Brad DeLong: 'Battered and Beaten' - how the recession might have been handled better

[muriel_volestrangler]

and a few questions and hypotheses from this respected economist on why it was handled so badly:

Indeed, we should not have been unable to escape from the trap. For one thing, the initial financial shock that set the downturn in motion was remarkably small.

We got irrationally exuberant about the demand for housing and the trajectory of housing prices. We built five million houses extra houses--largely in the swamps of Florida and in the desert between Los Angeles and Albuquerque--that simply should not have been built. Their cost of construction was to a first approximation covered entirely by mortgage debt. And on an average one of those five million houses the purchaser took out $100,000 in mortgage debt that simply will never be repaid: the buyer cannot afford it and the house is not worth it. That means that, as of the end of 2007, there were $500 billion of financial losses to be allocated: somebody's bonds and derivatives were going to pay off $500 billion less than people had thought.

Now in a global economy with $80 trillion worth of financial wealth, a $500 billion loss due to irrational exuberance and malinvestment should not be problem. Double it or quadruple it and it still should not be a problem. We have modern, sophisticated, highly liquid financial markets. We have originate-and-distribute securitization to slice, dice, and spread risks. The purpose of these institutions and vehicles is to spread financial risk broadly across the whole globe so that nobody bears any significant part of and so is ruined by any idiosyncratic risk like mortgage defaults in the desert between Los Angeles and Albuquerque. The losses from the collapse of the dot-com communications-and-computers bubble were an order of magnitude larger than those from subprime. Yet they did not create anything like our huge current problems.
...
The thumbnail explanation is that the trap was set by regulatory--we call it "forebearance" to be polite, but the real words cannot be said at a family conference like this--and by regulatory arbitrage. Regulatory forebearance allowed investment banks to ramp up their leverage to unheard-of
levels--30 to 1?--on the grounds that the financiers' had their fortunes at risk and knew their business. Regulatory arbitrage arose when investment banker said:

...

http://delong.typepad.com/20101029-battered-and-beaten.pdf

I'm not an economist, but this seems very well written, and easy to follow to me. One of the best descriptions of what happened, and what should have happened, I've seen. But DeLong can't say why it didn't - he can only guess at the failings and silly priorities of those involved.