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The global financial crisis of 2007-09 wasn’t unprecedented or unpredictable. It was the logical consequence of a sharp increase in credit supply, which led to a corresponding boom in borrowing and inflated prices for assets most easily used as collateral: housing and sovereign bonds. Lending standards and other limits on indebtedness can fall only so far, however. Once the endpoint is reached, the process begins to reverse, and the leverage accumulated during the boom amplifies that reversal into a catastrophe.

The best books about the crisis explain this process. In different ways, they illuminate our understanding of what happened and provide the intellectual framework for making future crises less painful.

First on our list are Misunderstanding Financial Crises: Why We Don’t See Them Coming (2012) by Gary B. Gorton, and The Bankers’ New Clothes: What’s Wrong With Banking and What to Do About It(2013) by Anat Admati and Martin Hellwig. Both focus on the core questions of what financial firms do, why they fail, and why it matters for everyone else. The key insight from their work is that most of what we call “money” is actually short-term debt backed by risky assets. At any time, savers can try to convert their deposits to cash and force banks to sell their assets, probably at a loss. This is inherently unstable.

For Gorton, the question is why financial crises are rare. His answer is that the state normally protects the value of banks’ short-term debts, which ensures that the value of money is “insensitive” to new information. Deposit insurance, for example, means that most savers don’t need to worry about the health of their bank. Panics occur when savers feel unprotected. To Gorton, the crisis of 2007-09 was caused by the government’s failure to recognize that repurchase agreements and other parts of the financial system had effectively become “banks” and required the same explicit and expansive government guarantees as traditional lenders.

Admati and Hellwig agree with much of Gorton’s analysis but come to the opposite conclusion. The problem, to them, is that protecting bank creditors with government guarantees makes risky bets obscenely profitable. This is a large but hidden subsidy paid to bankers by taxpayers. Worse, the subsidy gets bigger as banks take more risk. The crisis was therefore caused not by insufficient guarantees, but the widespread belief that the guarantees already existed. For Admati and Hellwig, limits on bank leverage are a necessary complement to Gorton’s proposal for additional government support. Shareholders, rather than the state, should be primarily responsible for protecting bank creditors.

The flip side of the financial sector’s excessive lending in the run-up to the crisis was an enormous increase in borrowing. This is the focus of Atif Mian and Amir Sufi in House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It From Happening Again (2014). The sudden shift in credit supply in the 2000s meant that Americans with the lowest credit scores in the worst neighborhoods were disproportionately likely to experience the biggest increases in indebtedness. The extra borrowing boosted house prices as well as spending on everything from cars to home renovations. During the boom, Las Vegas, Phoenix, Miami, and other bubbly metros grew more than places that missed the bubble, such as Texas, with its constitutional restrictions on home-equity extraction. However, they fared far worse after house prices peaked in 2006.

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The reason is that, like banks, people with low credit scores and high debts are extremely vulnerable to falling asset prices. Going ZIP Code by ZIP Code, Mian and Sufi show how everything from spending on cars and furniture to employment at restaurants and grocery stores was affected by differences in borrowing during the bubble. They also persuasively argue that the government failed by focusing its response on restoring the banking system to health rather than addressing the financial situation of the Americans who would have wanted to borrow and spend. While the book focuses on the recent U.S. experience, Mian and Sufi’s subsequent research corroborates the universality of their findings across time and other countries. (See Other Voices.)

The debt bubble was also accompanied by rampant fraud. Alarmingly, the fraud didn’t stop after 2008. This important and underappreciated story is ably told by David Dayen in Chain of Title: How Three Ordinary Americans Uncovered Wall Street’s Great Foreclosure Fraud (2016). In the aftermath of the bust, mortgage-servicing companies, often owned by the big banks, foreclosed on millions of defaulting borrowers, often at the expense of first lien creditors who would have preferred making loan modifications. The servicers didn’t have the capacity or the desire to fill out the paperwork properly, so they often resorted to forging documents signed by the implausibly productive “Linda Green.”

