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POLITICAL BUBBLES

Nolan McCarty, Keith T. Poole, and Howard Rosenthal

Princeton University Press, 2013

Abstract

Behind every financial crisis lies a "political bubble" -- policy biases that foster market behaviors leading to financial instability. Rather than tilting against risky behavior, political bubbles -- arising from a potent combination of beliefs, institutions, and interests -- aid, abet, and amplify risk. Demonstrating how political bubbles helped create the real estate-generated financial bubble and the 2008 financial crisis, this book argues that similar government oversights in the aftermath of the crisis undermined Washington's response to the "popped" financial bubble, and shows how such patterns have occurred repeatedly throughout US history.

The authors indicate that just as financial bubbles are an unfortunate mix of mistaken beliefs, market imperfections, and greed, political bubbles are the product of rigid ideologies, unresponsive and ineffective government institutions, and special interests. Financial market innovations -- including adjustable-rate mortgages, mortgage-backed securities, and credit default swaps -- become subject to legislated leniency and regulatory failure, increasing hazardous practices. The authors shed important light on the politics that blind regulators to the economic weaknesses that create the conditions for economic bubbles. The authors recommend simple, focused rules that limit regulatory discretion and financial products.

The first full accounting of how politics produces financial ruptures, Political Bubbles offers timely lessons that all sectors would do well to heed.



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