Abstract
Edward Gramlich in his presentation during the Jackson Hole yearly central bankers symposium of August 31, 2007, said that, 'productivity often improves in fits and starts, in other words, booms and busts play a prominent role. In the 19th century, the United States benefited from the canal boom, the railroad boom, the minerals boom, and financial boom. The 20th century saw another financial boom, a stock market boom, a post-war boom, and a dotcom boom. The details differ, but each of these cases feature initial discoveries or breakthroughs, widespread adoption, widespread investment, and then a collapse where prices cannot keep up, and many investors lose a lot of money. When the dust clears, there is financial carnage, many investors learning to be more careful next time, but there are often the fruits of the boom still around the benefits of productivity'. Indeed, the current financial crisis is another episode of excess investment due to unwarranted expectations of the results of an innovation. Investors thought the financial innovation they were using protected them from any risk. The slicing up of dubious loans and their repackaging minimizes risk by spreading it. It does not eliminate this risk, and that is what investors had forgotten. But that is not the whole story, and Gramlich acknowledges it when he said, 'the subprime market was the Wild West'. It is the lack of adequate regulation, that allowed for predatory lending and 'no-doc' loans, which, combined with the financial innovations of the last decade, was the major source of the subprime crisis. The quantity of liquidity available in the market is an amplifying factor, for when liquidity is high, interest rates are low and the appetite for risk goes up. In a liquidity scarce market, there would never have been a market for residential mortgage backed securities (RMBS); therefore, there could not have been a subprime crisis.
