What Caused the Financial Crisis?

The financial crisis of 2008 (that we are still living through) is worse than anything we have seen in our lifetimes. There have been slumps and recessions before but nothing like the worldwide credit crunch that took hold of the international financial system in mid-2007, bringing it to the edge of implosion by September 2008, and leading the whole world into an extraordinary panic and economic collapse over the next six months.

Since the middle of 2009 conditions have improved, spectacularly in some areas, very likely owing to the emergency steps taken by authorities, but people have continued to debate vigorously in blogs, books, and magazines, both the causes of the crisis as well as public policy measures taken in response, especially as the first anniversary of the Lehman Brothers episode came around last week.

Looking at the variety of explanations being offered -- some ideological (such as free markets, laissez faire economics and capitalism) some institutional (such as under-regulation of banks) some systemic (such as securitization of mortgages, or derivatives) -- one could be forgiven for thinking that even experts are confused about the causes. Indeed, the academic failure is so severe that we need not rush to form any judgment on the matter. Instead, we can look to ongoing events, in the expectation that they will teach us more than arguments alone could.

The role of public policy in these events is likely to be huge (as Keynesian thinking makes a comeback) but will not go unquestioned. Recently, James M. Buchanan, winner of the 1986 Nobel Prize in Economics, endorsed a study that asks if the Obama administration is making Depression-era mistakes again. Similarly, the Fed's lightning moves in counteracting the crisis have been praised but its "exit strategy" is being carefully scrutinized. And won't such policies, critics of government intervention ask, ultimately lead to inflation (higher prices)?

As this large scale panorama unfolds, perhaps another question to ask is: can the right public policy always prevent a depression? Consider this message from the study Buchanan endorsed:

[T]he market depends on the aggregate consequences of millions of individual plans, responses to outside signals about what to do, based on private knowledge of what to do it with. No bureaucracy could possibly coordinate these plans, or be aware of these resources.

Once millions of individual plans have gone awry, for whatever reason, and associated resources depleted, getting the remaining resources back in line will not be easy -- and may even be impossible -- despite the best-laid plans of officials, bureaucrats and bankers, who are, after all, only individuals with bigger plans than others'.