The financial crisis is not unprecedented; treating it as a unique 'perfect storm' is a reverse-myopia mistake, since an extraordinarily large number of banking crises stretch back into the 19th century in the US and worldwide.

We need to put the financial crisis in historical perspective.

Banking crises share a cyclical timing driven by loose monetary policy or credit cycles, but timing alone is insufficient—a crisis of large magnitude requires something deeply wrong with the microeconomic incentives in the banking system, not merely a normal business-cycle reaction.

Government housing policies—FHA lending pressures, the affordable-housing push on Fannie Mae and Freddie Mac since ~1994, and a 2006 law plus 2007 SEC rules making it harder for ratings agencies to be tough on subprime MBS—distorted incentives by inducing lending to poor-credit borrowers with no money down and no documentation, which is a large part of why the US housing sector failed so severely.

Securitization itself is not the flaw: credit-card securitization used the same originate-and-distribute model for 30 years without failing alongside subprime, because the prudent incentives long applied in credit-card securitization were deliberately set aside in mortgage securitization—made possible by government programs.

The Minsky/'madness of crowds' explanation—that banking crises arise from unchanging human frailty, greed, or panic—is refuted by the basic fact that crisis frequency varies enormously across time and place; if human psychology were the driver, we would not see such variation, so something other than human nature must explain the difference.

During the first globalization era (1874-1913)—free banking entry, fixed exchange rates, large capital flows—there were only about four major banking crises (Argentina 1890, Australia 1893, Norway 1900, Italy 1893), all sharing government-policy distortions, whereas from 1978 to the present there have been roughly 140 major banking crises, with about 20 of them larger than the two biggest pre-1913 crises.

Government protection policies—deposit insurance and bailouts—plus government policies promoting real estate development (analogous to Fannie/Freddie) are the key factors that changed between the two eras and that invite excessive risk by removing market discipline, since banks then take risk at someone else's expense.

The real-estate bubble was not a US-only phenomenon, which undercuts the objection that Fannie/Freddie cannot explain global bubbles; many governments over-promoted home ownership in the prior 15 years, and Norway had a Fannie Mae-style institution before its pre-WWI crisis.

Banking panics and waves of large bank failures are distinct phenomena that only sometimes overlap; the Fed's 1913 founding genuinely reduced US panics by stabilizing seasonal reserve fluctuations (tied to the cotton market) made acute by America's peculiar unit-banking structure, but the US did not historically suffer the large-loss bank-failure crises seen elsewhere, so the Fed's panic-prevention role is separate from the over-speculation/large-loss problem.

Canada, with a branch-banking system from the 1860s and no central bank until 1935, experienced none of the panics the US suffered (1873, 1884, 1890, 1893, 1896, 1907), demonstrating that US panics stemmed from the fragility of its unit-banking structure rather than from an inherent need for central banking.

Deposit insurance was historically known to be a bad idea—FDR opposed it because all eight state deposit-insurance systems created in the 1910s-1920s failed disastrously with worse bank losses than uninsured systems—yet it passed in ~1933 as a temporary emergency measure with very limited coverage, pushed by Henry Steagall of Alabama as special-interest legislation to protect politically influential small rural banks from competition along the dimension of risk.

Deposit insurance protects small banks by removing competition along the dimension of risk: without it, large stable branch banks (like Canadian banks) could win depositors by advertising their stability, but government backing of deposits eliminates that competitive advantage, which is precisely why small banks lobbied for it.

Deposit insurance coverage expanded over time from a temporary small-deposit measure to effectively blanket protection—statutory limits rose to $100,000 (1980) then $250,000, but in practice ~99.7% of all deposits ended up insured, and innovations like CDARS let wealthy depositors swap a $50 million deposit across ~200 banks to insure the entire amount, completing the destruction of risk-based depositor discipline.

The recent crisis wave required two coinciding trends: expanding deposit-insurance/bailout coverage AND increased macroeconomic risk—the low-volatility 1950s-60s offered little risk to bet on, but rising inflation and business-cycle volatility from the 1970s provided risk to exploit, so the S&L crisis emerged in the late 1970s as expanding coverage met expanding risk.

