant “money market mutual funds and others that had provided short-term financing to Lehman, on the expectation that it too would be bailed out if necessary, were caught off guard.” That is what sparked a panic, one “driven by the fear that other similarly exposed and critical financial institutions might be allowed to fail as well.” In the face of this sudden uncertainty, markets imploded.
Next Time
Sheets’ diagnosis of the deeper reasons for the financial crisis suggests his three-fold approach to preventing a similar crisis in the future. It involves 1) eliminating the role played by GSEs in national housing markets; 2) eliminating or drastically limiting the Fed’s ability to pump up asset bubbles via interest rates; and 3) requiring variable net asset value reporting for all money market mutual funds. That adds up to significant changes that bring together transparency with important restraints on the power of particular state agencies.
Yet, as significant as these measures would be if ever transformed into policy, they do not constitute the key reform the author has in mind. For Sheets, meaningful change is about addressing a problem that has continually manifested itself from the Republic’s beginning: the presence of politically privileged institutions in the U.S. economy.
In our time, they are personified by GSEs. They are, after all, “private institutions endowed with special government privileges.” Those privileges were the means by which outfits like Fannie Mae and Freddie Mac were able to acquire considerable influence over politicians in the executive and legislative branches who are supposed to oversee them. This put Fannie Mae and Freddie Mac in a prime position to influence the housing market, which is such a large part of America’s economy.
No institution with privileges, whether private or public, willingly gives them up. Avoiding a major crisis akin to the 2008 financial meltdown certainly requires clearheaded economics and commensurate policies. The bigger challenge is to persuade individuals to shed considerable power, to subject themselves to more transparency and accountability, and to embrace a humbler view of what they can and cannot do. It is the third of these transformations that is surely the most difficult.
