"Kee Points" with Jim Kee, Ph.D.

Will there ever be agreement in academia and in the popular press regarding the causes of the 2007-09 financial crisis? I doubt it. Does that make it more probable that a similar crisis will occur in the future? Probably. The view I run into the most, that one that seems to be the most commonly shared, is that the financial crisis was caused by three things, (1) unregulated or under-regulated capital markets, (2) former Fed Chairman Alan Greenspan’s loose monetary policy, and (3) plain old Wall Street greed.

Economist William Poole, retired President and CEO of the Federal Reserve Bank Of St. Louis, took issue with these views recently in Business Economics, the journal of the National Association for Business Economics. In a review of Sebastian Mallaby’s The Man Who Knew: The Life and Times of Alan Greenspan, Poole argues, basically, that Congress under both the Clinton and Bush administrations pushed Fannie Mae and Freddie Mac to accumulate subprime mortgages under pressure from the Department of Housing and Urban Development. These are Government Sponsored Enterprises (GSEs), with Fannie Mae being the Federal National Mortgage Association and Freddie Mac being the Federal Home Loan Mortgage Association. Specifically, Poole, cites Peter Wallison’s case (dissenting member of the 2010 Financial Crisis Inquiry Commission) that affordable housing goals under both Republican and Democrat administrations led to declining underwriting standards (e.g. income tests, etc.) and a huge accumulation by Fannie and Freddie of subprime mortgages (rather than prime mortgages, their traditional function-Poole). Due to accounting irregularities, neither firm presented standard financial reports for years, and when they did, “they lied,” according to Poole.

These assertions aren’t new but it is somewhat surprising to hear them stated so forcefully by a former FOMC (Federal Open Market Committee) member. Poole’s point is that it will be difficult to avoid the next crisis if the causes of the recent one - lax lending standards promoted by two administrations - aren’t recognized. Specifically, he feels that markets by themselves would automatically have done more due diligence in making loans, but the GSEs reduced the need for that, so the conclusion that markets were to blame is “off by 180 degrees.” Poole also argues that whether or not monetary policy during Greenspan’s tenure leading up the crisis was too loose, (a common explanation for the crisis ) is highly debatable.

My own view of the financial crisis is that you have to start with the huge reduction in capital gains taxes on housing assets that occurred as part of the Taxpayer Relief Act of 1997. 2002 Nobel Laureate Vernon Smith credited it with “fueling the mother of all housing bubbles.” I think it did increase the after-tax rate of return or yield to housing assets, which should and did cause capital to move into housing, bidding up the price and lowering the yield until it was back in equilibrium with other assets. So I wouldn’t call that a bubble, but I would say that the fairly loose monetary policy that followed in the early 2000s, and the aforementioned pressure on agencies to accumulate sub-prime debt, certainly helped to make it a bubble.

I also take the economists' view that greed isn’t really an explanation for much of anything. That is, greed is more or less a constant in human nature and human history, and a constant can’t explain a change or catastrophic event. But changing incentives, for a given level of greed, can. All of the above…changing tax rates on housing, HUD pressure on Fannie and Freddie to acquire subprime mortages, and central bank policies of low interest rates (i.e. loose monetary policy), constitute changing incentives. Those changes in incentives, and the normal behavioral responses to them, are what caused the crisis.