There are several prevailing narratives for what went wrong to cause the financial crisis. Was it too much government involvement in the markets via Fannie and Freddie? Was it not enough government regulation of Wall Street? Brookings Fellows Douglas J. Elliott and Martin Neil Baily recently published a paper examining this question. They prefer a comprehensive approach to explaining the crisis, and so do I. Although I have a few minor quibbles with some of their analysis, I think their underlying thesis is spot-on.

Elliott and Baily present three potential narratives for explaining what caused the crisis:

Narrative 1: It was the fault of the government, which encouraged a massive housing bubble and mishandled the ensuing crisis.

Narrative 2: It was Wall Street's fault, stemming from greed, arrogance, stupidity, and misaligned incentives, especially in compensation structures.

Narrative 3: "Everyone" was at fault: Wall Street, the government, and our wider society. People in all types of institutions and as individuals became blasé about risk-taking and leverage, creating a bubble across a wide range of investments and countries.

The first narrative is favored by conservatives; the second narrative is favored by liberals. The third narrative should be favored by anyone who reviews the situation in an objective, unbiased light. Both of the first two narratives are correct in some ways and incorrect in other ways. So much went wrong to create such a disastrous market failure that it cannot be blamed on only housing or just Wall Street greed.

In their paper, the authors explain that there was certainly an enormous housing bubble that formed, and it was likely intensified by government sponsored entities like Fannie Mae and Freddie Mac. But there were also other smaller bubbles in areas like commercial real estate and leveraged loans. They say:

This does not rule out the possibility that housing started the problem and the blow was so strong that it took down the other sectors. However, it is strongly suggestive that the imbalances in other areas were also very large prior to the housing bubble bursting, reinforcing the notion of a more comprehensive bubble made up of many sectoral bubbles.

They theorize that the reason for such cheap credit that spawned so many bubbles was because investors' aversion to risk fundamentally changed over the past few decades. I agree -- to a point.

I believe that credit becoming so cheap in the housing market did affect credit in other markets. On some fundamental level, credit is credit. If it becomes incredibly cheap for some sector, then others will benefit, as arbitrage opportunities will exist if the gap in price between various credit markets becomes too large.

This was quite apparent with the securitization market. Credit spreads for residential mortgage-backed securities shrunk incredibly from 2003 through 2006. As a result, other AAA-rated securities had to follow suit. On some level, the return on AAA-rated bonds shouldn't differ that much, no matter what the underlying collateral. So you had a situation where securities based on commercial mortgages, credit cards, auto loans, business loans, and other assets also saw tighter spreads to their respective benchmarks. Asset-backed commercial paper and collateralized debt obligations also made credit easier and less expensive. Cheaper credit in the mortgage market drove cheaper credit in other markets.

This created a situation where irrationally bred more irrationality. So while I think that the authors should give the housing market a little more weight for causing other credit markets to create smaller bubbles, risk aversion surely had something to do with it. Investors' view of risk is what should prevent them from doing stupid things. They threw caution to the wind when they started believing that huge real estate returns created a new norm. That same attitude bled into other markets as well.

So I think there's little doubt that housing played a huge part, but I also think it's silly to say that it's the only thing that went wrong. As for what should be done, I think this statement by the Elliott and Baily is utterly sensible:

As we have said, our preference is for narrative 3, but that still leaves open the question of what policymakers can and should do. For our part, we believe that it makes sense to fix the many known problems that became evident during this crisis and to strengthen the rules on capital and liquidity, which serve as safeguards against any type of trouble and therefore do not necessitate guessing the exact form of a future crisis. Accepting that some crises may still occur does not imply that systemic weaknesses in the markets or regulation should be accepted passively.

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