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
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.