The Unexamined Crisis

By Luigi Zingales

CHICAGO - Three years have now passed since the collapse of Lehman Brothers, which triggered the start of the most acute phase of the 2007-2008 financial crisis. Is the financial world a safer place today?

Within days after the 9/11 terrorist attacks in 2001, the US had erected new and enormous security measures at airports throughout the country. Within a month, the US military was on the ground in Afghanistan. Within three years the US had an official report on the causes of the events of 9/11; the well-resourced expert commission that produced it identified the weaknesses of America's national-security agencies and provided recommendations for addressing them.

But what do we have three years after the financial crisis began? To be sure, America has the 2,000-page Dodd Frank Act to show for its efforts. Unfortunately, few of those pages address any problem suspected to have caused the financial crisis.

Bond investors' heavy reliance on credit-rating agencies, which tend to be laxer with powerful issuers, has not been fixed. The shadow banking sector's dependence on the official banking sector's liquidity and guarantees, and thus ultimately on the government, has not even been touched. And limits on financial institutions' leverage will change only in the next decade.

The list of shortcomings goes on and on. Money-market funds' perverse incentives to take on excessive risk remain largely intact. Problems with incentive pay have been ignored.

The most highly touted change - the separation between proprietary trading and commercial banking (also known as the 'Volker rule,' after former US Federal Reserve chairman Paul Volker) - has nothing to do with what caused the crisis, and most likely was approved because it was ineffective.

The Financial Crisis Inquiry Commission, chaired by Phil Angelides, did produce a report on the crisis - in fact, three reports. By contrast, the Rogers Commission, which investigated the causes of the Space Shuttle Challenger disaster, produced just one report.

The best minds of the time, including the Nobel laureate physicist Richard Feynman, were part of the investigation, and no stone was left unturned in finding the cause.

Ultimately, the culprit was precisely identified as a defective O-ring that became too stiff at low temperatures and caused a leak. To convince the public, Feynman demonstrated that conclusion with a televised experiment.

Economics is not as precise a science as physics, but this cannot justify the failure of the Angelides Commission. With sufficient data, we do have methods to identify the likely causes of an economic phenomenon. We are even better at refuting potential explanations.

The major limits are imposed by the availability of data, not by our methodologies. But the data were not made available, because the interested parties were (and remain) afraid to share it, knowing full well what would be revealed.

Unfortunately, the Commission - composed mostly of elected officials, rather than experts - wasted its time in political squabbles. Its members could not agree even on how to define subprime mortgages and calculate how many such mortgages there were in the United States at the time of the crisis.

A subsequent investigation into the work of the Commission was more thorough than the Commission's investigation of the crisis. After reading through the emails, a congressional report found evidence that the Commission's work was guided by politics rather than fact-finding.

After all, the fixes had already been decided and approved, before any fact was found; the Commission's focus was on supporting or discrediting (depending on the commissioner?s political party) the Dodd/Frank legislation, rather than on establishing the truth.

It was a great opportunity lost. With its subpoena power, the Angelides Commission could have collected and made available to researchers the data needed to answer many crucial questions about the crisis. Did companies that compensated their traders (and not just their CEOs) more highly take more risk?

Was financial institutions' assumption of excessive risk the result of incompetence or stupidity, or was it a rational response to the implicit guarantee offered by the government? Did the market see the spread of lax lending standards and price the relevant pools of loans accordingly, or was it fooled? Who were the ultimate buyers of these toxic products, and why did they buy them? How important a role was played by fraud?

These are the questions that needed to be answered. Unfortunately, they are likely to remain unanswered without a major mandatory disclosure of data. Barring that, there is the risk that we will find out what caused this crisis after the next one.

Luigi Zingales is Professor of Entrepreneurship and Finance at University of Chicago Graduate School of Business and co-author, with Raghuram G. Rajan, of Saving Capitalism from the Capitalists.