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Book Reviews: Politics in The Face of Financial Crisis
Our economy still struggles to recover from the 2008 financial meltdown. Dozens of books, both journalistic and scholarly, have been published to explain its causes. In Engineering the Financial Crisis, Jeffrey Friedman and Wladimir Kraus distinguish themselves by presenting the most systematic and rigorously empirical analysis of the crash to date. They counter the conventional wisdom of a crisis metastasizing in unregulated financial markets and make a compelling case for regulatory failure as the key causal variable.
The authors first dissect competing explanations of the crash. Conservative narratives blame the government: overly loose monetary policy and slack lending standards by Fannie Mae and Freddie Mac (government-sponsored enterprises, or GSEs) induced a housing bubble. The housing bubble was, however, a necessary but insufficient condition for the crisis. Liberals interpret this more as market failure. Deregulation allowed the development of exotic mortgage-backed securities (MBSs); banks shifted their activities to unregulated "shadow banks;" and Wall Street executives enriched themselves through compensation schemes that rewarded excessive risk taking, knowing that they were "too big to fail." The market failure thesis is the most widely accepted, and it is meticulously, dispassionately, and devastatingly debunked by Friedman and Kraus. A thumbnail sketch of their critique follows, yet it does not do justice to the depth of their argument, including two detailed appendices.
Deregulation created an environment in which financial innovations like credit default swaps (CDSs) could be created. Yet the crisis occurred not because banks created and sold these securities to others; it happened because they bought loads of MBSs themselves. That is, the dependent variable is the demand for MBSs, not their supply. Deregulation in general, or specific regulatory changes (i.e., the repeal of Glass-Steagall) do not link specifically...