We need to get the story straight. Already, a crude consensus has formed over what caused the financial crisis. We were victimized by dishonest mortgage brokers, greedy bankers, and inept regulators. Easy credit from the Federal Reserve probably made matters worse. True, debate continues over details. Fed chairman Ben Bernanke recently gave a speech denying that it had loosened credit too much, though he admitted to lax bank regulation. Just recently a congressionally created commission opened hearings on the causes of the crisis. Still, the basic consensus seems well established and highly reassuring. It suggests that if we toughen regulation, suppress outrageous avarice, and improve the Fed's policies, we can prevent anything like this from ever occurring again.
There's only one problem: the consensus is wrong—or at least vastly simplified.
Viewed historically, what we experienced was a classic boom and bust. Prolonged prosperity dulled people's sense of risk. With hindsight, we know that investors, mortgage brokers, and bankers engaged in reckless behavior that created economic havoc. We know that regulators turned a blind eye to practices that, in retrospect, were ruinous. We know that the Fed kept interest rates low for a long period (the overnight fed-funds rate fell to 1 percent in June 2003). But the crucial question is: why? Greed and shortsightedness didn't suddenly burst forth; they are constants of human nature.
One answer is this: speculation and complacency flourished because the prevailing view was that the economy and financial system had become safer. For a quarter century, from 1983 to 2007, the United States enjoyed what was arguably the greatest prosperity in its history. The boom was triggered by the conquest of high inflation, which had destabilized the economy since the late 1960s. From 1979 to 1984, inflation dropped from 13 percent to 4 percent. By 2001, it was 1.6 percent. As inflation fell, interest rates followed—though the relationship was loose—and as interest rates fell, the stock market and housing prices soared. From 1980 to 2000, the value of household stocks and mutual funds increased from about $1 trillion to nearly $11 trillion. The median price for existing homes rose from $62,200 in 1980 to $143,600 in 2000; by 2006, it was $221,900.
Feeling enriched by higher home values and stock portfolios, many Americans skimped on savings or borrowed more. The personal saving rate dropped from 10 percent of disposable income in 1980 to about 2 percent 20 years later. The parallel surge in consumer spending, housing construction, and renovation propelled the economy and created jobs, 36 million of them from 1983 to 2001. There were only two recessions in these years, both historically mild: those of 1990–91 and 2001. Monthly unemployment peaked at 7.8 percent in mid-1992.
The hard-won triumph over double-digit inflation in the early 1980s, engineered by then–Fed chairman Paul Volcker and backed by newly elected president Ronald Reagan, qualifies as one of the great achievements of economic policy since World War II. The temptation is to portray it as a pleasing morality tale. The economic theories that led to higher inflation were bad; the theories that subdued higher inflation were good. Superior ideas displaced inferior ones, and the reward was the increased prosperity and economic stability of the 1980s and later. But that, unfortunately, is only half the story.
Success also planted the seeds of disaster by creating self-defeating expectations and behaviors. The huge profits made in these decades by investors conditioned many to believe in the underlying benevolence of financial markets. Although they might periodically go to excess, they would ultimately self-correct without too much collateral damage. The greater stability of the real economy—by contrast, there had been four recessions from the late 1960s to the early 1980s—provided an anchor. The Fed was also a backstop: under Alan Greenspan, it was lionized for averting deep downturns after the stock-market crash of 1987 and the burst "tech bubble" in 2000. Money managers, regulators, economists, and the general public all succumbed to these seductive beliefs.
The explosion of the subprime-mortgage market early in the 2000s may now appear insane, but it had a logic. Housing prices would continue rising because they had consistently risen for two decades. Consumers could borrow and spend more because their wealth was constantly expanding and they were less threatened by recession. That justified relaxed lending standards. Homeowners with weak credit histories could refinance loans on more favorable terms in two or three years because the value of their houses would have risen. If borrowers defaulted, lenders could recover their money because the homes would be worth more.
The paradox is that, thinking the world less risky, people took actions that made it more risky. The pleasures of prosperity backfired. They bred carelessness and complacency. If regulation was lax, the main reason was that regulators—like the lenders, investors, and borrowers they supervised—shared the conventional wisdom. Markets seemed to be working. Why interfere? That was the lesson of experience, not an abstract devotion to the theory of "efficient markets," as is now increasingly argued.
Unless we get the story of the crisis right, we may be disappointed by the sequel. The boom-bust explanation does not exonerate greed, shortsightedness, or misguided government policies. But it does help explain them. It doesn't mean that we can't—or shouldn't—take steps to curb dangerous risk taking. Greater capital requirements would protect banks from losses; the ability to control the shutdown of large, failing financial institutions might avoid the chaos of the Lehman Brothers collapse; moving the trading of many derivatives (such as credit default swaps) to exchanges would create more transparency in financial markets. But it's neither possible—nor desirable—to regulate away all risk. Every bubble is not a potential depression. Popped bubbles and losses must occur to deter speculation and compel investors to evaluate risk. Finally, a single-minded focus on the blunders of Wall Street may also distract us from other possible sources of future crises, including excessive government debt.
The larger lesson of the recent crisis is sobering. Modern, advanced democracies strive to deliver as much prosperity as possible to as many people as possible for as long as possible. They are in the business of creating perpetual booms. The cruel contradiction is that this promise itself may become a source of instability because the more it is attained, the more people begin acting in ways that ultimately invite its destruction. Booms often have unintended and nasty side effects; even anticipated side effects that are ultimately unsustainable—stock-market bubbles, excessively tight labor markets—can be hard to police because they're initially popular and pleasurable.
The quest for ever-more and ever-better prosperity subverts itself. It might be better to tolerate more frequent, milder recessions and financial setbacks than to strive for a sustained prosperity that, though superficially more appealing, is unattainable and ends in a devastating bust. That's a central implication of the crisis, but it poses hard political and economic questions that haven't yet been asked, let alone answered.