Although I worried about banker incentives and regulatory motives at the time of the financial crisis, and although many more commentators and regulators have since come around to my point of view, I have come to believe that these issues are just the tip of the iceberg. The true sources of the crisis we have experienced are not only more widespread but also more hidden. We should resist the temptation to round up the most proximate suspects and pin the blame only on them. Greedy bankers can be regulated; lax government officials can be replaced. This is a convenient focus, because the villains are easily identified and measures can be taken against malfeasance and neglect. What's more, it absolves the rest of us of our responsibility for precipitating the crisis. But this is too facile a response.
We should also resist the view that this is just another crisis, similar to every financial crisis before it, with real estate and foreign capital flows at its center. Although there are broad similarities in the things that go wrong in every financial crisis, this one centered on what many would agree is the most sophisticated financial system in the world. What happened to the usual regulatory checks and balances? What happened to the discipline imposed by markets? What happened to the private instinct for self-preservation? Is the free-enterprise system fundamentally broken? These questions would not arise if this were "just another" crisis in a developing country. And given the cost of this crisis, we cannot afford facile or wrong answers.
Although I believe that the basic ideas of the free-enterprise system are sound, the fault lines that precipitated the crisis are indeed systemic. They stem from more than just specific personalities or institutions. A much wider cast of characters share responsibility for the crisis: it includes domestic politicians, foreign governments, economists like me, and people like you. Furthermore, what enveloped all of us was not some sort of collective hysteria or mania. Somewhat frighteningly, each one of us did what was sensible given the incentives we faced. Despite mounting evidence that things were going wrong, all of us clung to the hope that things would work out fine, for our interests lay in that outcome. Collectively, however, our actions took the world's economy to the brink of disaster, and they could do so again unless we recognize what went wrong and take the steps needed to correct it.
There are deep fault lines in the global economy, fault lines that have developed because in an integrated economy and in an integrated world, what is best for the individual actor or institutions is not always best for the system. Responsibility for some of the more serious fault lines lies not in economics but in politics. Unfortunately, we did not know where all these fault lines ran until the crisis exposed them. We now know better, but the danger is that we will continue to ignore them. Politicians today vow, "Never again!" But they will naturally focus only on dealing with a few scapegoats, not just because the system is harder to change, but also because if politicians traced the fault lines, they would find a few running through themselves. Action will become particularly difficult if a more rapid recovery reinforces the incentives to settle for the status quo. This book is, therefore, an attempt to heed the warnings from this crisis, to develop a better understanding of what went wrong, and then to outline the hard policy choices that will tackle the true causes of the crisis and avert future ones.
Let us start with what are widely believed to be the roots of this crisis, which is, in part, a child of past crises. In the late 1990s, a number of developing countries (in the interests of brevity, I use the term developing for countries that have relatively low per capita incomes and industrial for those that have high per capita incomes), which used to go on periodic spending binges fueled by foreign borrowing, decided to go cold turkey and save instead of spend. Japan, the second largest economy in the world, was also in a deepening slump. Someone else in the world had to consume or invest more to prevent the world economy from slowing down substantially. The good news for any country willing to spend more was that the now-plentiful surplus savings of the developing countries and Japan, soon to be augmented by the surpluses of Germany and the oil-rich countries, would be available to fund that spending.
In the late 1990s, that someone else was corporations in industrial countries that were on an investment spree, especially in the areas of information technology and communications. Unfortunately, this boom in investment, now called the dot-com bubble, was followed by a bust in early 2000, during which these corporations scaled back dramatically on investment.
As the U.S. economy slowed, the Federal Reserve went into overdrive, cutting interest rates sharply. By doing so, it sought to energize activity in sectors of the economy that are interest sensitive. Typically, such a move boosts corporate investment, but corporations had invested too much already during the dot-com boom and had little incentive to do more. Instead, the low interest rates prompted U.S. consumers to buy houses, which in turn raised house prices and led to a surge in housing investment. A significant portion of the additional demand came from segments of the population with low credit ratings or impaired credit histories -- the so called subprime and Alt-A segments -- who now obtained access to credit that had hitherto been denied to them. Moreover, rising house prices gave subprime borrowers the ability to keep refinancing the low interest rate mortgages (thus avoiding default) even as they withdrew the home equity they had built up to buy more cars and TV sets. For many, the need to repay loans seemed distant and remote.