Two new books on the 2008 financial debacle from very smart insiders have emerged that may be of interest. The first is Econned by Yves Smith. It's a very detailed analysis of the debacle that attempts to trace it back to economic religion ideology and outright looting. The second is The Big Short by Michael Lewis. This book attempts to show the mass delusion and stupidity of Wall Street, mostly due to perverse incentive structures, led to the subprime meltdown. Both push the boundaries of what's possible to learn from an insiders perspective.
The only way to learn more is to look at it from a wider perspective, at the level of systems theory. To do this, we need to establish what the financial system looks like at a controls and systems level. The best candidate for this is the bow-tie control system. This kind of control system is very common -- it's used in everything from our body's metabolism to the Internet/Web. Here's a short paper on bow-tie control systems from John Doyle of CalTech that you might find helpful.
A bow-tie control system is very simple. It takes a wide variety of inputs and simplifies them into a small set of common components. These simple components are then used to create a bewildering variety of outputs. In the case of metabolism, the inputs are the vast variety of foods we can eat and the simplified components are simple sugars etc. The outputs are cellular structures to proteins. In the case of the Internet/Web, the inputs are sites built using a wide variety of technologies. The simplified components are data packets and the output is the visualization and interactivity seen by the end user sitting at a personal computer (in tech we call bow-tie control systems by another name: platforms).
This type of system is very robust to almost all forms of environmental change. The inputs and outputs can change radically, to respond to changes in the environment. The only glaring vulnerability of the this system are attacks made directly against the bow. Why? In order for this type of system to work, the bow's components need to remain simple and the simple controls (feedback loops) that regulate the number and availability of the components can't be impaired. If the bow ever does become corrupted, systemic failure is inevitable.
In the case of the financial system, the simplified component of the bow-tie control system is money. The regulatory system for these simplified components are markets (price discovery). Through this lens, what happened in the financial system is actually relatively simple. The financial industry created a system called the shadow banking system (a notional value of $400 trillion ++), which is essentially a complex web of interconnected derivative contracts. These contracts are, by and large, NOT regulated by market mechanisms (they "derive" their value from other things, including market prices). Instead, they are customized and complex. These derivatives created a set of interconnections that bypassed the financial system's simple bow to directly connect inputs to outputs. This had the following results.
- Since individual banks issued and participated in these derivatives, they became central to the system's operation. These banks are now, since they own a portion of the financial and economic system's bow: "too big to fail."
- The system became brittle to changes in inputs. The shadow banking system doesn't provide a way to price and "clear" these derivatives using a market mechanism. Information typically discoverable by markets (fraud and bad assumptions) isn't accomplished. As a result, very small changes in sub-prime mortgage default rates (an input) rocketed through this system and was one of the factors that led to a systemic collapse.
- The banks that have a stake in the shadow banking system are parasitic. Like cancer, they actively redirect financial resources away from useful pursuits (in the bow-tie) into a much larger shadow banking system over which they have exclusive control for their own benefit. Worse, these connections are potentially fatal to the operation of the bow-tie system upon which we rely. Efforts to defend this parasitism, from the subversion of control mechanisms (i.e. the rating agencies) and distortion of government operations (to prevent regulation that would limit or unwind these contracts) are inevitable.
So, what does this mean? Since nothing has changed -- the banks are still too big to fail, the derivates that make these connections are still being offered, the operations of the shadow banking system are still opaque, and attempts to regulate this arena have been rebuffed -- the financial system will remain corrupted, brittle, and ridden with parasites that sap its strength. Catastrophic failure is inevitable.