The causes of the financial crisis

I remember about nine months ago, when McCain was suggesting we set up a 9/11-like commission to investigate the financial crisis and its causes, one of my friends berated McCain for his ignorance. He said, "the cause of the latest financial crisis seems readily apparent". At the time, and even still today, I find this statement laughable. There is still a heated debate over what caused or contributed to the crisis. And before we know what caused it, we won't know how to prevent it in the future.

Was it the global savings glut that kept mortgage rates down? Was it the lax regulation of the shadow banking system? Was it the compensation policy of banks? Was it Greenspan's interest rate decisions? Was it the government's push for homeownership, including the involvement of Fannie and Freddie? Was it risky bets made by the banks due to a moral hazard problem? Did the government's reaction to the crisis make it much worse?

I am sure there are other possibilities as well that I am forgetting at this time. But my point is, that it is still debatable over the amount by which each one of the factors above contributed to the crisis. Many commentators have complained that Obama's financial reform plan was rushed, that it concentrates too much on increased regulations, and that it fails to recognize the failures of the regulators in the crisis. I agree with this.

Brad Delong has a nice post outlining some of the mistakes the government made before or during the crisis. I agree with all of the three points listed at the beginning of his article, but I disagree with his comment on Greenspan's involvement. Brad DeLong states:

On Tuesdays and Thursdays I think that going forward central bankers must now also recognize that it is imprudent to lower interest rates in pursuit of full employment when doing so risks an asset price bubble. On Mondays, Wednesdays, and Fridays I think that even with the extra information about the structure of the economy we have learned in the past two years that Greenspan's decisions in 2001-2004 were prudent and committed us to a favorable and acceptable bet. And I am writing this on a Friday.

I think before explaining my point of view, let me explain something about Alan Greenspan. Alan Greenspan believed (I don't know if he still holds this view) that central bankers should not involve themselves in asset bubbles. According to Mr. Greenspan, it is too difficult to identify when something is actually a bubble, until after it blows up. I think this is an incredibly irresponsible opinion. But I think if you are going to take the view, as Brad DeLong does at the end of his post, that Greenspan's actions were reasonable at the time, you have to take into account how Greenspan would react if he lost this bet. If an asset bubble occurs, in my opinion a central banker needs to step in and try to deflate it before it creates a crisis. However, Greenspan didn't believe in deflating bubbles; he believed in dealing with them after they blew up. Taking this view into account, it seems unreasonable to me to say Greenspan's actions were correct. I think they were only correct if he would have been willing to deflate bubbles. But we know he wasn't.