He said, she said

In response to Jacob Weisberg’s column in Slate magazine (one which I have already commented on), Peter Klein of Organizations and Markets refers to a WSJ article by Charles Calomiris; Calomiris writes that Basel norms, and not deregulation, should be blamed for the credit crisis

It’s grind-your-favorite-axe day on the network news shows. The financial crisis is all the fault of dreaded “deregulation,” shout some pundits; others blame the “small government” mentality of the Bush administration and Republicans in Congress.
[S]ubprime lending, securitization and dealing in swaps were all activities that banks and other financial institutions have had the ability to engage in all along. There is no connection between any of these and deregulation. On the contrary, it was the ever-growing Basel Committee rules for measuring bank risk and allocating capital to absorb that risk (just try reading the Basel standards if you don’t believe me) that failed miserably. The Basel rules outsourced the measurement of risk to ratings agencies or to the modelers within the banks themselves. Incentives were not properly aligned, as those that measured risk profited from underestimating it and earned large fees for doing so.

That ineffectual, Rube Goldberg apparatus was, of course, the direct result of the politicization of prudential regulation by the Basel Committee, which was itself the direct consequence of pursuing “international coordination” among countries, which produced rules that work politically but not economically. International cooperation, in case you haven’t heard, is exactly what the French and the Germans now say was missing in the past few years.

So why blame deregulation and small government? The social psychologist Gustav Jahoda says that unreasonable beliefs often arise in circumstances where people lack control and need to believe in something to get them through a highly stressful situation. And a fellow named Machiavelli might help us to understand a different reason for simplistic explanations.

So, Greenspan ran a loose monetary policy. Banks and mortgage companies slush with cheap funds lent it out to people who couldn’t afford to repay them; they packaged the mortgages, securitized them and sold them as MBS (mortgage backed securities); most sold the mortgages off to Mae and Mac who issued their own MBS. People who bought them used CDS (credit default swaps) to insure against the risk of default; AIG underwrote many CDS contracts; so did many other financial institutions. The housing loan defaults triggered a fall in the value of MBS, a corresponding re-rating of various financial institutions and a panic in the CDS market on whether the contracts would be met; Mae and Mac had to be nationalized because their securities were “implicitly” guaranteed by the US government. Banks no longer knew whom to trust and whom not to; the fall in the value of MBS cleaned out most balance sheets; and the credit market came to a grinding halt. This is what I can make out of everything I have read until now.

So who are to blame here?

  1. The Fed under Greenspan for its “bad” monetary policy (no one seemed to mind it when the going was good though).
  2. Mortgage companies who loaned out money cheaply knowing they could palm the loans off to Mae and Mac (“housing for all”).
  3. The government for having created Mae and Mac and thus granting incentives for bad practices.
  4. Financial institutions that played around with derivatives without understanding the risk involved.
  5. Credit rating agencies that granted AAA ratings without measuring the risk.
  6. Politicians who touted Basel and its risk measurement models as some kind of panacea and who forced it on to banks.

Should deregulation or lack of regulation be blamed? In the socialist universe, yes; because their ideology allows for massive government failure and abdication of responsibility, but not “market failure”. Monetary policy ills are acceptable to them (1); socialism in housing is acceptable (3), but profiteering is not (2); financial institutions endangering the economy – not acceptable (4); (5) and (6) – don’t ask.

This is why they blame a deregulated derivatives market and profiteering, and want controls placed on them. And no argument to the contrary will move them. Donkeys will learn Latin before pragmatists learn economics. Libertarians are “intellectually immature”. Indeed.

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