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Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008.

Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008.

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This paper looks at the roots of the current crisis through an analytical framework of bad bets, excessive leverage, domino effects, and 21st-century bank runs. It shows that broad policy areas—including housing policy, capital regulations for banks, industry structure and competition, autonomous financial innovation, and monetary policy—affected elements of this framework to varying, but important degrees. Ultimately, this special study seeks to draw meaningful lessons for policymakers by understanding the complex history, evolution, and integrated nature of financial regulations.
This paper looks at the roots of the current crisis through an analytical framework of bad bets, excessive leverage, domino effects, and 21st-century bank runs. It shows that broad policy areas—including housing policy, capital regulations for banks, industry structure and competition, autonomous financial innovation, and monetary policy—affected elements of this framework to varying, but important degrees. Ultimately, this special study seeks to draw meaningful lessons for policymakers by understanding the complex history, evolution, and integrated nature of financial regulations.

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10/19/2013

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NOT WHAT THEY HAD IN MIND:
A History of Policies that Produced the Financial Crisis of 2008
ARNOLD KLING
SEPTEMBER 2009
MERCATUS CENTER
George Mason University
 
Arnold Kling
Dr. Arnold Kling served as a senior economist at Freddie Mac from 1986–1994 and was an econo-mist on the staff of the Board of Governors of the Federal Reserve System from 1980–1986.The author of three books—
 Learning Economics, Under the Radar,
and
Crisis of Abundance: Rethinking How We Pay for Health Care
—Dr. Kling co-authors
 EconLog 
with Brian Caplan. Heis a member of the Mercatus Financial Markets Working Group and a contributing editor for
TCSDaily
. He has testied before Congress on the collapse of Fannie Mae and Freddie Mac. 
 
    M    e    r    c    a    t    u    s    c    e    n    t    e    r    a    t    G    e    o    r    G    e    M    a    s    o    n    u    n    i    v    e    r    s    i    t    y
1
ExEcutivE Summary
The financial crisis
of 2007 to 2008 will go down as one of the most significantevents in economic history. Large financial institutions such as Bear Stearns andLehman Brothers failed, and stock prices plummeted. This major crisis affected thereal economy, culminating in the current recession, and many analysts predict a long road to economic recovery for the United States.The severity of the current crisis raises many questions about its root causes. Any attempt to understand these root causes, however, requires the placement of policiesand regulations in the appropriate context.This paper looks at the roots of the current crisis through an analytical framework of  bad bets, excessive leverage, domino effects, and 21st-century bank runs. The papershows that broad policy areas—including housing policy, capital regulations for banks,industry structure and competition, autonomous financial innovation, and monetary policy—affected elements of this framework to varying, but important, degrees. Whileconsidering alternative points of view concerning the causes of the financial crisis, thepaper concludes that bank capital regulations were the most important causal factorin the crisis and that the policy “solutions” to previous financial and economic crisessowed the seeds for this current crisis.To fully understand the current crisis, one must account for the complex history, evo-lution, and integrated nature of financial regulations. Without this evolutionary his-tory, there will be no meaningful lessons for today’s policy makers. Unless the UnitedStates comes to terms with the fact that the actions of policy makers and regulatorscontribute to financial fragility, it has little hope of moving in the direction of a lessfragile system for the future.I would like to thank Ben Klutsey for research assistance. I would also like to thankLawrence J. White, Tyler Cowen, Russ Roberts, Brian Hooks, and Rob Raffety forhelpful comments. Errors that remain are my own.The ideas in this paper do not represent an official position of George Mason University or the Mercatus Center. The Mercatus Center wishes to acknowledge the support of the Legatum Institute in making this project possible.

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