Root Causes of the Financial Crisis: A Primer


It is not yet clear whether we stand at the start of a long fiscal crisis or one that will pass relatively quickly, like most other post-World War II recessions. The full extent will only become obvious in the years to come. But if we want to avoid future deep financial meltdowns of this or even greater magnitude, we must address the root causes.

In my estimation two critical and related factors created the current crisis. First, profligate lending which allowed many people to buy overpriced properties that they could not, in reality, afford. Second, the existence of excessive land use regulation which helped drive prices up in many of the most impacted markets.

Profligate lending all by itself would not likely have produced the financial crisis. It took a toxic connection with excessive land-use regulation. In some metropolitan markets, land use restrictions, such as urban growth boundaries, building moratoria and large areas made off-limits to development propelled house prices to unprecedented levels, leading to severely higher mortgage exposures. On the other hand, where land regulation was not so severe, in the traditionally regulated markets, such as in Texas, Georgia and much of the US Midwest and South there were only modest increases in relative house prices. If the increase in mortgage exposures around the country had been on the order of those sustained in traditionally regulated markets, the financial losses would have been far less. Here is a primer on the process:

  1. The International Financial Crisis Started with Losses in the US Housing Market: There is general agreement that the US housing bubble was the proximate cause for the most severe financial crisis (in the US) since the Great Depression. This crisis has spread to other parts of the world, if for no other reason than the huge size of the American economy.
  2. Root Cause #1 (Macro-Economic): Profligate Lending Led to Losses: Profligate lending, a macro-economic factor, occurred throughout all markets in the United States. The greater availability of mortgage funding predictably led to greater demand for housing, as people who could not have previously qualified for credit received loans (“subprime” borrowers) and others qualified for loans far larger than they could have secured in the past (“prime” borrowers). When over-stretched, subprime and prime borrowers were unable to make their mortgage payments, the delinquency and foreclosure rates could not be absorbed by the lenders (and those which held or bought the "toxic" paper). This undermined the mortgage market, leading to the failures of firms like Bear Stearns and Lehman Brothers and the virtual failures of Fannie Mae and Freddie Mac. In this era of interconnected markets, this unprecedented reversal reverberated around the world.
  3. Root Cause #2 (Micro-Economic): Excessive Land Use Regulation Exacerbated Losses: Profligate lending increased the demand for housing. This demand, however, produced far different results in different metropolitan areas, depending in large part upon the micro-economic factor of land use regulation. In some metropolitan markets, land use restrictions propelled prices and led to severely higher mortgage exposures. On the other hand, where land regulation was not so severe, in the traditionally regulated markets, there were only modest increases in relative house prices. If the increase in mortgage exposures around the country had been on the order of those sustained in traditionally regulated markets, the financial losses would have been far less. This “two-Americas” nature of the housing bubble was noted by Nobel Laureate Paul Krugman more than three years ago. Krugman noted that the US housing bubble was concentrated in areas with stronger land use regulation. Indeed, the housing bubble is by no means pervasive. Krugman and others have identified the single identifiable difference. The bubble – the largest relative housing price increases – occurred in metropolitan markets that have strong restrictions on land use (called “smart growth,” “urban consolidation,” or “compact city” policy). Metropolitan markets that have the more liberal and traditional land use regulation experienced little relative increase in housing prices. Unlike the more strongly regulated markets, the traditionally regulated markets permitted a normal supply response to the higher market demand created by the profligate lending. This disparate price performance is evidence of a well established principle of economics in operation – that shortages and rationing lead to higher prices.

    Among the 50 metropolitan areas with more than 1,000,000 population, 25 have significant land use restrictions and 25 are more liberally regulated. The markets with liberal land use regulation were generally able to absorb from the excess of profligate lending at historic price norms (Median Multiple, or median house price divided by median household income, of 3.0 or less), while those with restrictive land use regulation were not.

