Monday, November 30, 2009

Anatomy of the Financial Crisis

To start the blog, it seemed appropriate to discuss the ongoing global financial crisis. Rather than attempting to create a highly nuanced explanation of the series of events and decisions that led to this emergency, I'm going to stick to the 35,000 foot view and hope to get the major features. The next series of blog postings will focus on this subject; I intend to avoid a deterministic, single-factor explanation ("Wall Street's greed") and construct a (hopefully still relatively straightforward) multi-factor model. As will be seen, once this model has been set in place and allowed to run an eventual systemic crisis becomes a clear possibility.

Let's begin by using the metaphor of an impossibly simple car. Imagine that this car was designed without brakes, and that it has only four major performance components:

1. An engine
2. A fuel supply
3. A steering wheel
4. A gas pedal

Now imagine that this car has left the parking lot and proceeded to slam at full speed into a crowd of pedestrians, doing horrific damage. In order to do this, the four components managed to work in concert. For our purposes, these components have some other names:

1. The engine is also called fractional-reserve banking.
2. The fuel supply is also called monetary policy.
3. The steering wheel is associated with government-directed affordable housing programs.
4. The gas pedal is pleased to feature complex over-the-counter mortgage-backed securities and credit default swaps.

We'll get into each of these, sticking with non-technical descriptions, and discuss how they worked together to create conditions for a monstrous debt-deflation scenario. The crisis clearly had many, many fathers, but keep this car metaphor in mind as we proceed and I think the major contributors can be placed in correct context. The car is a "cognitive schema" designed to chunk a lot of information into one accessible unit and to ease the transfer of information from working memory to long-term memory. I will attempt to use the schema concept---heavily researched in a field called "cognitive load theory"---on this blog site as much as I can.

Unfortunately, it appears likely that public outrage will be directed towards free markets whenever possible and government officials who were intimately involved in the creation of the problem will pose as messianic figures in its wake.

Here goes...