Too Big to Function: The Absurdity of Market Regulation

Dan Markham

4/3/2012

Economic and Public Policy Issues

Paper Assignment –Book Review

Too Big to Function: The Absurdity of Market Regulation

There are many theories as to what was the underlying cause of the Great Recession from which America is still recovering. Popular ideas generally include irrational exuberance on the part of commercial banks, executive compensation packages which encouraged bankers to over-leverage themselves, and the collapse of the sub-prime housing market.  While it is probable that some of these factors played a role in the crisis, none of them can accurately explain the near complete collapse of the financial system that began in late 2007. In fact, the cause of the financial crisis can be directly traced to the failure of government regulators to recognize the dangers of interactions between several different laws designed to protect the system.

In their book entitled Engineering the Financial Crisis, authors Jeffery Friedman and Wladimir Kraus lay out an argument asserting that the crisis was caused by an unforeseen interaction between capital requirements for banks and the use of Mark to Market accounting methods. They further contend that there was a “master regulatory mistake that precipitated the crisis: using the bond ratings produced by Moody’s, S&P, and Fitch as the determinant of the capital levels required of banks by law” (Friedman

148). The book contains four chapters; the first is devoted to the refutation of several prevailing theories as to the cause of the financial crisis, the second and third explore the

regulatory failures which Friedman and Kraus believe are responsible for the crisis, and the final chapter is a more broad take on the psychology of market behavior as well as the ideology of its players, including regulators.

The first element of conventional wisdom concerning the cause of the financial crisis which the authors seek to debunk is that “the very low interest rates from 2001 to

2005 fueled a virtually unprecedented nationwide housing bubble in the United States” (Friedman 5). On this point, Friedman and Kraus actually concede that low interest rates did in fact fuel a housing bubble. They point to the fact that the Federal Funds Rate fell from 6.5% in January 2001 to 1% in June 2003 as evidence that cheap financing was available. Furthermore, they discuss the advent of a large quantity of Adjustable Rate Mortgages (ARM’s) in 2004 as a “major cause of the trouble experienced by subprime borrowers, strictly defined as those with low credit scores” (Friedman 9). The authors, however, draw issue with the assertion that the housing bubble was responsible for the financial crisis. Instead, they believe that it was a “trigger” event that initiated a causal chain of already deep seeded problems in the financial system. That is, the housing market collapse itself was not enough to trigger a recession had it not been for the much larger underlying problems which it brought to light.