What caused the financial crisis? The widely accepted narrative, prominent in the media and pressed by the Obama administration, is that the crisis was caused by deregulation--the "repeal" of the Glass-Steagall Act and the failure to regulate both derivatives and mortgage brokers--which allowed excessive financial innovation, risk taking, and greed among financial players from mortgage brokers to Wall Street bankers. With this diagnosis, the proposed remedy is more regulation and government control of the financial system, from the over-the-counter derivative markets to mortgage brokers and the compensation of CEOs. The alternative explanation is that the crisis was caused by the government's own housing policies, which fostered the creation of 25 million subprime and other low-quality mortgages--almost 50 percent of all mortgages in the United States--that are now defaulting at unprecedented rates. In this narrative, the fact that two-thirds of all these weak mortgages are now held by government agencies, or were produced by government requirements, shows that the demand for these mortgages--and the financial crisis itself--originated in Washington. The problem for the administration's narrative is that its principal examples do not stand up to analysis: the repeal of a portion of the Glass-Steagall Act did not eliminate the restrictions on banks' securities activities (they were left unchanged), the mortgage brokers were responding to demand created by the government, and, there is no evidence that the failure to regulate credit default swaps (CDS) had any effect in causing or enhancing the financial crisis. Without a persuasive explanation for the cause of the financial crisis, the administration's regulatory proposals rest on a mythic foundation.

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