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By Root 6781 0

sure, the 2008 subprime meltdown was the product of many causes. A mountain of excess savings built up in Asia was looking for a higher return and flowed to subprime bonds—which paid significantly higher interest rates because they were made up of mortgages granted to people who were higher lending risks. The government directly relaxed mortgage standards to help more Americans buy homes. Banks and rating agencies relaxed their standards to get their share of the subprime housing bubble. Government failed to regulate exotic new financial instruments such as derivatives, under pressure from a financial industry that wanted free rein in this lucrative new area.

The University of California Berkeley economist Barry Eichengreen argues that the subprime crisis was partly a case of regulation and regulators not having kept up with the consolidation and internationalization of the commercial banking, investment banking, and brokerage industries. In other words, we did not update our formula in this area. Over the previous two decades, some of the key firewalls erected after the 1929 crash came down, along with regulations stipulating the amount of reserves banks had to keep on hand. The merging of the different financial industries was actually “sensible and well-motivated,” argues Eichengreen. It lowered the costs of stock trading for consumers, reduced borrowing costs, and created new financial products that, in theory, could promote growth in different markets. The problem was that this kind of global financial integration was a total misfit with the fragmented, outdated American financial regulatory system, so it was very hard for regulators to get the full picture of the level of risk and leverage different players in the market were taking on. “At the most basic level,” Eichengreen argued in an October 2008 paper entitled Origins and Responses to the Crisis, “the subprime crisis resulted from the tendency for financial normalization and innovation to run ahead of financial regulation.” It ran so far ahead that not only did the regulators not fully understand the level of risks being piled up by different financial houses, but even the CEOs of these firms did not understand what the rocket scientists turned bankers were concocting under them.

One of those new financial instruments—a derivative known as the credit-default swap, a form of private insurance that paid off if a subprime package of loans defaulted—was specifically kept out of the jurisdiction of government regulators through aggressive lobbying by the financial industry. We wound up with a trillion-dollar market in these swaps without either meaningful government oversight or transparency. Its implosion helped to create the worst financial crash since 1929.

That lack of oversight was a bipartisan effort. In 1999, Republicans passed legislation specifically exempting credit-default swaps from regulation—and President Bill Clinton signed it. There is a fine line between a regulatory environment that promotes the risk-taking that is necessary in a market economy and an environment that fosters destructive recklessness. In the Terrible Twos, we crossed that line, in part because some important people, chief among them Federal Reserve chairman Alan Greenspan, came to believe that the markets could be “selfregulating”—and that big financial institutions would police themselves because it would be in their self-interest to do so—and in part because the financial industry used its ever greater clout on Capitol Hill to ensure lax regulation in the new markets it had pioneered and to “capture” regulators. It did so in order to maximize risk-taking so as to create astronomical sums of personal wealth for its executives.

Better regulation and regulators might not have prevented the economic crisis in the last part of the Terrible Twos, but it surely would have made the crisis less severe. In the wake of the crisis, Congress passed and the president signed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which imposed new regulations on the financial industry