What the Eurozone Crisis Teaches Us About the Subprime Crisis

Consider the following:

Banks pour huge amounts of money into one particular asset class.  They are encouraged to do this by public policymakers, although there is some dispute about whether that was the main reason for their decisions.  These assets have a long tradition of doing well, although a close look at the evidence would have raised red flags.  The asset market in question suddenly takes a big dive as default risk increases sharply.  This drags down many large banks, forcing policymakers to provide assistance.

What have I just described?  The sub-prime fiasco or the PIGS sovereign debt fiasco?  I’d say both.  I’d say these two crises are essentially identical.  (I should clarify that by “essentially identical” I mean in essence, not in every detail.)

Of course the sub-prime crisis came first, so let’s consider the dominant (progressive) narrative of the sub-prime crisis.  If you read the mainstream media you will see it described as a sort of morality play; the evils of deregulation, which allowed the greedy big banks to take highly leveraged gambles with other people’s money, and then off-load the risk on to both taxpayers and unsuspecting buyers of MBSs.  Or something like that.

Obviously it would be impossible to tell a similar story for the sovereign debt crisis.  No regulator in his right mind would ever contemplate telling big banks not to buy European sovereign debt because it’s too risky.  Indeed the previous attempt at regulation (Basel II) encouraged banks to put funds into those “safe investments.”  Blaming the euro crisis on deregulation doesn’t even pass the laugh test.  The criminals were the regulators themselves.  Is the term ‘criminal’ hyperbole on my part?  Not at all.  Suppose Enron executives had used the same accounting techniques as the Greek government.  They’d all be in jail.  And as for Berlusconi, what can one say about a leader who continually passes laws exempting the Prime Minister from the very crimes he was accused of having committed?  As Keynes said:

Words ought to be a little wild, for they are the assaults of thoughts on the unthinking.

So here’s what I wonder.  Assume the eurozone crisis was obviously not caused by deregulation and greedy bankers.  Then if the sub-prime crisis was basically identical, at least in its essence, how can deregulation be the root cause of the former crisis?  I’m not saying it’s logically impossible, but doesn’t it seem much more likely that there’s a deeper systemic problem, which transcends this glib cliche?  I’m going to leave you with two very different items, which together seem to point to the flaws in our financial system being very deeply ingrained, far too deep to fix with any sort of politically plausible “reforms.”

The first is a heartfelt lament by Steve Waldman, from the recent Kauffman Foundation blogger’s conference.  Steve wonders why after all the outrage in late 2008, nothing fundamental has actually changed.  Even with Obama elected in 2008 and taking office along with a heavily Democratic Congress.

The other item is a very funny Jon Stewart routine (courtesy of Greg Mankiw.)   He shows that one of the progressive political figures who showed the greatest outrage, then left the government, set up his own investment company, used leverage even greater than Lehman Brothers, used political pull to fight off the regulators when they complained, and eventually drove his firm into a messy bankruptcy.

Why is all this so hard to change?  Why didn’t we just adopt the Canadian model, which never has these problems?  I don’t really know, but something tells me that the problems go much deeper than you might imagine when reading cliched morality tales about “deregulation.”

PS.  Of course you and I know that the real problem was (mostly) nominal; tight money turned medium size debt fiascoes into catastrophic financial crises.

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