Peter J. Wallison, at AEI, debunks the Baily-Eliott thesis, which attempts to deflect the responsibility for the housing market bubble from government social policies by dispersing shares of the responsibility to financial institutions for failing to manage risk, to insufficient regulatory oversight, to reckless and naive consumers, and even to the actions and inactions of “many outside the United States.”

Exculpating social engineering policies emplaced by the Clinton Administration was vital for the defense of the Progressive political agenda, and it was the Baily-Elliott interpretation of events that led to passage of the Dodd-Franks Act.

Last November, two highly respected Brookings Institution scholars, Martin Neil Baily and Douglas J. Elliott, published a paper entitled “Telling the Narrative of the Financial Crisis: Not Just a Housing Bubble.”

Baily and Elliott make a strong case for explaining the financial crisis as the result of a general decline in risk aversion because of the effect of the great moderation—the period from 1982 to 2007 when it seemed that we understood the causes of financial crises and had found a way to avoid or mitigate them. The evidence for a general weakening in risk aversion coming out of this period is plausible. But the Baily-Elliott narrative assumes that the 1997–2007 housing bubble was also caused by this factor, and that seems implausible. The extraordinary lengths to which the government went to force private-sector lending that would not otherwise have occurred—through affordable-housing requirements for Fannie and Freddie as well as demands on FHA and on the banks under CRA—shows that the housing bubble that ended in 2007 was not a natural occurrence or the result of mere risk aversion. If it had been, there would have been no need for these government programs.

The housing bubble that finally burst in 2007 was driven by a U.S. government social policy that was intended to increase homeownership in the United States and was thus not subject to the usual limits on the length and size of asset bubbles. As such, it was far larger and lasted far longer than any other bubble in modern times, and, when it deflated, the vast number of poor-quality mortgages it contained defaulted at unprecedented rates. This drove down U.S. housing values and caused the weakening of financial institutions around the world that we know as the financial crisis.

Market participants were certainly taking risks as the bubble grew, and it may well be, as Baily and Elliott posit, that this private risk taking was greater than in the past. But the facts show that the bubble was inflated by a government social policy that created a vast number of subprime and Alt-A mortgages that would not otherwise have existed. And the risks associated with this policy—which could produce losses of more than $400 billion at Fannie and Freddie alone—were being taken by only one unwitting group: the taxpayers.

Read the whole thing.

Hat tip to Scott Drum.