Even Friedman and Schwartz endorsed deposit insurance in 1963, but they were observing an unusually placid, limited-coverage period and were wrong; deposit insurance is unnecessary because small savers could be protected via postal savings (invested in Treasuries with no risk), and it has been the single most important contributor to financial-system risk by removing risk-based bank competition.

When deposit insurance's perceived reliability falls, market discipline returns: in Mexico's 1990s crisis, nominal 100% coverage remained but depositors, doubting the government could cover the losses, withdrew from weak banks—demonstrating that depositors discipline banks whenever they actually bear risk.

Britain's recurring 19th-century banking panics (1819-1857) stemmed from Parliament pressuring the Bank of England to provide an implicit put option on the London bills market—a quid pro quo for its privileges, directly analogous to Fannie Mae/Freddie Mac—and the crises ended only after the Bank publicly renounced this put in 1858 and credibly enforced it by letting Overend Gurney fail in 1866 despite having bailed it out in 1857.

The current US system has three compounding failures: deposit insurance and too-big-to-fail (first seen in the 1983-84 Continental Illinois bailout) removed depositor discipline, leaving only prudential regulators to identify risk; those regulators fail because they outsource risk measurement to the banks themselves and to ratings agencies; and the government simultaneously subsidizes huge housing risk—so when loose 2002-2005 monetary policy (negative real Fed Funds, >1-2% departures from the Taylor rule) added cheap credit, a severe banking crisis was the predictable result.

Fannie Mae and Freddie Mac deliberately entered subprime no-doc lending in a big way in 2004 over the explicit objections of their own credit-risk managers (who knew from late-1980s experiments that not verifying borrowers attracts bad credit risks like a magnet); as the dominant 800-pound gorillas, their decision to 'make markets' caused subprime no-doc volumes to triple in 2004.

Roughly half of all subprime losses are attributable to no-doc lending's adverse-selection problem (not verifying borrowers attracts bad credit) and the other half to the modeling assumption that housing prices could never fall, which was built into stress tests; both assumptions were knowably unreasonable in advance.

The most shocking fact of the crisis is that even after mid-2006—when ratings agencies' own assumptions were being violated and delinquencies in the 2004-05 cohorts were forming, prompting Deutsche Bank and Goldman Sachs to protect themselves—Fannie, Freddie, Citibank, UBS, and Merrill Lynch continued to originate, sponsor, and hold subprime deals at peak levels; had just those five institutions stopped in mid-2006, the crisis would not have occurred.

Fannie and Freddie continued buying low-down-payment mortgages aggressively into 2007—23% of their home-purchase loans by number that year were low-down-payment—because, politically cornered after the 2003 accounting scandal and growing opposition (including from every Treasury Department across administrations and Alan Greenspan), they bought a political 'insurance policy' by pleasing affordable-housing advocates like Barney Frank.

Citibank's and UBS's disastrous behavior reflects bad corporate governance—both ranked low on value-creation and ethical-culture measures before the crisis—made possible because banks are regulated to be relatively immune to corporate governance: the Bank Holding Company Act bars hedge funds and private equity from taking large controlling stakes, and the 1940 Act limits institutional investors to 1-2% ownership, so concentrated owners who would discipline management are largely prevented.

Concentrated share ownership by sophisticated investors is the single most important driver of good corporate governance: an owner with a 10-20% stake (or two-three owners who can coordinate over dinner) will monitor and can oust management, whereas the dispersed ownership US bank regulation enforces leaves management undisciplined.

Ratings agencies are not the root problem but a symptom: the conflict-of-interest 'issuers pay' story is wrong because everyone always knew about that conflict; ratings agencies actually work for the buy side, whose investors wanted inflated ratings because ratings determine their regulatory treatment (how much they can leverage and what classes they may hold), so 'ratings shopping' could only have produced a race to the bottom because the buy side wanted it to.

Once regulation outsourced risk classification to ratings agencies, the agencies inevitably became 'ratings inflators,' which is why the ratings inflation documented by Cantor and Packer (1994) occurred specifically in securitization markets (bought entirely by ratings-regulated institutional investors) rather than in ordinary corporate debt markets bought by individuals and corporations.

