Cooking the Books 2: Was the crisis just a mistake?

The Financial Crisis Inquiry Commission set up by the US government reported at the end of January. They concluded that the crisis of 2007 and 2008 was the result of “human action and inaction, not of Mother Nature or computer models gone haywire”, but “of human mistakes, misjudgments, and misdeeds” and so avoidable (http://www.fcic.gov).

Obviously, the crisis was the outcome, even if unintended, of decisions by humans to behave in particular ways, but that’s not at issue. We need to know why the economic decision-makers involved took the decisions they did. What was the context of their decisions? What were the constraints acting on them?

The driving force of capitalism is the pursuit of profits by competing enterprises. As the Commission put it, “in our economy, we expect businesses and individuals to pursue profits…” If there is a chance to make a profit from some activity then the businesses in that field will go for it. If the profits are high enough then other businesses will enter the field to share in the bonanza.

This is what happened in the US. From 1997 until 2006 there was a boom in house building and buying. Big profits were to be made from lending money either directly to housebuyers or to businesses that did so. Easily able to borrow funds at relatively low rates of interest, the Wall Street investment banks decided to get in on the act, and in a big way,

“The large investment banks and bank holding companies,” the Commission reported, “focused their activities increasingly on risky trading activities that produced hefty profits.” The prospect of making “hefty profits” out of lending money to build and buy houses led them to borrow more and more money to take part in the chase after them:

“In the years leading up to the crisis, too many financial institutions, as well as too many households, borrowed to the hilt, leaving them vulnerable to financial distress or ruin if the value of their investments declined even modestly. For example, as of  2007, the five major investment banks – Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley – were operating with extraordinarily thin capital. By one measure, their leverage ratios were as high as 40 to 1, meaning for every $40 in assets, there was only $1 in capital to cover losses.”

Note the matter-of-fact acceptance here that banks cannot create money out of thin air but are dependent on themselves borrowing the money they lend.

The Commission criticised the investment banks and other financial institutions for taking such risks but could those involved in making these decisions have decided otherwise? Could they have decided to forgo the chance of making the ‘hefty profits’ that were there to be taken? No, because if one of them decided not to pursue these profits, the others would have enthusiastically taken their place. It wasn’t a mistake on their part. Given the competitive, profit-seeking nature of capitalism they had to take the decisions they did. In that sense the financial crisis was not avoidable.

It was outside the remit of the Commission to examine the housing boom whose collapse in 2006 triggered the financial crisis. They merely recorded that “when housing prices fell and mortgage borrowers defaulted, the lights began to dim on Wall Street”. If they had gone further into the housing boom and why it ended, they would have discovered that it was a classic case of the pursuit of profits leading to overproduction (too many houses being built in relation to what people could afford to buy) and perhaps revised their view that “the profound events of 2007 and 2008” were not “an accentuated dip in the financial and business cycles we have come to expect in a free market economic system.”