Krugman Nails the Root Cause of the Liquididy/Insolvency Crisis

Basically, he sees the cause as being the free market fundamentalism that is practiced by regulators, brokers, and politicians. I wholeheartedly agree.

This time, market players seem truly horrified — because they’ve suddenly realized that they don’t understand the complex financial system they created.

This is, of course, a symptom, not the cause, but he does see the cause too.

How did things get so opaque? The answer is “financial innovation” — two words that should, from now on, strike fear into investors’ hearts.

O.K., to be fair, some kinds of financial innovation are good. I don’t want to go back to the days when checking accounts didn’t pay interest and you couldn’t withdraw cash on weekends.

But the innovations of recent years — the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn’t have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized.

Why was this allowed to happen? At a deep level, I believe that the problem was ideological: policy makers, committed to the view that the market is always right, simply ignored the warning signs. We know, in particular, that Alan Greenspan brushed aside warnings from Edward Gramlich, who was a member of the Federal Reserve Board, about a potential subprime crisis.

(emphasis mine)

So, when does he get his Nobel?

Go and read the whole thing