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Two Myths of the 2008 Meltdown

The 2008 financial crisis was not the result only of moral hazard; nor was it unforeseeable. While too-big-to-fail banks believed – rightly, it turned out – that they would be bailed out, consumers, rating agencies, and policymakers all bet on housing as well, destabilizing the system.

CAMBRIDGE – Over the last decade, research by many economists, including us, arrived at a broadly shared narrative of the 2008-2009 financial crisis. As we describe in our new book, A Crisis of Beliefs: Investor Psychology and Financial Fragility, the fundamental cause of the crisis was the deflation of the housing bubble, starting in early 2007. For several years until then, home prices in the United States rose dramatically, fueled by massive borrowing by homebuyers and banks’ investments in mortgages and mortgage-backed securities. As the housing bubble burst, both borrowers and bankers suffered.

By mid-2008, banks were projected to lose hundreds of billions of dollars. After months of growing losses, bankruptcies, and market freezes, the financial system finally cracked. Lehman Brothers declared bankruptcy, and many other firms had to be saved by the government. In short order, the financial woes of banks and consumers dragged the economy into the Great Recession.

This widely accepted and well-documented narrative highlights two misconceptions in the current retrospectives of the crisis. These misunderstandings may seem purely academic, but they are not. They have major consequences for the ability of policymakers to prevent future crises.

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