Four Ideas to Blame for the Financial Crisis

Last week, Time.com published a list of "25 People to Blame for the Financial Crisis" (http://www.time.com/time/specials/packages/article/0,28804,1877351_1878509_1878508,00.html). I won't say much about the choices other than to note the absence of anyone currently in a position of power in the American Government. Certainly there are plenty of candidates (Barney Frank, Chris Dodd). So much for the press guarding our liberties by standing up to public officials.

The reason I won't say much about this list is I think it’s the wrong list to make. People act according the ideas that they believe. If you want to know the root cause of what people do, look at their ideas. You don't need 25 of them; four is enough. Ideas are not only more fundamental. They're more economical.

So here are Four Ideas to Blame for the Financial Crisis:

1. Individuals should be protected from the consequences of their actions. The implied Federal guarantee of loans owned by Fannie Mae and Freddie Mac contributed to the housing bubble by encouraging investors to place billions of dollars in risky securities backed by these enterprises. Economists call this "moral hazard".

2. This is the worst economy since the Great Depression. As you can see from two leading indicators of economic health, unemployment rate and GDP growth, this is not the worst economy since the Great Depression. In the past fifty years, there were many recessions more severe than this one:

Unemployment rate: January 2009 7.6%, June 1992 7.8%, November 1982 10.8%, May 1975 9.0%, October 1949 7.9% (source MiseryIndex.com).
Seasonally adjusted annual rate of change of GDP based on chained 2000 dollars: 2008 QIV –3.8%, 1980 QII –7.8%, 1975 QI –4.7%, 1958 QI –10.4%, 1949 QI –5.8% (source: BEA).

Nevertheless, the constant repetition of the "worst economy" falsehood by Democratic politicians spooked investors, shrinking the 401k and IRA balances of millions of Americans. If this economy does become the worst since the Great Depression, it will be in part due to this self-fulfilling prophecy.

3. Any criticism of a black person is racist. The regulators were not, as John McCain claimed, "asleep at the switch". OFHEO reported to Congress on the precarious state of Fannie Mae and Freddie Mac in 2004. When they did, Democrats refused to acknowledge there was a problem. This was in part due to their belief that OFHEO's criticisms were racially motivated because the chairman of Fannie Mae, Franklin Raines, was a black man. In particular, Rep. Lacy Clay (D-MO) said, "This hearing is about the political lynching of Franklin Raines." "Lynching" is, of course, a racially charged term. The Democrats prevented Congress from acting on OFHEO's warnings by threatening to filibuster any measures to rein in Fannie and Freddie. Had Congress intervened to stop expanding the housing bubble in 2004, it would not have burst in 2008.

4. Government should interfere in the operation of markets in order to obtain a particular outcome. Above all, the housing bubble was inflated by the efforts of the Federal Government to expand homeownership more widely than the free market allowed. These efforts included the creation of Fannie Mae and Freddie Mac, the continuation of a cheap money policy long after the recession of 2001 required it, and the Community Reinvestment Act.