Origins of the credit crisis: two overlooked structural mismatches.

• Author: Connolly, Bernard

Throughout this decade this writer has argued that massive intertemporal misallocation in the world-too much bringing forward of spending from the future--would create an economic shock as severe as that of the 1930s unless firms and households were given more and more incentives to keep on bringing spending forward. But giving them those incentives would involve bubbles and Ponzi games. Ultimately, the choice would lie between much more extensive government control of many areas of financial and economic activity, and a devastating financial and economic collapse--a collapse whose political consequences would be unpredictable in detail but almost certainly malign.

That choice has been staring the world in the face for several months. But the underlying reasons for the terrible choice have still not been understood. Blame is being misdirected, and policy reactions are likely to be misguided. Most emphatically, the crisis does not represent a failure of capitalism; rather, it represents a failure of governmental (including central bank) involvement in capitalism.

Whether hundreds of banks lent and hundreds of millions of households borrowed without sufficient regard for ability to pay is a question with a moral aspect. But the nature of bankers' and households' moral universe, whatever it is, is unlikely to have changed much in recent years. What caused the crisis was not a sudden disappearance of a moral compass. The most important factors were two structural mismatches in the world economic and financial system. One was between the spread of "Anglo-Saxon" financial markets and the victory of the Bundesbank model of central banking. The second was between the globalization (in effect, the de-nationalization) of financial markets and economic activity on the one hand and the persistence of potentially overriding geopolitical considerations on the other. Together, these two structural mismatches sent extremely strong perverse signals that constituted massive moral hazard.

What are central banks for? In the beginning, banks such as the Riksbank and the Bank of England were created to finance wars. But by the final third of the nineteenth century, social choices had been made in many countries that the central bank's function was to protect depositors via a lender-of-last resort function. Central bankers might insist that the objective was preventing systemic problems caused by the collapse of a solvent but illiquid bank. But the politics went beyond that, increasing the degree of moral...