Telling the Narrative of the Financial Crisis: Not Just a Housing Bubble

Douglas J. Elliott and Martin Neil Baily

Major crises, such as the recent financial crisis, usually end up being understood by the public in terms of some simple narrative, which then heavily influences the choices politicians make. We believe there are three major story lines still vying for acceptance by the public and that whichever one comes to dominate could strongly affect public policy.

For example, our entry into World War I came to be seen after the fact as the result of financiers looking to protect their loans to Europe and our trade flows. This attitude played a major role in the isolationism that kept us out of World War II for so long. Similarly, one of the earliest theories of the Great Depression was that it sprang from the crash on Wall Street, which came to be associated with financial manipulation by bankers and rich speculators. This created much of the impetus for the separation of commercial and investment banking and the creation of the Securities and Exchange Commission and the associated laws to protect investors. In both cases, there were many complex causes and therefore the potential for alternative story lines to have taken hold, which would have led to different legislative outcomes.

We have a great body of facts about the current financial crisis, but do not yet have a consensus narrative about the fundamental causes. In our view, there are three major story lines vying for acceptance:

Narrative 1: It was the fault of the government, which encouraged a massive housing bubble and mishandled the ensuing crisis.

Narrative 2: It was Wall Street’s fault, stemming from greed, arrogance, stupidity, and misaligned incentives, especially in compensation structures.

Narrative 3: “Everyone” was at fault: Wall Street, the government, and our wider society. People in all types of institutions and as individuals became blasé about risk-taking and leverage, creating a bubble across a wide range of investments and countries.

The authors believe that narrative 3 comes closest to the truth and that it matters whether that story line becomes accepted by the public.  In our judgment, a well-designed program of regulatory reforms would fix the wide-spread problems in both the markets and in government regulation, or at least greatly improve the problems in both areas.  In contrast, public acceptance of narrative 1 would lead to too little regulatory change or change of the wrong kind, while narrative 2 would likely encourage a stifling of markets without fixing the problems inherent in our regulatory structure. Our preferred narrative encourages a balanced and comprehensive set of changes.

This paper will explain our reasons for preferring narrative 3 to narrative 1, since the “government did it” story line presents the strongest challenge to our beliefs, as it essentially treats the financial crisis as a one-off fluke extremely unlikely to be repeated in our lifetimes. We believe narrative 2 is also flawed, but we have addressed that previously as part of our larger papers and may tackle it again in other contexts.

Caveats and apologies

Postulating simple narratives that may take hold in the minds of the public intrinsically forces us to over-simplify and to ignore the subtleties of the analyses presented by those whose views come closest to these simplistic stories. We do not mean to imply that any of the policy analysts arguing for facets of narratives 1 or 2 fail to understand the complexities of this crisis nor that any of them hold precisely the views described here. In addition, we must note that this paper is considerably too short to do justice to those complexities. We have tried to cover some of this ground more comprehensively in several previous, much longer, pieces .

We should also note that we will be using the term “bubble” somewhat loosely, in the manner in which it has come to be used in popular discussion. It will refer to any situation in which asset prices become substantially over-valued as a result of psychological factors, including an unsustainably large decline in the premium investors charge to take on a given level of risk. We generally will not attempt to distinguish between over-optimism about future prospects and a willingness to take a correctly estimated risk for an unusually low premium.