Agreed, but I think there's a hierarchy of causes. I'd say the principal uber-root cause was declining interest rates: the central bankers sometimes blame the "global savings glut," but I blame them. At the next level, you have enablers like derivatives (and underlying those, statistical methods and cheap computing) which allowed risk to accumulate in non-transparent ways in critical choke points in the system (and purveyors to fleece less-sophisticated clients). Hovering over all this was a buoyant social mood consistent with the end of the long bull market, which always brings lighter due diligence (c.f. Madoff) and distorted judgments about risk vs. reward. For the record, interest rate swaps--which I believe come to about $150T in notional value--are what I think present the greatest current systemic risk, precisely because we don't know where they all are and to what extent they've been marked to market. Once the Fed loses control of the yield curve, the speed and severity of the run on counterparties will far exceed those of predictable crises like insolvency of the European banking system and the crash of the Chinese real estate market.
Originally Posted by Simon Willard
This topic is wonderful because there are so many facets to it; so many things to point to and say "here is the problem".
I am troubled by the emphasis on derivatives as the culprit. It seems to me that derivatives should be a stabilizing force: they give investors more ways to place different kinds of bets. If many thoughtful people are making many different bets, the bets will go in many different directions, which acts to deflate bubbles. The first guy who places an honest bet against the housing market should be considered a hero, and should be rewarded if the market goes south.
Investors should understand risk, as you say. Paul Krugman's column today recounts the sins of the corrupt ratings agencies, which seem to me to be a very big part of the problem. Unfortunately, Krugman comes up empty-handed about how to fix this. Wherever you have the power that a ratings agency has, it's hard to prevent corruption.
The answer has to involve a robust market with many types of instruments, firms that are broken in pieces when they become too big to fail, and a lot of transparency.