Quora Question: What We Learned From the Financial Crisis

A woman shelters from the rain as she passes a screen showing trading market graphs in west London January 21, 2008. Reuters

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Answer from Russell Roberts, EconTalk host, research fellow at Stanford University's Hoover Institution:

I learned way too much from the financial crisis.

Like many economists, I hadn't paid enough attention to the financial sector and how it can affect the rest of the economy. When the tech sector struggled from 1999 to 2001, it was tough on some tech companies, but it didn't threaten to create another Great Depression. The troubles in the financial sector were much more dangerous.

The main reason for that was something else I hadn't been aware of: the incredible degree to which investment banks and other financial institutions use borrowed money, what's called leverage. That, in turn, made them very vulnerable to a drop in asset prices, in this case the reduction in housing prices and the assets that had bundled mortgages together that were thought to be extremely safe. They weren't.

The most important thing I learned is how much the government had intervened in financial markets going back to 1984 and intervened in a very particular way; policies tended to bail out lenders and creditors, institutions that had lent money to risky projects. This meant if you made a bad loan or bought a bad bond, you still got your money back instead of paying for your mistake. This is particularly unfortunate because lenders tend to look for safe bets. Their upside is limited by the interest they are promised, but their downside is losing everything, so lenders try to avoid high risk because they can't get high return the way an equity holder can. Lenders tend to be prudent.

Once the government started protecting lenders from that downside risk, lenders became less prudent. The idea is simple: by protecting lenders from losses, policy essentially began to subsidize recklessness and when you subsidize something, you get more of it.

I came to understand the importance of this chain of events: the almost constant bailing out of large institutions that lent to risky projects made it a lot easier for other large institutions to use borrowed money to finance their investments instead of equity or their own money. That in turn made the collapse of those large institutions much more likely (and catastrophic) than it otherwise would have been. Instead of the financial sector having a bad quarter or year, the whole economy was threatened.

Unfortunately, we don't seem to have internalized the full force of this experience. Too many institutions are still considered too big to fail and that means they have an incentive to be much less careful. That sows the seeds for the next crisis.

I see the financial crisis as the natural unfortunate result of the cooperation between Wall Street and Washington. We need to find a way to break that connection, but it's not easy. Republicans and Democrats both tend to profit from it, so most of them are not so interested in fixing the problem.

As Milton Friedman liked to say, capitalism is a profit and loss system, not just a profit system. It's important that investors or managers who make bad decisions pay a serious price. In the financial sector, that isn't the case, and that's bad for how we allocate capital and where investment goes but also bad for democracy. Crony capitalism is a disaster.

If you want to learn more about these ideas, here's my essay on the crisis.

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