What Caused the Financial Crisis?

Posted by Kathy G, The G-Spot at 2:22 PM on September 22, 2008.

Chris Hayes has a very interesting post explaining the roots of the current financial meltdown. He says it has two basic causes: one is too much leverage, i.e., making investments where the amount of borrowed capital far exceeds the amount you have in assets. That seems fairly obvious.



The other explanation he gives is much more counterintuitive: too much capital. He explains:

This insight isn't mine. It comes largely from an episode of This American Life called The Global Pool of Money (an absolute can't miss episode, the best explanation of the whole crisis I've encountered.) This is a strange way to think about the problem, perhaps, but it's illuminating. The entire amount of capital that needs to find a home in the financial markets is roughly $70 trillion (in fixed income securities). But here's the thing, the size of this pool in 2000 was just 36 trillion. As Adam Davidson says in the TAL: "It took several hundreds years to get to 36 trillion and then it took six years to get to another 36 trillion."

Much of what's gone so wacky is simply that there's too much money chasing too few good investment opportunities and that's led to lots of risky schemes. Now, there's a lot of reasons for all this capital suddenly appearing, but at least one thing to consider is that the distribution between labor and capital is totally skewed, and if labor were capturing more of profits, they'd be consuming, and saving in (relatively safe) commercial enterprises. Which is to say, broadly distributed economic growth is more stable and better over the long-run, than sharply unequal growth.

I'm still working on getting up to speed this stuff myself, and I'm not certain that this explanation is correct. But it's intriguing, and it definitely bears looking into.

Tagged as: wall street, financial crisis, meltdown

Kathy G Runs The G-Spot blog.