The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It

Citation

Xu, Y. (2009), "The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It", Journal of Property Investment & Finance, Vol. 27 No. 2, pp. 215-216. https://doi.org/10.1108/14635780910937872

Ever since 2007, we started to hear about the crisis of Northern Rock Building Society in the UK, then the collapse of Lehman Brothers in the USA and so on. During the past year, every day when we turned on the television or read the newspaper, we would always hear terms such as “subprime crisis” or “credit crunch”. They might be ranked as the most frequently used terms of the year. In considering the wide spread of this financial crisis, there is one simple question that every layman to expert would like to ask “What on earth has gone wrong?”

We know that ever since the 1950s, financial economists have developed sophisticated financial models to quantify and manage investment risks. These models are covered in any financial textbooks, and taught in almost all finance and investment related programmes. So in theory, financial practitioners should have been well trained in these models and should have known how to make appropriate investment decisions. So why did this credit crunch occur and why was it on such a large scale?

Bearing these questions in mind, this recent and timely publication by Professor Robert Shiller caught my attention. Within the 196 pages, Professor Shiller uses simple language to explain the fundamental problems of this subprime crisis, and provides some short‐term as well as long‐term solutions to it.

Professor Shiller first demonstrates that the current credit crunch is caused by the two most recent bubbles in the stock market in the 1990s, and in the housing market between 2000 and 2007. He uses the now‐famous term “irrational exuberance”, first used by Alan Greenspan, to describe the bubbles, and explains how this speculative enthusiasm of credit has pushed today's crisis. Professor Shiller then further suggests that the current credit crunch has its psychological origins. He describes the ultimate cause of the current credit crunch as the psychology of the property bubble, rather than other factors such as the growing dishonesty among mortgage lenders.

To solve these problems, Professor Shiller suggests that in the short term, bailouts are urgently needed because: “People are suffering and businesses are collapsing. The memories of these traumas will harm confidence and trust in our markets for years to come, just as they did during the Great Depression. With each passing day more damage is done to our social fabric” (p. 171).

In the long term, Professor Shiller considers this credit crunch as an opportunity to rethink and improve the existing financial system. He describes the current system as running bullet trains on ancient tracks. He urges people to calm down and explains that “every crisis contains the seeds of change. Now is the time to restructure the institutional firmament of financial activity in positive ways that will stabilise the economy, rekindle the wealth of nations, reinforce the best of financial innovation, and leave society much better off than if there had not been such a crisis” (p. 10). A better financial democracy has thus been introduced by Professor Shiller to restore the public's confidence in the economic principles.

For example, one of the key features of this financial democracy is to better handle moral hazard. This is because in the past decades, psychologists have contributed their knowledge of human beings' decision making into the financial field. Behavioural economics, including behavioural finance, has therefore been introduced. This new school has argued that we, human beings, have moral hazards, and we do not make decisions in a rational way as we are supposed to. Therefore, Shiller further addresses that “denying the importance of psychology and other social sciences for financial theory would be analogous to physicists denying the importance of friction in the application of Newtonian mechanics” (p. 119).

In summary, this is an exciting book that is to be read under the current market condition. It provides us some hope of correcting the existing problems, so as to have a brighter future.