What caused the crisis? It seems like most of the plausible answers I’ve heard come down to one of two basic explanations:
(1) “We were living beyond our means” — Congressman Dan Maffei (D-NY), in a WRVO Community Forum in Syracuse last week that included, um, me. Sounded very reasonable coming from Congressman Maffei, less so coming from stockbroker/ investment advisor/ author Peter Schiff on the other night’s “Daily Show”, probably because of the diametrically opposite policy prescriptions the two draw. Maffei backs the stimulus bill and wants to see the economy recover as soon as possible; Schiff is an adherent of the Austrian school and thinks a good old bloodletting (oops, “liquidation” or “correction”) is just what the doctor ordered. Either way, this explanation has a lot going for it, as it explains the rash of subprime mortgage borrowing, home equity loans, maxed-out credit cards, etc.
(2) A “global savings glut” led to stock and housing bubbles, which finally burst — Fed Chairman Ben Bernanke, Nobel economist / NYT columnist Paul Krugman. The idea here is that while we spendthrift Americans were running up huge debts, people in other countries, notably China and Japan, as well as the minority of wealthy Americans with high savings rates, had large pools of savings seeking a good risk-adjusted return. And they invested much of it here, in Treasury bonds, thereby keeping U.S. interest rates low; in the stock market, reinflating the late 1990s bubble; in the corporate bond market, lowering rates on all bonds, even junk bonds; and in real estate, largely through securitized collections of other people’s mortgages. (By some accounts, demand created its own supply of mortgage-backed securities — after the 2001 stock debacle, investors were looking for an alternative to stocks and thought real estate looked promising.) A particular problem here seems to be that many investors opted for wildly risky investment vehicles, like investing in “diverse” portfolios of dodgy mortgages or blindly handing their money over to a Bernie Madoff or a Robert Allen Stanford, without realizing they were risky.