Sometimes, this led to foreclosures on homeowners with current mortgages, and even on homeowners who had no mortgage debt at all. The judicial system proved remarkably forgiving of these “clerical errors.” Eventually, the U.S. government collected fines from the servicers, but it did little to punish the perpetrators of these large-scale thefts. Dayen’s account mixes detailed explanations of the mortgage-securitization process with vivid accounts of the human cost of the bubble and bust.

All of these books leave readers wondering why the global debt boom happened where and when it did. Michael Pettis answers these questions in The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy (2013). He starts with a simple but profound insight: While all income comes from someone else’s spending, many people spend either more or less than they earn. Those who spend more cover their deficit by selling assets, while those who spend less than they earn have a surplus that is necessarily used to accumulate assets. As a result, “Japanese interest rates, Spanish real estate bubbles, American mortgage derivatives, and copper mining in Chile are all part of a single system.”

Problems arise when decisions in certain countries distort behavior elsewhere. Pettis focuses on the consequences of the surpluses in China and Germany, which he convincingly argues were caused by insufficient domestic spending. The Chinese government’s development strategy focused on transferring household wealth to businesses, which depressed purchasing power that could have been used to buy more imports. Meanwhile, the German elite’s preoccupation with “competitiveness” led to wage stagnation. The resulting surpluses forced corresponding deficits and debt bubbles upon the few countries that tolerate capital inflows from abroad, until the debts became unbearable or the capital flows reversed. Pettis sees the crisis as the first step in the resolution of these “global imbalances,” which remain a threat to global peace and prosperity.

Adam Tooze’s Crashed: How a Decade of Financial Crises Changed the World (2018), and Martin Wolf’s The Shifts and the Shocks: What We’ve Learned—and Have Still to Learn—From the Financial Crisis (2014) are the most comprehensive single-volume accounts of the global crisis and its aftermath. Tooze, recently interviewed by Barron’s, wrote a detailed narrative history, while Wolf focuses on the implications for economic thought and policy making.

Tooze’s history is centered on the global structure of the financial system and the political implications of these international connections. Banks based in Europe borrowed and lent trillions of dollars in the U.S. German regional banks were at least as important as the traditional Wall Street firms in fueling America’s housing debt bubble. Meanwhile, American banks, through their operations in London, were heavily exposed to Europe. Tooze convincingly argues that the subsequent euro crisis wasn’t a separate event from 2008 but the natural consequence of these links.

His history is enriched by his focus on geopolitics. While central banks in countries of strategic importance to the U.S., such as Korea and Mexico, got relatively unrestricted access to cheap dollar loans from the Federal Reserve during the crisis, the Russian central bank would never get dollars from the Fed to support its financial system so soon after the invasion of Georgia. The European Central Bank’s treatment of borrowers in the Baltics, Hungary, and Poland reinforced domestic attitudes that they were second-class Europeans who couldn’t depend on the West. Perhaps the most fascinating section of the entire book is Tooze’s explanation of the Ukraine crisis and its connection to 2008.

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To Wolf, the crisis and the subsequent weak recovery were intellectual failures. Politicians are always shortsighted, and bankers cannot be blamed for responding to the incentives established by governments. Academics and technocrats, however, made two profound errors. First, they ignored the possibility of trouble before the crisis. Soaring indebtedness was of no concern as long as home ownership and asset prices were rising. Second, their response to the downturn was often counterproductive. Economists claimed high unemployment was caused by an abundance of workers with “zero marginal product.” They wrongly warned that inflation was imminent. And they argued that governments should tighten their budgets even though inflation-adjusted interest rates were at the lowest levels in generations.

Wolf’s conclusion is that much of what economists believed to be true back in 2007 should be discarded in favor of ideas from outside the mainstream, or ideas that had been long forgotten. Unfortunately, events since his book’s publication suggest things may have to get worse before they can get better.



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Write to Matthew C. Klein at matthew.klein@barrons.com