Research AreasFinance, Jobs & MacroeconomicsSAFER Financial ReformCommission ActivitiesComment on Feb 26-27 FCIC Hearings

Comment on February 26-27, 2010 FCIC Hearings

Second Public Hearings: Causes of the Financial Crisis

March 1, 2010
Adam S. Hersh, SAFER Associate Coordinator

The FCIC got down to business with two days of testimony from academic economists on the causes of the financial crisis. (The Wall Street Journal provides a concise run-down of what was said on its Real Time Economics blog). Much of the discussion focused attention on the proximate causes of the financial crisis: problems arising from or inherent to the securitization of sub-prime mortgages and the financial structures that helped the crisis cascade through the system. There was less consideration of what enabled the build-up of an $8 trillion real estate bubble or how the financial regulatory and supervisory environment allowed financial institutions to become so fragile.

Most out-of-step with the tone of the hearings was Randall Kroszner of the University of Chicago, who offered a message that regulators can't really do much (nor should they) to limit size of financial institutions or the extent of interconnectedness that led to contagion among financial institutions. At a time when many are questioning the social benefits of some kinds of financial innovations, Kroszner rooted his argument in the principle that regulation should be careful not to impede any innovation. He seemed to suggest it would be folly to attempt a return to Glass-Steagall or any such limitations on the scale or scope of financial institutions, nor should regulations impose higher capital reserve requirements. With Kroszner having chaired the committee on Supervision and Regulation of Banking Institutions during his stint as Fed Governor from 2006-2009, it is evident why the Fed failed to take any actions to avert financial meltdown. He proposed collecting more information on the interconnectedness of financial institutions' balance sheet positions, but was unclear as to how regulators and supervisors might use such information or what guidelines they might follow in deciding when to intervene. In fact, Kroszner offered no solution to the moral hazard problem created by over-sized banks, suggesting this is just the price we must pay for the presupposed benefits of an innovative financial system.

John Geanakoplos of Yale University highlighted the importance of financial leverage in explaining both cause and effect in the financial boom-bust cycle first described by economist Hyman Minsky. Geanakoplos described the solution to the leverage cycle as both simple and complicated: simple because instruments to manage it such as collateral or margin requirements are readily available to regulators, but complicated in that such interventions require the political will to declare rapid credit expansions problematic and to prevent (overly rapid) increases in asset prices. Collateral rates are even more important than interest rates in determining supply and demand in credit markets, and Geanakoplos argues for active government intervention to manage collateral rates in order to break the boom-bust leverage cycle. 

Annamaria Lusardi of Dartmouth College stressed in her testimony an extensive lack of financial literacy among the American public. Her research finds that not only do a vast number of people lack financial management competencies, but many who self-report high financial literacy in fact fare quite poorly on financial literacy quizzes. The lack of financial literacy is problematic for individuals and families, but the aggregation of these individual behaviors can also pose problems for the overall economy. The evidence overwhelmingly points to the necessity of the proposed Consumer Financial Protection Agency as an integral part of comprehensive financial reform.

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