Tag Archives: financial crisis

Causes of the financial crisis, redux

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Washington Post columnist Barry Ritholtz:

Rather than attend a college-level seminar on the complex philosophy of causation, we’ll keep it simple. To assess how blameworthy any factor is regarding the cause of a subsequent event, consider whether that element was 1) proximate 2) statistically valid 3) necessary and sufficient.

These are some strange criteria. Actually, I’m not sure I can even call them “strange” since they aren’t ever defined in the piece. I guess it’s just a way for Ritholtz to justify appealing to actual standards for evaluating causation–as he puts it, things taught in a “college-level seminar on the complex philosophy of causation.”

But to get to what Ritholtz is arguing against (what he calls the “big lie” of the crisis):

Consider the causes cited by those who’ve taken up the big lie. Take for example New York Mayor Michael Bloomberg’s statement that it was Congress that forced banks to make ill-advised loans to people who could not afford them and defaulted in large numbers. He and others claim that caused the crisis. Others have suggested these were to blame: the home mortgage interest deduction, the Community Reinvestment Act of 1977, the 1994 Housing and Urban Development memo, Fannie Mae and Freddie Mac, Rep. Barney Frank (D-Mass.) and homeownership targets set by both the Clinton and Bush administrations.

Running through his counter examples, I guess it’s not completely unconvincing.

Credit ratings and political gridlock

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Lots of chatter lately about the causes and consequences of standard and poor’s decision to downgrade the USA’s credit rating. One thing I haven’t seen discussed is whether the agency’s judgment of our political system is at all rooted in reality.

From the recent coverage of the downgrade, I learn that the ratings are said to be driven by five criteria, four of them economic and one political. I also learn that S and P has been clear that their downgrade is driven entirely by the fifth criterion.

So that makes me wonder: are they right that our political system is unstable and dysfunctional? Is that a stupid question? Sure it’s true that most people accept that statement at face value. But as a political scientist I’d like something more than a single “expert opinion”. As they teach us in intro econometrics, statistical estimators of population parameters (eg, the mean but say in our case we want to estimate some underlying “quality of government”) can be judged by both bias–deviations from the truth–and variance–the uncertainty surrounding the estimate. As they also teach us, expert opinions like S and P’s are great in terms of having zero variance, but probably terrible in terms of their distance from the truth.

Some political scientists have ventured to measure government performance quantitatively–see David Mayhew’s book Divided we Govern, which uses a count of important legislation passed per Congress as a measure of government performance. Not a perfect measure, but I trust it more than S and P. Economic indicators are probably good too–indeed as John Sides at the monkey cage has shown, mass support for government moves in tandem with changes in disposable income. But recall that S and P explicitly said they were not relying on economics in their evaluation.

What caused the financial crisis? (ii)

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(See this earlier post.) Yale economist Robert Shiller authored a piece in the New York Times “Economic View” column the other day on the role of housing in the financial crisis. The piece begins with a criticism of “news accounts” of how the crisis began:

THE origins of the current economic crisis can be traced to a particular kind of social epidemic: a speculative bubble that generated pervasive optimism and complacency. That epidemic has run its course. But we are now living with the malaise it caused.

News accounts of the economic crisis rarely put it in these terms. They tend to focus on distinct short-term developments or on the roles of prominent people like Federal Reserve governors, members of Congress or Wall Street financiers. These stories grab attention and may be supported by some of the economic statistics that the government and private institutions collect.

But the economic situation is primarily driven by hard-to-quantify sociological factors that play out over many years.

So is Shiller absolving anyone of responsibility for the crisis? He writes:

During the bubble, the sense of rising wealth and high expectations gave people a good reason to spend and a greater willingness to plunge into investment, too. Government policy makers breathed in the same optimism, which no doubt encouraged them to be lax on regulatory restraint.

For what it’s worth, I find this alternative explanation more persuasive. I also find it more practical: what are we supposed to do with the Shiller thesis? The key idea there is that people are uniformly “irrational”, and I’m not sure what more you do after that. Talking about the incentives of firms and regulators somehow seems more tractable.

Did a push for homeownership cause the financial crisis?

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Gretchen Morgenson, a Pulitzer Prize-winning reporter for The New York Times, and financial analyst Joshua Rosner have written an engaging and insightful analysis of the subject.

The authors argue that while there is plenty of blame to go around, the major culprits are the past leaders of mortgage buyers Fannie Mae and Freddie Mac and the politicians who pushed for an increase in homeownership, with little regard for possible collateral damage.

From a book review in the May 30 Boston Globe. I admit with embarrassment, I’ve always been puzzled as to what caused the financial crisis, or even what the crisis was. But my lack of any firm explanation in my head doesn’t help me follow Morgenson and Rosner’s argument, at least as it comes through the review. Let’s try to unpack the model, such as it is.

More Homeownership => Financial Crisis

Too simple, right? Well there is one intermediate step I seem to remember.

More Homeownership => More Subprime Mortgages => Financial Crisis

Hmmm…I’m still not seeing the mechanism. I’ll try to dig deep into my memory of 2008, and all the documentaries I’ve watched on this topic since then, which weren’t actually that helpful in explaining what happened.

More Homeownership => More Subprime Mortgages => Banks Doing Crazy Stuff => Banks Fail => Financial Crisis

So I wonder if these authors are focusing a little too much on the consumer side of the problem. I also wonder if their work plays into the argument that the crisis was a result of the government being too responsive to the needs and wishes of the poor. Yes, apparently that view is out there, being put forth by respected economists. See this MIT news story, and the accompanying slides, about Daron Acemoglu (note that Acemoglu is countering this view, drawing on work in political science).

What I also found interesting in this piece was this bit about the role of economists:

They note that many of the policies aimed at increasing homeownership were designed to counter existing policies that were believed to discriminate against minorities. A widely heralded 1992 study by the Boston Federal Reserve found evidence that racial discrimination among mortgage lenders in Boston was pervasive.

Fannie and Freddie used the report, which was based on data supplied by the lenders, as a reason to launch widespread outreach efforts to minority communities and encouraged other financial institutions to do the same.

However, upon closer examination of the study several economists discovered important flaws. These included failing to consider whether rejected applicants met the lender’s financial requirements and using an analytical method that oversimplified the mortgage application process.

That last paragraph is hard to unpack, but it sounds like the economists tried to correct for selection bias or something.