The eye of the hurricane.

• Author: Kavanagh, Shayne C.

Crisis Economics: A Crash Course in the Future of Finance

By Nouriel Roubini and Stephen Mihm

Penguin Press

2010, 368 pages, $27.95

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Nouriel Roubini is one of the economists who famously predicted the recent economic crisis. In Crisis Economics, he and his co-author, Stephen Mihm, trace the history of crisis economics, explore the origins of .the recent crisis, propose solutions to these causes, and examine the prospects for the future.

FAULT LINES AND MORAL HAZARDS

A common view of the recent crisis is this: During the housing bubble, people took out mortgages they couldn't afford and then eventually defaulted on them. Because the mortgages were securitized, the bad mortgages went on to throw the entire financial system into crisis. The authors contend that this account is inaccurate because it pins the crisis on a few actors and events that occurred in the recent past. In fact, an economic crisis is like an earthquake, the authors say--over time, pressure on tectonic plates builds, eventually culminating in a crisis. For example, financial innovation in the 1970s saw mortgages securitized by the loan originator (e.g., a local bank) and sold to investors. As a result, originators now had less motivation to carefully examine the quality of the original loan--rather, their motivation shifted toward making loans and securitizing and selling them to investors to get cash to make more loans. Over time, the practice of securitization spread to other assets such as credit card debt, delinquent tax liens, and many others. As these products became more complex, they also came more difficult, if not impossible, to accurately value and assess for risk, and therefore illiquid when a deteriorating economy called into the question the optimistic assumptions these products were based on. Moral hazard is another of the authors' tectonic plates. Bonus systems in financial firms encouraged short-term thinking and excessive risk taking, and, hence, the interests of the shareholders of these firms were in many ways not aligned with those of employees. Government policies also contributed to the problem through "easy money" policies by the Federal Reserve and laws that created incentives for homeownership to the point where individuals were making choices that were not consistent with society's best interests. Eventually, these and other tectonic plates generated a pressure that created the conditions for the crisis.

Crisis Economics...