Nobody Caused the Financial Crisis, Really

October 9, 2008 · Posted in Credit Crunch, Financial Crisis 

Nothing ever seems to happen without causing some good. For instance, there seems to be a little uptick in analyzing our thinking, as a result of wading through this financial crisis.

Radicals are starting to say that simple cause and effect reasoning could have prevented the current financial crisis. You may remember cause and effect from school, where as a thinking skill it is second in popularity only to the skill of avoiding thinking completely. But could an understanding of cause and effect have made a difference in the financial crisis?

Undeniably, cause and effect has its uses. The neat thing about cause and effect is that it makes you look good without much effort. When you know that something causes a certain effect, you can easily impress your friends. You look up and see a bunch of dark clouds and you casually mention that you think it’s going to rain. Then sure enough, it rains. Clouds then rain: cause and effect. Just don’t tell anybody how you do it and you’ll get a reputation for being really smart.

Unfortunately, cause and effect can get tricky. After you start using cause and effect, you begin to believe that everything has a cause and that you can spot that cause. Not so fast; you’re getting a little ahead of yourself. Sometimes things just happen out of the blue, without warning or reason.

That’s the situation with the financial crisis. No matter what anybody says, the current crisis is just the result of bad luck. There was no cause. It just happened, like all those forest fires, droughts, 100-year floods, and mega-storms that people predicted would be caused by global warming. Get real; predicting something doesn’t actually mean that you know the cause.

Let’s take a closer look at the financial crisis. With something this large, which has created hardships for more than half of the US population, people will probably ask questions: Couldn’t something have been done to prevent it? Cause and effect reasoning might have put us on the right track, if only those government economists could have found cause for alarm.

But nothing was obvious enough to cause concern. You can see that if we look at the major pieces of this crisis.

Cheap, cheap money – The Federal Reserve lowered interest rates, a lot. Who could know that cheap money would create a huge market of unsophisticated buyers and a huge industry of unscrupulous lenders?

Bait-and-switch loans, aka ARMs – Adjustable Rate Mortgage loans (ARMs) expanded the market and lender profits. And there was also something for consumers: low rates upfront and impossible rates to follow.

Inflated property appraisals – Lenders often worked with appraisers to inflate values and stimulate the market, creating what we now call “the housing bubble.” Sure the bubble attracted capital, but just because it was called a bubble, who knew it might burst?

Liar loans – Mortgage brokers from 2000 to 2007 routinely manipulated loan applications to let people get loans. Converting humbug into moolah is alchemy, not fraud.

Risk-free profits – Mortgage brokers quickly dumped new loans to avoid their default risk. Fannie Mae or Freddie Mac happily took on the debt with the backing of their rich uncle. Fannie and Freddie sound like the names of your slow-witted cousins; maybe if we called them Frances and Frederick they’d get a little more respect.

More profits – Weak loans were bundled, given blue-ribbon ratings, and sold to investors. Loan laundering is more important than money laundering because money has intrinsic value, while loans rely on a nice laundered appearance.

Reckless home buyers – People bought briefly affordable homes. Government economists didn’t see any problem at the time, but then they weren’t dealing with their own money. These economists now believe that home buyers should have known better.

This may seem confusing at first, because there were so many moving parts. Clearly, the government economists were perplexed. Were cause and effect signposts warning us of a crisis? Was danger lurking in harmless business activities? The economists wondered.

Once the crisis struck, of course, the wondering didn’t stop, but it changed focus. Now, the economists wondered if the economy was sound; everyone agreed it was. The politicians wondered how to bailout businesses, including Fannie and Freddie, whose lending practices were so outrageously unsound that they were on the verge of collapse.

As the focus shifts to working through the crisis, cause and effect is something of a hot potato in official circles. Politicians are looking for airtime to show us that they’re fully engaged after the fact. This may result in some cause-effect rhetoric, accusing the financial industry of causing the crisis. No doubt it will blow over after the November election.

In the short run, politicians do have a small dilemma. They want to convince us that they were smart enough to see the causes of impending problems, while avoiding the question of why they didn’t work to prevent the bad effects. Here is an example of why people in the know say that politics is a tough business.

You can see now that cause and effect reasoning fails to explain the financial crisis. There was no cause; the crisis was just bad luck. You can’t expect this thinking skill to fit in every situation.

In general, however, cause and effect reasoning could be a great tool for holding people accountable. Instead of telling each other to get over it and “move on,” we might start telling government to “hold on,” as in “we want to check this out.” This could cause unpleasantness in which responsible parties are held responsible, but it might have a cleansing effect.

Michael Durr is a marketer and writer. He publishes a website and blog on applied thinking, http://www.thebusinessofthinking.biz

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