The financial industry collapse of September 2008 and the ensuing precipitate decline of the entire economy taught many lessons, both economic and political.

The principal economic lesson is the inherent instability of the financial sector and the consequent need for alert, intelligent regulation.

Banking, broadly defined to embrace all financial intermediation, is basically a matter of borrowing short at low interest rates and lending long at higher rates. It is risky because short-term capital can be withdrawn suddenly, leaving the lender stuck with long-term loan commitments, and because lending long exposes it to greater risks than lending short does, which is why long-term rates are higher than short-term ones.

The risks are amplified if regulation is lax and inattentive, as it proved to be. Unsound monetary policy under Alan Greenspan, and his successor as chairman of the Federal Reserve, Ben Bernanke, caused interest rates to plunge between 2001 and 2004. The plunge triggered a rise in housing prices (because homes are an asset bought mainly with debt), which turned into a self-sustaining bubble that eventually burst. Housing prices plummeted, carrying the banking industry down with it because the industry was so heavily invested in housing finance.

Fed Inaction

Had the Fed been on its toes, it would have pricked the bubble by raising interest rates before housing prices had risen to absurd heights. Alternatively, had the Fed and other regulators realized how risky lending had become and used their considerable authority to prevent banks from taking risks that endangered the economy, the collapse of the real-estate market wouldn’t have precipitated a collapse of banking and all the economic misery that ensued.

Government had become complacent about the economy. It thought the financial markets were self-regulating. It thought we could have very low interest rates without inflation while ignoring asset-price inflation.

The Fed and the other regulators ignored the rise of the shadow banking industry, consisting of firms such as Bear Stearns Cos., Lehman Brothers Holdings Inc., and Merrill Lynch & Co., which took even more risks than commercial banks did because no part of their capital was federally insured and because they were even more loosely regulated than commercial banks.

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