The “Invisible” Cause of Economic Crisis

Mark Thornton, an Austrian School economist at the Mises Institute, highly praised the 2015 film *The Big Short*, saying that it contains the most realistic portrayal of “capitalism” among all Hollywood films to date. Because it conveys to viewers, as plainly and directly as possible, what kinds of distorted products existed in the U.S. financial market before the 2007–8 global financial crisis—such as mortgage-backed securities (MBS) and collateralized debt obligations (CDO)—the film can serve as a starting point for understanding the global economic crisis that continues to trouble us even now. In that sense, the film is excellent. In truth, however, the screenplay itself is rather dull. At times the cinematography stands out, but even that does not rise to a particularly distinctive level. Rather than approaching it aesthetically, it would be more appropriate to regard this film as a documentary with strong cinematic qualities.

However, as former Mises Institute vice president and current president of the American Institute for Economic Research (AIER), Jeffrey Tucker, has pointed out, *The Big Short* is also a very dangerous film. Although it certainly deals with facts as they are, it lacks sharpness. In other words, it deals only with “what is seen,” and not with “what is unseen.”

It is clear that the economic crisis occurred because the marketing of defective financial products was encouraged in the market. But it is not clear whether that itself was the cause—whether the cause of the crisis lay in the greed of banks and the financial industry, or in an inherent flaw in the incentive structure of unregulated capitalism. To infer the causal origins of the crisis from only what is “seen” can hardly be considered a rigorous academic attitude. If we truly wish to trace causality and pursue a lucid understanding of the phenomenon, we must, following Frédéric Bastiat’s lesson, also grasp “what is unseen.”

The most important keywords for understanding the U.S. housing bubble and economic crisis of the late 2000s are government regulation and the role of the central bank. This is an issue that can be understood on the basis of Business Cycle Theory. The theoretical explanation for the 2007 economic crisis is that risky, unstable, and defective financial products were derived in the market by the government’s inefficient monetary and credit policies. It is inappropriate for media dealing with economic crises not to mention Business Cycle Theory and monetary policy. Nevertheless, *The Big Short* contains no mention whatsoever of central bank monetary policy, while suggesting that the solution to recession lies in market regulation. This is plainly not a realistic analysis.

Even so, as noted repeatedly, the film has value as a journalistic medium dealing with facts themselves, and therefore it can be useful if viewed with a basic understanding of Business Cycle Theory and monetary and credit theory. But because the film excludes theoretical content and deals only with phenomena, viewers who watch it without theory are likely to reach the conclusion that the financial industry and capitalism must be subjected to strong government control. That is clearly not a causally realistic conclusion.

Without accurate theory, watching *The Big Short* makes it almost inevitable that most financial activity before the crisis will appear to be malicious fraud. But the actors involved were merely engaging in economic activity under the assumption that past behavior would continue into the future, following the market signals generated under the conditions they were given. At the time, the profit-and-loss incentive signals in the financial market could not be regarded as abnormal. It was because the structure of the financial market itself was distorted that those incentive signals led to outcomes that were unsustainable in the long run. After the September 11 attacks in 2001, the U.S. central bank began pursuing a policy of lowering interest rates in order to stimulate the economy. Artificially lowering interest rates is, in effect, subsidizing borrowing and discouraging saving. Because borrowing became easier, buying homes with borrowed money using the homes themselves as collateral became established as a necessity for ordinary people. As a result, the housing market became bloated in a direction that would not have been possible in a normal market, and in proportion to that expansion, defective financial products also emerged—products that likewise could not have existed in a normal market. In this sense, the economic crisis of 2007–8 was ultimately the government’s responsibility.

The film’s two main protagonists predicted the economic crisis long before it occurred. They accurately foresaw that the financial products were unsound and would one day reach a breaking point. Yet throughout the film, these two protagonists are treated like fools. That is because they do not anticipate the future and analyze the current state on the basis of sound economic theory, but rely only on personal experience and entrepreneurial alertness. In the end, these two protagonists also failed to make a proper prediction of the future, in the sense that they too were looking only at the result, not the cause, of the situation. They merely had good instincts.

If one relies not on theory that grasps even what is invisible, but only on personal insight and a sensibility concerned with what is plainly observable, confusion is inevitable. From a merely intuitive perspective, the long-term maintenance of the market economy appears to depend on the personal morality of economic actors. But from a theoretical perspective, if we take into account economic actors’ demonstrated preference and the law of supply and demand, the market economy guarantees us the best possible state regardless of morality. Even in an unhampered market economy, failures and successes continue to repeat themselves, but cases like the 2007–8 economic crisis—in which highly intelligent and experienced top elites make cascading mistakes—cannot occur.

Without Business Cycle Theory, which explains the behavior of economic actors, the one critical insight this film succeeds in offering is its accurate point that taxpayers serve as the guarantors of the moral hazard pervasive among the elite class. A recession is a period in which malinvestment is corrected. Recession is the process of normally reallocating misallocated capital and restoring the market economy to its original condition. This is certainly painful, but it is by no means something that can be avoided. Since the economic structure was malformed from the outset, reconstructing it cannot be avoided. If, in the name of preventing the pain of recession, the government implements quantitative easing or rescues bankrupt firms, the pain of recession will only persist longer over the long term. During the last recession, the U.S. federal government, along with many governments around the world, forgave the debts of bankrupt firms or paid them on their behalf. Those resources ultimately came from taxes paid by ordinary citizens. If bankruptcy is prevented on the grounds that firms are “too big to fail,” entrepreneurs’ mistakes will be repeated, because even if they fail, the government will restore them again. A market economy with “insurance” placed over the entire structure cannot function.

In Jeffrey Tucker’s words, this film is something like a Rorschach test for the economics profession. That is because people with flawed economic theories, people who know nothing about economic theory, and people with sound economic theory each react differently when they watch it. It is nevertheless clear that this is a film worth watching.

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Original title: 경제위기의 ‘보이지 않는’ 원인

Author: Kyeong-hun Kim

Date: 2020-01-28

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=free_opinion&pn=16&idx=22319