I'M FINDING the exchange on the financial crisis illuminating in a number of ways, but especially as it lays bare the ideological assumptions and motivations we each bring to these questions. In his latest assay, my esteemed colleague seeks to absolve government from any significant responsibility for the meltdown. (We seem to have moved beyond the question of inequality, which is fine by me.) Having concluded that "the CRA was largely irrelevant" and that "Fanny and Freddie were also-rans", he finds it "hard to understand how one could put government at the heart of the crisis." Let me try to help.

I find Vernon Smith (a brilliant Nobel laureate) and Steven Gerstad's thumbnail account of the bubbly run-up to the crisis compelling:

[T]he largest [housing bubble] in U.S. history started in 1997, probably sparked by rising household income that began in 1992 combined with the elimination in 1997 of taxes on residential capital gains up to $500,000. Rising values in an asset market draw investor attention; the early stages of the housing bubble had this usual, self-reinforcing feature. The 2001 recession might have ended the bubble, but the Federal Reserve decided to pursue an unusually expansionary monetary policy in order to counteract the downturn. When the Fed increased liquidity, money naturally flowed to the fastest expanding sector. Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded. Lenders and the investment banks that securitized mortgages used rising home prices to justify loans to buyers with limited assets and income. Rating agencies accepted the hypothesis of ever rising home values, gave large portions of each security issue an investment-grade rating, and investors gobbled them up.

Why did investors gobble them up? Peter Wallison says:

Mortgage brokers--even predatory ones--cannot create and sell deficient mortgages unless they have willing buyers, and it turns out that their main customers were government agencies or companies and banks required by government regulations to purchase these junk loans. As of the end of 2008, the Federal Housing Administration held 4.5 million subprime and Alt-A loans. Ten million were on the books of Fannie Mae and Freddie Mac when they were taken over, and 2.7 million are currently held by banks that purchased them under the requirements of the Community Reinvestment Act (CRA). These government-mandated loans amount to almost two-thirds of all the junk mortgages in the system, and their delinquency rates are nine to fifteen times greater than equivalent rates on prime mortgages.

Perhaps my colleague can point out the error in Mr Wallison's learned synopsis, in which the CRA and the GSEs appear to play more than "largely irrelevant" or "also-ran" roles.

So we know what happened next. Everything fell apart when the value of mortgage-backed securities went to hell. This wouldn't have been such a momentous problem had investment and commercial banks not loaded up on them. For Jeffrey Friedman and Wladimir Kraus, authors of the forthcoming "Engineering the Perfect Storm: How Reasonable Regulations Caused the Financial Crisis", "[t]he question...is why the commercial banks held so many mortgage-backed bonds." They point the finger at an obscure regulation called "the recourse rule."

[U]nder the recourse rule, "well-capitalized" American commercial banks were required to spend 80 percent more capital on commercial loans, 80 percent more capital on corporate bonds, and 60 percent more capital on individual mortgages than they had to spend on asset-backed securities, including mortgage-backed bonds, as long as these bonds were rated AA or AAA or were issued by a government-sponsored enterprise (GSE), such as Fannie or Freddie. Specifically, $2 in capital was required for every $100 in mortgage-backed bonds, compared to $5 for the same amount in mortgage loans and $10 for the same amount in commercial loans. One can readily see that the recourse rule was designed to steer banks' funds into "safe" assets, such as AAA mortgage-backed bonds. The fact that 93 percent of the banks' mortgage-backed securities were either AAA rated or were issued by a GSE shows that this is exactly what the rule accomplished. Unfortunately, these bonds turned out not to be so safe. Without the recourse rule, however, there is no reason for portfolios of American banks to have been so heavily concentrated in mortgage-backed bonds.

Messrs Friedman and Kraus go on to make the intriguing observation that diversity of business strategies in competitive markets makes those markets less prone to coordinated failure. When competing firms make bets on a wide array of strategies, the damage of bad bets are contained. Not everyone made the same bad bet. Winning strategies are swiftly emulated, thereby swiftly neutralizing their competitive advantage. And this induces a new round of search and experimentation, the emergence of new winners and losers, and so on. However, regulation can wipe out strategic diversity by creating (intentionally or not) a single best strategy—an offer none can refuse—that continues to dominate even when the entire field converges on it. But if this bet goes bad, everyone goes down together. Messrs Friedman and Kraus argue that "Regulations, by their very nature, align the behavior of those being regulated with the ideas of those doing the regulating. Regulations are like mandatory instructions for herd behavior, automatically increasing systemic risk."

Does this add up to an outline of the one true story? Of course it doesn't. All I can say is that it sounds plausible to me, but that others are much better placed to render a dispositive judgment. I think it at least fair to say that it is very plausible that government policy played a central role in the crisis. If the combination of low interest rates, favourable tax treatment for residential capital gains, a web of heavily promoted initiatives to make it easier for lower and middle-income Americans to buy houses, regulations mandating the purchase of subprime loans, capital requirements goading banks into holding lots of "safe" assets do not "put government at the center of the crisis", I can't imagine what would. Which is not to say that the market did not fail. Indeed, it is impossible to specify what the market is in isolation from the rules that define the possibilities and terms of exchange. The market failed. And the market was what it was because government made it that way.

All this is an exhausting prelude to why it is that I find it frustrating when my co-blogger writes:

The evolution of this story leads me to believe that what's happening here is that many people who hold laissez-faire economic views have an extremely difficult time accepting that markets can behave in a collectively irrational and disastrous fashion without any kind of government intervention.

Is it really so clear that the truth of the matter is plain to see, but that some of us are so blinded by ideology that we deny our very eyes? I do not think the truth is so clearly evident. In any case, I don't doubt that there are laissez-faire die-hards who cannot accept that markets sometimes fail on their own steam, but I'm quite certain neither I nor Mr Rajan is among them. Vernon Smith, one of my intellectual heroes, and a laissez-faire kind of guy, has shown in his trailblazing experimental work that bubbles arise again and again without special assistance. My own Hayek-inflected views, which put a heavy emphasis on ineradicable ignorance, straightforwardly imply the possibility of coordinated failures of economic foresight. The same Hayekian convictions also straightforwardly imply that regulation meant to govern interaction within complex and evolving economic, legal, and political institutions will inevitably lead to unpredictable and unintended consequences, some fortuitous, some disastrous. Markets crash now and again. That's just the nature of things. We should accept that. Government regulation and intervention sometimes prevent or moderate a crash. Sometimes they cause it. Sometimes they make it worse. We do the best we can.

If I could have one wish as this important debate continues, it would be that all sides abandon the false dichotomy between market and state, and instead embrace the idea that there is but a single order of human action determined by the interface between human psychology, technology, and the integrated scheme of legal, political, moral, professional, and cultural rules. The question is not whether markets are to be regulated, but how, and to what end.