An explanation of the financial crisis that's good enough for me

by phil on Sunday Mar 22, 2009 12:08 PM

There's this game in the media about, "How can we best explain the financial crisis." This is my contribution to it. It's based on This American Life's Giant Pool of Money episode. The following mixes my wording plus wording from a transcript of that episode [pdf].

There's three main causes of the financial crisis. They are A, B, C in the following piece:


All the money the world is saving is about 70 trillion dollars. This is money that insurance companies are saving for a catastrophe, pension funds saving money for retirement, the central bank of England saving for whatever central banks save for, and so on. And that money comes with an army of very nervous men and women watching over the pool of money: investment managers. This army is nervous because they don't want to lose any of that money and they also want to make it grow bigger. But to make it grow, they have to find something to invest in. And so they were aggressively buying up mortgages with fixed returns. (If an institution buys a mortgage, the homeowner's monthly payments goes to the institution). This was fine because housing prices were always increasing (A).

Also, the "global pool of money" number doubled since 2000 (B). In 2000 this was about 36 trillion dollars.

How did the world get twice as much money to invest? Lots of things happened, but the main headline is all sorts of poor countries became kind of rich making TVs and selling us oil: China, India, Abu Dhabi, Saudi Arabia. They made a lot of money and banked it. China, for example, has over a trillion dollars in its central bank, and there are office buildings in Beijing filled with math geniuses looking for a place to invest it.

At the same time, Alan Greenspan decided to keep the Fed Funds rate at the absurdly low level of one percent (C). This tells every investor in the world: you are not going to make any money at all on US treasury bonds for a very long time. Go somewhere else. We can't help you.

And so the global pool of money looked around for some low-risk, high-return investment. And among the many things they put their money into, there was one thing they fell in love with: mortgages.


When they keep comparing the current times to the Great Depression, it never makes sense to me. While our situation compared to the 90s may be like the Great Depression, in absolute terms we are still a hundred times better off than the 1930s. What's going on is a sad, natural consequence of this free market principle:

Faster-than-usual growth leads to speculative bubbles.

And speculative bubbles are based on another free market principle:

Nothing makes money like money.

I don't know if there's ever going to be a fix for this. My futuretracking persona says that we're just going to have more and more frequent boom-and-bust cycles for the next 20 years until we're in a completely different place. Or maybe the IMF or a charismatic leader will come up with an instrument that pierces bubbles before they start, Wall Street-be-damned.

Cross-posted on Drunk Log

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