Social Engineering and the Roots of the Financial Crisis

Many books and articles have been written about the financial crisis of 2007–2008. Unfortunately, much of this literature is deeply flawed, mistakenly treating, for example, unscrupulous mortgage lenders and securities dealers as the primary cause of the calamity rather than as factors subordinate to more fundamental causes. One book exempt from this criticism is Alchemists of Loss: How Modern Finance and Government Regulation Crashed the Financial System (2010), by Kevin Dowd and Martin Hutchinson.

The book traces the development of modern finance and the institutional setting in which it operates, and explains how they set the stage for the mortgage meltdown and the mess that ensued. Although Dowd, an economist, and Hutchinson, a financial journalist who worked for many years as an investment banker, examine a host of causal factors that contributed to the financial calamity, they place the primary institutional blame on the agency assigned to promote maximum employment, stable prices, and moderate long-term interest rates: the Federal Reserve.

Economist Roger W. Garrison, a leading theorist of the business cycle, agrees with Dowd and Hutchinson’s overall assessment (see Garrison’s outstanding review essay, “Alchemy Leveraged: The Federal Reserve and Modern Finance,” in the Winter 2012 issue of The Independent Review).

In brief, under the leadership of former chairman Alan Greenspan, the Fed, in the years of the housing boom, pursued an expansionary monetary policy that drove down interest rates far below market levels. Along with policies designed to broaden homeownership that were pursued or influenced by other agencies of the federal government, the Fed’s reckless credit expansion precipitated an unsustainable housing bubble whose burst was bound to devastate much of the rest of the economy. Dowd and Hutchinson’s discussion of this aspect of the financial crisis will sound familiar to readers of this blog.

Other parts of Alchemists of Loss illuminate less familiar dimensions of the financial crisis. One fascinating contribution is the authors’ novel theory of how public policies enacted to redistribute income helped set the stage for the crash.

Motivated by income redistribution, changes to the U.S. tax code that were initiated many decades ago, along with the addition of various regulations, contributed to the demise of the partnership as a leading model for business enterprises and to the rise of the corporation. This development profoundly altered the incentives that business managers face, Dowd and Hutchinson argue, partly because the corporate form of organization separates ownership from control. One result is that contemporary business managers often possess shorter time horizons than the owner-managers who preceded them. The underlying concern for long-term profitability that characterized the “old partnerships” has given way to a focus on the exploitation of short-term profit opportunities. The growing importance of traders in securities firms—the practitioners of the “alchemy” of modern finance referenced in the book’s title—is a creature of this transformation.

Dowd and Hutchinson suggest that the opportunities for cumulative short-run gain would not have been available, at least not at any significant level, had the vigilant and long-term-oriented “old partnerships” continued to play a large role in the economy. Thus, by penalizing the partnership, the redistributionist tax code has eroded what had been a stabilizing influence on the macroeconomy.

Although Dowd and Hutchinson argue that these and other developments have weakened the financial system, it bears repeating on whose doorstep they place the blame for the recent crisis. Without the credit expansion initiated by the Federal Reserve’s Open Market Committee, there would have been no artificial boom for the economy in general and no unsustainable bubble in the housing market in particular. Dowd and Hutchinson’s refreshing emphasis on distortions to long-term investment patterns caused by the Fed’s credit expansion, Garrison notes, accords with the business cycle theory of the Austrian School of Economics even though they don’t cite its influence on their thinking.

But if Alchemists of Loss shares the analytical tenets of a tradition that sprouted in Vienna, some of its policy prescriptions hail from the Windy City. For although Dowd and Hutchinson favor the abolition of the Federal Reserve, a goal advocated by many Austrian economists, they offer a set of “second-best” proposals associated with the monetarism of the University of Chicago. Chief among these is a Federal Reserve policy aimed at stabilizing the level of prices.

Unfortunately, monetary policies designed to maintain a stable price level would still leave the economy vulnerable to Fed-induced business cycles, according to Garrison. So although Alchemists of Loss has many virtues, a well-developed and full-proof prescription for avoiding future booms and busts isn’t one of them.