    Moreover, the demand was greater in the more liberal markets, not the restrictive markets. Since 2000, population growth has been at least four times as high in the traditional metropolitan markets as in the more regulated markets. The ultimate examples are liberally regulated Atlanta, Dallas-Fort Worth and Houston, the fastest growing metropolitan areas in the developed world with more than 5,000,000 population, where prices have remained within historic norms. Indeed, the more restrictive markets have seen a huge outflow of residents to the markets with traditional land use regulation (see:

  4. Toxic Mortgages are Concentrated Where there is Excessive Land Use Regulation: The overwhelming share of the excess increase in US house prices and mortgage exposures relative to incomes has occurred in the restrictive land use markets. Our analysis of Federal Reserve and US Bureau of the Census data shows that these over-regulated markets accounted for upwards of 80% of “overhang” of an estimated $5.3 billion in overinflated mortgages.
  5. Without Smart Growth, World Financial Losses Would Have Been Far Less: If supply markets had not been constrained by excessive land use regulation, the financial crisis would have been far less severe. Instead of a more than $5 Trillion housing bubble, a more likely scenario would have been at most a $0.5 Trillion housing bubble. Mortgage losses would have been at least that much less, something now defunct investors and the market probably could have handled.

    While the current financial crisis would not have occurred without the profligate lending that became pervasive in the United States, land use rationing policies of smart growth clearly intensified the problem and turned what may have been a relatively minor downturn into a global financial meltdown.

Never Again: All of the analyst talk about whether we are “slipping into a recession” misses the point. For those whose retirement accounts have been wiped out, or stock in financial companies has been made worthless, those who have lost their jobs and homes, this might as well be another Great Depression. These people now have little prospect of restoring their former standard of living. Then there is the much larger number of people whose lives are more indirectly impacted – the many households and people toward the lower end of the economic ladder who have far less hope of achieving upward mobility.

All of this leads to the bottom line. It is crucial that smart growth’s toxic land rationing policies be dismantled as quickly as possible. Otherwise, there could be further smart growth economic crises ahead, or, perhaps even worse, a further freezing of economic opportunity for future generations.

Wendell Cox is a Visiting Professor, Conservatoire National des Arts et Metiers, Paris and the author of “War on the Dream: How Anti-Sprawl Policy Threatens the Quality of Life

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In my estimation two

In my estimation two critical and related factors created the current crisis. First, profligate lending which allowed many people to buy overpriced properties that they could not, in reality, afford. Second,the existence of excessive land use regulation which helped drive prices up in many of the most impacted markets.
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That is true..!How pathetic

That is true..!How pathetic to know that. Well, as a human being who live in this restless life, we have to strive hard in order for us to live. Spring season is prevailing, but due to our economic condition, a person doesn’t feel it. What do you think is the solution to our main problem? Payday loan is the most recommended for it. Spring is here or at least it is for us Northern Hemisphere folks. Spring, when a young man's thoughts turn to love, but these days they turn invariably to the economy and whether or not to get a payday loan at times. The recession has been the headline for months, and the doom and gloom gets old. However, there seem to be more glimmers of hope on the horizon. Some companies have been announcing that they aren't going to be firing anyone else, or even that they're hiring. Maybe less people will need a payday loan this Spring.

Root cause of the financial

Root cause of the financial crisis? How about all the banks who gave out a mortgage like it was candy on Halloween? And the people who took them who couldn't afford them?

Stop Repossession

The real cause of the financial crisis is the black pool of derivatives—the bets placed by financial wizards whose greed was not satisfied by the paltry returns of the "normal economy." They placed bets they could not cover, bets that the whole financial system itself is not big enough to cover. It is the casino-finance con artists and their cronies in key government positions that have caused this problem. How can I Stop Repossession? Do you have any ideas?

Root cause of the financial Crisis

Check out 2008 Financial Crisis: How Did We Get Here?. Very interesting perspective.

RESPONDING: Correcting Misinterpretations

Thank you for your comments (epar). I have been overseas for some weeks and apologize for taking time in preparing this response.

Let me explain the thesis, because your comments indicate a misunderstanding.

The markets with the largest losses all that have significant land use restrictions, including urban growth boundaries, minimum lot sizes and a range of other strategies that have made it impossible to develop housing at the low land prices that previously prevailed (a complete list of the strategies is in “The Costs of Sprawl---2000). So our list of strategies is longer than yours.

The cost escalating markets you mention all classify as highly regulated. None among them are liberal or traditional. (Our classification is principally based upon one developed by the Brookings Institution.) Similarly, Sarasota is included among the more regulated markets (with regard to the previous comment from Richard Reep).

The thesis is not about housing price declines, it is about financial losses in the housing sector, which have been concentrated in the smart growth markets. Thus, that the losses have been less severe in some smart growth markets, such as Portland and Seattle is not of any relevance. The issue is that the losses have been concentrated in inflated smart growth markets and that the losses have been modest in other markets.

