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Too Big to Regulate

The Ludwig von Mises Institute of Canada re-publishes my review of Jeffrey Friedman’s and Wladimir Kraus’ Engineering the Financial Crisis. I call the book “undoubtedly one of the best books written yet on the causes of the Great Recession” — simply stated, there are few scholars who have done the amount of historical research Friedman and Kraus committed themselves to (that being said, much of the book’s thesis, admittedly, is based on a number of journal articles published in a special 2009 issue on the financial crisis in the Critical Review journal).

The authors may not consider themselves “Austrian,” or at least may not necessarily sympathize with the entire corpus of Austrian theory, but Engineering the Financial Crisis is extremely compatible with the broader Austrian theory of intertemporal discoordination (malinvestment). The authors also borrow from and develop a particularly Austrian insight: radical uncertainty. Both Friedman and Kraus vehemently believe that, generally speaking, bankers had no idea that their assets would collapse, and thus discard the possibility that the financial crisis was caused by malintentioned financiers.

The authors blame regulation. They bring to the table evidence which suggests that regulations — specifically, capital minima regulations set by the recourse rule — provided bankers an incentive to overconcentrate their investments into the mortgage market. The method of risk pooling adopted by the recourse rule (and the Basel II accords agreed upon by foreign governments) created an artificial preference for mortgage-backed securities over other types of investments, including business loans, since it lowered the capital reserve minima banks were required to maintain (i.e. these types of loans came with a lower cost).

The one major flaw, as I point out in my review, is what I perceive to be an inadequate reasoning for why these assets were so poorly rated. Here, I think, Friedman and Kraus drop the “radical uncertainty” thesis, and instead suggest that it was a product of a lack of competition. They do bring up that there is a broad industry of private investment firms who were coming out with their own ratings, but can only give one example of such a firm that sold its investments in mortgage-backed securities before the crisis. If Friedman’s and Kraus’ thesis was incorporated into the Austrian story of a distorted pricing process (i.e. price signals which falsely convey consumer preferences and cause discoordination) it would be a much stronger and more comprehensive one.

Engineering the Financial Crisis is primarily a history book — it deals with empirical data relating to the pattern of investments which characterized the boom period. As a piece of historical research, it is an invaluable contribution to economic history. It can be easily incorporated into the Austrian narrative (and even, in some ways, bolster the Austrian story), and I think that anybody interested in the topic would be deeply rewarded by reading the book.

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