This post adds points to Mark Thoma’s post, where he said that both low interest rates and regulatory failure were responsible to the credit crisis. In response to the question of whether the Fed’s low interest rate policy is responsible for the bubble, most respondents point instead to regulatory failures of one type or another. Ben Bernanke has also made this argument. However, I don’t think it was one or the other, I think it was both. That is, first you need something to fuel the fire, and low interest rates provided fuel by injecting liquidity into the system. And second, you need a failure of those responsible for preventing fires from starting along with a failure to have systems in place to limit the damage if they do start.
This need for yield necessitated that they go after what would normally be considered riskier investments, or investments that sacrificed more of liquidity. Without the impetus coming from low interest rates, finance would not have found the need to chase after yield at the expense of liquidity.
Now this also came at a time when regulations were also getting lax. In this environment, it became easier for investment bankers, the ultimate intermediary to other intermediaries, to come up with products and structures that effectively clouded the true extent to which liquidity was being sacrificed for yield. In this way, finance (investment bankers) compromised much of the trust from the market (the fund providers) that enabled it to do its job.