Each of your six contributing factors operated throughout the nation and cannot explain the huge differences in price increases and losses between smart growth markets and those that are traditionally (liberally) regulated.

All that having been said… here is the thesis in summary..

1. The international financial crisis would not have happened without the profligate mortgage lending that led to the US housing bubble.

2. The US housing bubble was highly concentrated in areas with strong land use regulation (often called “smart growth”), where the profligate lending created demand that was beyond the capability of the market to supply.

3. Without smart growth the housing bubble would have been far less intense because the housing price increases in the smart growth markets would have replicated the modest increases relative to incomes that occurred in the traditional or liberally regulated markets.

4. Without the intense bubble induced by smart growth, the international financial crisis would have been far less serious, or would not have occurred at all.

Given the fact that there is general agreement that the financial crisis is by far the worst since the 1930s (and may become deeper or longer), these are issues that need to be fully vetted.

Wendell Cox

An important distinction

Aren't you failing to distinguish between land use restrictions that mandate higher density within a fixed boundary (smart growth influenced) and use restrictions that mandate decreased density? In particular I'm thinking of restrictions requiring a minimum of 1 acre or so per single family lot. That's not a smart growth-style use restriction, but it sure would artificially drive up prices.
Looking at the 10 metro areas that have seen the largest % increases in home prices, according to the case shiller index, they are:
Los Angeles
Washington DC
San Diego
Las Vegas
San Francisco
New York
Seattle (quite far behind NY in terms of rise & fall)

In terms of % price decline from peak, the ranking is:
Phoenix, Las Vegas, Miami, San Diego, LA, San Fransisco, Detroit, DC, Minneapolis and Chicago. Dallas shows one of the lowest declines, but smart growth-loving Portland is holding up fairly well too, at only a 7.8% decline, compared to the 20 city average of 20%. Phoenix and Las Vegas, both with liberal regimes, are one and two.

Overall, it looks like theres a mix of cities with both liberal and restrictive use policies on the lists. And again, you should distinguish between use restrictions that have an ambiguous price effect (fixed boundary but higher density) and use restrictions that unambiguously increase price (mandating lower density, characteristic of the 'burbs).

To a larger point, I agree that certain use restrictions would restrict supply and increase prices. But in the scheme of things, land use restrictions probably rank down there with the CRA as causes of the crisis. Much more important were:
1) the global savings glut
2) very low short-term rates starting in 2002
3)lack of regulation of non-depository mortgage finance institutions
4)lack of regulation and standardization of the CDS market
5) lack of any type of leverage restriction on investment banks and hedge funds, along with any type of incentive structure that rewarded long term performance of the security
6) the complete collapse of underwriting standards at commercial banks, who could sell the loans to guys in #3 and 5.

Forgive me for being under the impression that you approached the issue with an axe to grind.

Land Use Reform

For all the examples Mr. Cox points out, there are counter examples - Sarasota, Florida, for example - where lax regulation and a foreclosure crisis coexist. While it is tempting to blame the economy on land-use regulation, I see far more blame at the level of those in charge of the financial system and their personal morality. Wall Street is ruled by greed and fear. Greed is, and probably always will be, unregulated.

Land-use regulation is a symptom, not a cause. When the dotcom bubble burst in 2000, investors fled the stock markets and turned to the housing market. I see New Urbanists as enablers of greed, rather than the root cause. Greed fueled the mortgage crisis, not land use codes. It is a little too reminiscent of Randall O'Toole to call our current land use regulation excessive, especially knowing what is coming next.

Form-based codes (so-called "smart growth") are currently sweeping the country's urban planning departments, and the desire to throw out 50 years of function-based codes is huge. Function-based codes have weathered multiple booms and busts including this one.

I agree that land rationing policies should be stopped immediately and that we all get involved in the core values of what makes cities work, rather than create cloyingly nostalgic frankencities. But, as a design professional who has been involved in private development for most of my career, I see too many easy ways to defeat "tough growth management" codes to take them too seriously. Let's focus on communities that work well now, and try to make more of them.

Richard Reep
Poolside Studios
Winter Park, FL

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Thanks for taking the time to post such a detailed and informative article. It has given me a lot of inspiration.
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