Did the Invisible Hand Fail? A Conversation on the 2008 Financial Crisis

|| Photo by  Aditya Vyas  on  Unsplash .

|| Photo by Aditya Vyas on Unsplash.


The conventional wisdom surrounding the cause of the 2008 financial crisis has fundamental flaws, Dr. Paul Mueller explained to students and faculty at The King’s College on Feb. 15.

After years of research, Mueller came to share the findings explained in his new book: “Why the Conventional Wisdom about the 2008 Financial Crisis Is Still Wrong.”

Troubled by the economic catastrophe of 2008 and its implications for free-market philosophy, Mueller attempted to answer the question: “Is this a black eye for free markets—Is finance something that market discipline and the invisible hand of Adam Smith can’t coordinate?” Mueller asked.

There are a few traditional explanations for the 2008 financial crisis. All of which, according to Mueller, lack explanatory power or fail to address the problem at a causal instead of a symptomatic level.

“The biggest explanation is deregulation. The problem is it’s basically not true. It’s not true that the financial sector was not heavily regulated,” Mueller said.

Dr. Mueller shares his research with students and faculty of The Kings College. || Photo credit to Liza Vandenboom.

Dr. Mueller shares his research with students and faculty of The Kings College. || Photo credit to Liza Vandenboom.

The key causes of the 2008 financial crisis were not driven by deregulation. “In fact, we can find several specific regulations that pushed individuals into making riskier bets,” Mueller explained. Counterintuitively, the restrictions put in place to encourage responsibility actually increased moral hazard.

Another leading explanation for the crisis attributes responsibility to a reckless Wall St.  “There’s this idea that Wall St. went crazy. The issue with this story is that it fails to address the why,” Mueller explained. “If we want to understand why it happened analytically, we need an explanation for a change in behavior.” This view fails to account for a logical beginning. It traces the spiral from the middle.

Mueller suggested an alternative framework that fills in the gaps of conventional theory. He traces the germination of the crisis to failed government policy.

“The Federal Reserve in the early 2000s lowered short-term interest rates significantly, but then kept them low for a long period of time—longer than most policy analysts thought would be good,” Mueller said. In doing this, the government “in part fueled the housing bubble, because the largest cost in purchasing a house is the mortgage and the interest you have to pay on it.”

Congress also played a role in the brewing catastrophe, Mueller argued.

Dr. Mueller invites audience questions for a Q&A. || Photo credit to Liza Vandenboom.

Dr. Mueller invites audience questions for a Q&A. || Photo credit to Liza Vandenboom.

“There was a concerted effort in the early 90s through the early 2000s to undermine lending standards,” Mueller said. “They were complaining [...] that the market—left to itself—would lead to too high of standards for mortgage lending. The worry was that [...] poor people would not have access to homes.”

In response to this concern, congress intentionally pushed banks to lower their underwriting standards to make loans more widely available.

“Standards quickly fell from the traditional rules: the standard 20% down payment, the rule that mortgage payments had to be no more than ⅓ of your pre-tax income, etc.” The result was thousands of Americans saddled with debt they could not pay back.

The bailout acted as another major culprit. “It was creating legal and regulatory uncertainty,” Mueller said. “By bailing out failing institutions, putting money in the system, and messing up market signals, government intervention led to slow growth and the slowest recession recovery in U.S History.”

The Troubled Asset Relief Program actually worsened stock market volatility. “The ten largest one-day declines happened after TARP.” Mueller said. “In the single week following its passage, stock markets declined 18 percent.”

In light of the shortcomings of conventional wisdom, Mueller returned to his catalyzing question: “Was this a failure of free-market principles?.” After extensive research, he concluded that government intervention, not a collapse of the invisible hand, provided the seeds for catastrophe and worsened the consequences.

In order to avoid future crises, “the biggest thing we need is less distortions and restrictions.”