Policy Analysis No. 693

What Made the Financial Crisis Systemic?

By Patric H. Hendershott and Kevin Villani
March 6, 2012

The current narrative regarding the 2008 systemic financial system collapse is that numerous seemingly unrelated events occurred in unregulated or underregulated markets, requiring widespread bailouts of actors across the financial spectrum, from mortgage borrowers to investors in money market funds. The Financial Crisis Inquiry Commission, created by the U.S. Congress to investigate the causes of the crisis, promotes this politically convenient narrative, and the 2010 Dodd-Frank Act operationalizes it by completing the progressive extension of federal protection and regulation of banking and finance that began in the 1930s so that it now covers virtually all financial activities, including hedge funds and proprietary trading. The Dodd-Frank Act further charges the newly created Financial Stability Oversight Council, made up of politicians, bureaucrats, and university professors, with preventing a subsequent systemic crisis.

Markets can become unbalanced, but they generally correct themselves before crises become systemic. Because of the accumulation of past political reactions to previous crises, this did not occur with the most recent crisis. Public enterprises had crowded out private enterprises, and public protection and the associated prudential regulation had trumped market discipline. Prudential regulation created moral hazard and public protection invited mission regulation, both of which undermined prudential regulation itself. This eventually led to systemic failure. Politicians are responsible for both regulatory incompetence and mission-induced laxity.

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Patric Hendershott holds a chair in real estate economics and finance at the University of Aberdeen, Scotland. Previously he held tenure positions at Purdue University and Ohio State University. Hendershott is also a research associate at the National Bureau of Economic Research. Kevin Villani is a former chief economist for the U.S. Department of Housing and Urban Development and Freddie Mac.