Institutional investors (pensions, mutual funds, insurers) bought toxic securities because their fee structures pay a percentage of assets managed while law (the 1940 Act) bars them from hedge-fund-style asymmetric profit-sharing; this creates an agency problem—'we have to put our money to work'—incentivizing them to keep assets growing rather than return money to clients, unlike hedge funds whose symmetric upside/downside incentives led them to return capital when good investments dried up.

Ratings agencies served as a coordination device for plausible deniability: by giving everyone the same signal, they let every investor claim they did what everyone else did and provided after-the-fact cover (CYA), so the question of where else to invest under common compensation rules was resolved by collective conformity rather than independent judgment.

The crisis cannot be blamed on deregulation: the three main post-1980 deregulations—removing Regulation Q (deposit-interest ceilings), eliminating branching restrictions (culminating in the 1994 Riegle-Neal Act), and removing Glass-Steagall barriers on corporate-securities underwriting (phased out 1987-1999)—all stabilized banking and had nothing to do with subprime; underwriting carries little risk, and standalone investment banks (Merrill, Bear, Lehman) were never covered by Glass-Steagall yet were central to the problem.

The Glass-Steagall repeal actually helped resolve the crisis: it allowed Bank of America to buy Merrill Lynch and JPMorgan Chase to buy Bear Stearns, and let Goldman Sachs and Morgan Stanley become bank holding companies in September 2008, gaining depository funding and Fed access—each stabilizing the system—so the deregulation had zero effect on the risks taken but a positive effect on resolution.

The Gramm-Leach-Bliley Act contained a subordinated-debt requirement provision—championed by Phil Gramm and supported by academics—designed to restore market discipline by forcing large bank holding companies to fund ~2% via a class of subordinated debt explicitly excluded from any bailout, creating a 'canary in the coal mine' early-warning signal; the Fed staff confirmed it would work, but bank lobbying (via Larry Summers and Alan Greenspan) buried it with a 'more research is needed' conclusion.

The fundamental, still-ignored failure of the crisis was prudential regulation's inability to measure risk: Basel I and Basel II were in place and failed, yet reform proposals never mention this; worse, investment banks were regulated under Basel II via SEC supervision, so claims that they were 'unregulated' are false—they had capital-adequacy standards based on broken risk-measurement formulas that gave a false sense of security.

Protecting banks from market discipline sells well politically (as Zingales and Rajan argue): telling depositors they are protected is popular even though it is a flim-flam, which is why introducing even a small dose of market discipline is easily smashed politically and why neither politicians nor banks want it.

Economists have been too congratulatory toward those who rescued failing companies, thereby helping enable the too-big-to-fail doctrine; praising Bernanke, Paulson, and Geithner for keeping the system going while only nominally acknowledging too-big-to-fail's problems will create the next crisis.

The bailout costs are dominated by Fannie and Freddie: while all other bank bailouts may net cost taxpayers tens of billions or less, Fannie and Freddie alone are already costing about $350 billion (the current government figure), and the Fed additionally holds roughly $1 trillion of their mortgages without marking them to market.

The Fed cleverly threaded a needle in unwinding its balance sheet by announcing it will not sell its mortgage holdings but instead conduct reverse repurchase agreements with money market mutual funds, shrinking the balance sheet while retaining all the credit risk—avoiding recognition of losses but at the cost of transparency.

Stiglitz and Orszag wrote a paper for Fannie Mae in 2002 claiming the chance Fannie/Freddie would cost taxpayers was essentially zero (described as one in a billion), illustrating the unreliability of such reassurances—the paper subsequently disappeared from the Fannie Mae website.

Just as Britain learned from its 19th-century crises—aided by the Economist and the Bankers' magazine fomenting thoughtful public outrage that fed into parliamentary reform—the US could learn the right lessons if the public becomes more educated and channels its reaction into thoughtful policy responses rather than mere hatred of banks.

Whenever there is a financial crisis there is one event but about 20 different explanations, all with some truth, so the analytical task is assigning weights to each.

Unit banking means banks were constrained by regulation to operate in only one location, producing over 20,000 highly undiversified banks unable to coordinate responses to shocks, which made agricultural shocks systemically destabilizing.