Monday, September 22, 2008

Blame game for the financial crisis

David Blake at FT indicts Alan Greenspan's Federal Reserve for creating the housing bubble. While I would disagree with Blake's assertion that the Fed did not keep interest rates artificially low in the early 00's, his fundamental conclusion is sound. Greenspan's activist Fed, in a quest to manage the macro-economy (instead of just fighting inflation), helped create two massive asset bubbles (tech and housing) that subsequently deflated and hit the U.S. economy hard over the past 8 years.

Meanwhile, Kevin Hassert, a McCain economic advisor, blames the Democrats in a Bloomberg op-ed piece. He contends that Fannie and Freddie directly created the sub-prime mortgage market, which contained risks that remained hidden as long as home prices rose. But when prices fell, the systematic risk created by the securitization of this debt walloped the entire financial industry. Hassert blames Senate Democrats for holding up reform bills during 2005-2007, and calls out Obama for receiving $125,000 in campaign contributions from various Fannie and Freddie sources.

Putting aside the partisan blame (and I don't follow Congress enough to comment on the validity of Hassert's charge), these viewpoints seem like two sides of the same coin. We know from history that markets are susceptible to occasional asset bubbles; it can be difficult to establish prices for certain types of assets, especially in the face of new technologies or changing economic conditions. But this susceptibility didn't cause the crisis. Structural flaws in the housing market, created by Fannie and Freddie's efforts to separate the risk of sub-prime lending from the lenders themselves, were the underlying problem. And the Greenspan liquidity bubble fueled this dangerous habit, so much so that these dangerous securities, which were sold as "risk free," flooded the financial markets and created the systematic danger that has engulfed Wall Street in recent weeks.

Wall Street surely deserves some blame in this mess, but from where we now stand, it appears that Greenspan, Congress, Fannie, and Freddie are the culprits who distorted the market and added fuel to the fire.

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