On the Political Economy of the Financial Crisis and Bailout of 2008

Abstract:     
This paper provides an overview of the political and economic decisions that helped to create the financial crisis of 2008. It begins with an overview of U.S. efforts to promote home ownership and how those policies, along with banking regulatory decisions in the late 1990s and early 2000s, helped to create a highly leveraged and risky international portfolio of mortgage-based securities. Declines in the price of housing, consequently, had major effects on the balance sheets and portfolios of financial institutions throughout the world, because the risk of mortgage-backed securities was underpriced. The effects of mortgage-backed securities effectively doubled the usual effect of the end of a housing bubble.

The political response to the crisis of 2008 has been rapid and large. The response has been partially accomplished through new legislation (TARP) and partly through standing agencies with authority to address credit and housing issues. In general, the differences in the effectiveness of policy responses show the advantage of standing institutions at crisis management relative to innovative legislation. The paper concludes by discussing the relevance of public choice, constitutional political economy, and the theory of regulation for explaining the crisis management undertaken.

Number of Pages in PDF File: 46

Keywords: financial crisis, regulation, mortgage-backed securities, public choice, bail out

JEL Classification: D72, D73, D8, K2

Accepted Paper Series