Legal Commentary

Did Political Ignorance Help Cause the Financial Crisis?

By Ilya Somin

Political scientist Jeffrey Friedman has an excellent article arguing that political ignorance by both regulators and voters played a key role in causing the financial crisis:

You are familiar by now with the role of the Federal Reserve in stimulating the housing boom; the role of Fannie Mae and Freddie Mac in encouraging low-equity mortgages; and the role of the Community Reinvestment Act in mandating loans to ?subprime? borrowers, meaning those who were poor credit risks. So you may think that the government caused the financial crisis. But you don?t know the half of it. And neither does the government....

Given the large number of contributory factors ? the Fed?s low interest rates, the Community Reinvestment Act, Fannie and Freddie?s actions, Basel I, the Recourse Rule, and Basel II ? it has been said that the financial crisis was a perfect storm of regulatory error. But the factors I have just named do not even begin to complete the list. First, Peter Wallison has noted the prevalence of ?no-recourse? laws in many states, which relieved mortgagors of financial liability if they simply walked away from a house on which they defaulted. This reassured people in financial straits that they could take on a possibly unaffordable mortgage with virtually no risk. Second, Richard Rahn has pointed out that the tax code discourages partnerships in banking (and other industries). Partnerships encourage prudence because each partner has a lot at stake if the firm goes under. Rahn?s point has wider implications, for scholars such as Amar Bhidé and Jonathan Macey have underscored aspects of tax and securities law that encourage publicly held corporations such as commercial banks ? as opposed to partnerships or other privately held companies ? to encourage their employees to generate the short-term profits adored by equities investors.....

This litany is not exhaustive. It is meant only to convey the welter of regulations that have grown up across different parts of the economy in such immense profusion that nobody can possibly predict how they will interact with each other. We are, all of us, ignorant of the vast bulk of what the government is doing for us, and what those actions might be doing to us. That is the best explanation for how this perfect regulatory storm happened, and for why it might well happen again.

For more of Jeff?s analysis of the ways in which ignorance contributed to the crisis, see here, and his much longer academic article on the subject in a special symposium issue of Critical Review (which also includes important contributions by many other scholars).

I don?t know enough about financial regulation to have any strong opinion on whether Jeff?s arguments are correct (though many of them strike me as persuasive). However, his analysis does overlap with my own work suggesting that the size and complexity of modern government greatly exacerbates the dangers of political ignorance (e.g. here and here). It is definitely a good and thought-provoking piece, even if there are parts that are hard for me to judge.

CONFLICT OF INTEREST WATCH: Jeff was one of the people who played a key role in getting me interested in the issue of political ignorance back in the 1990s. As editor of Critical Review, he published my very first article on the subject back in 1998. So I owe Jeff a great debt for, among other things, pointing me towards a subject that is one of the main parts of my research agenda, and promoting my work at a time when I wasn?t well-known at all. At the same time, we have disagreed in print over several major issues relating to political ignorance. So I?m hardly an uncritical cheerleader for Jeff?s arguments, or he for mine. In this series of articles, I think he makes a valuable contribution to the debate, even if we ultimately conclude that some other explanation of the crisis is more compelling. My guess is that the ignorance Jeff points to was at least an important contributing factor, even if other causes also played a major role.

Full post as published by The Volokh Conspiracy on February 09, 2010 (boomark / email).