How Debt Caused the 2008 Financial Crisis and Why It Matters

Who, or what, is most responsible for the recent financial crisis? Politicians and pundits have vigorously debated this topic, each seeking to blame the other side of the aisle. Scholars, past and future, offer many explanations why, in 2008, the global financial system stood on the brink of collapse. For voters, however, the question should be anything but academic. This country’s long-term economic prospects will be largely determined by how policymakers interpret what caused the crisis and decide what measures should be employed to ensure it does not happen again.

Over the past year, I have both read and reviewed dozens of books on the financial crisis. Numerous causes, some credible and some not, have been cited. Some authors have suggested that government policy, such as deregulation of the financial sector, is to blame. Others have cited private sector behavior, either in the form of short-term thinking about finance, or avarice on Wall Street.

If one believes that the deregulation is to blame, the logical response is more government regulation of the nation’s financial markets. The flawed Dodd-Frank Act, which does not adequately address the “too big to fail” problem, is the result of this particular interpretation. By contrast, if one accepts the greedy banker theory, one would naturally seek to protest those alleged culprits. The Occupy Wall Street movement and its cheerleaders seem largely to have bought into this argument. Both explanations are inadequate.

The most salient explanations for the financial crisis are those that contextualize it within the broader systemic framework of our country’s ongoing debt crisis. As cheap money flowed into the United States from abroad, it was diverted into the housing sector, leading to an increase in home prices, leading to an asset boom and subsequent bust. It was only a matter of time from when housing prices plummeted until market uncertainty as to the value of mortgage-backed securities reigned. This is not to say that flawed federal housing policy and Wall Street recklessness did not contribute to the crisis. They did, but only within the greater context of mistakes in fiscal and monetary policy.

Unless politicians in Washington sincerely tackle how we as a society are to reduce the national debt, there will be not only episodic financial crises in the years ahead, but also significantly diminished economic opportunities. This is particularly the case for recent university graduates who will surely see their taxes raised in the decade ahead if the situation is not soon brought under control.

If we accept that it is debt that matters most, this begs the question: What should be done about it? There are, unfortunately, no easy solutions to a complex problem. Reducing the debt through immediate, massive spending cuts may win some populist support, but it is not practical. Entitlement reform, on the other hand, is absolutely critical. This is not the time for ambitious federal government programs, particularly in health care. While the American economy is more resilient than one might initially think, it nevertheless is time that to acknowledge that the financial crisis of 2008 is best understood with reference to the national debt.

Photo Credit: JeffreyTurner