What caused the global financial crisis? And how can the United States avoid a repeat? Those questions have sparked endless handwringing among economists, policymakers, financiers, and voters over the last decade. Little wonder: the crisis not only entailed the worst financial shock and recession in the United States since 1929; it also shook the country’s global reputation for financial competence.
Before the crisis, Wall Street seemed to epitomize the best of twenty-first-century finance. The United States had the most vibrant capital markets in the world. It was home to some of the most profitable banks; in 2006 and early 2007, Goldman Sachs’ return on equity topped an eye-popping 30 percent. American financiers were unleashing dazzling innovations that carried newfangled names such as “collateralized debt obligations,” or CDOs. The financiers insisted that these innovations could make finance not only more effective but safer, too. Indeed, Wall Street seemed so preeminent that in 2003, when I published a book about the Japanese banking crisis, Saving the Sun, I presumed that one of the ways to “fix” Japanese finance was to make it more American.
Within five years, this supposed success had been reduced to ashes. The brilliant innovations with strange abbreviations, it turned out, had contributed to a massive credit bubble. When it burst, investors around the world suffered steep losses, mortgage borrowers were tossed out of their homes, and the value of those once mighty U.S. banks shriveled as markets froze and asset prices tumbled. Instead of a beacon for the brilliance of modern finance, by 2008, the United States seemed to be a global scourge.
Why? Numerous explanations have been offered in the intervening years: the U.S. Federal Reserve kept interest rates too low, Asia’s savings glut drove up the U.S. housing market, the banks had captured regulators and politicians in Washington, mortgage lenders made foolish loans, the credit-rating agencies willfully downplayed risks.
Thinking about the original meanings of “finance,” “credit,” and “bank” helps explain what went wrong with American finance in
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