[Editor's Note: Matthew is one of our most venerable alums. He is attracted to financial crises like the moth to the flame.]
Generally speaking we ask more from our institutions than from ourselves. We expect our courts to be impartial, our priests to be celibate and our banks to be conservative even as we are partial, promiscuous and profligate. On one level this makes perfect sense since we set institutions to create a buffer between us and the consequences of our actions. The problem is that the more successful our institutions are at managing risk on our behalf, the more risk we are able to assume as individuals without concern for the consequences. This is the very definition of moral hazard.
Time was when margins of institutional safety were much slimmer and thus personal responsibility for one’s affairs more necessary. Particularly in the world of finance you could be sure there would be a major disruption to markets every generation or so. In a two-steps-forward-one-step-back fashion bankers and their ilk would think up new products that would spur greater investment that would spur greater prosperity until there was a panic and everything came crashing down. 
As markets became more sophisticated finance types thought up clever and not so clever ways to avoid crashes that were only sometimes effective but which basically involved the same methods used today–pooling and pumping money into the system and telling everyone to be calm. J.P. Morgan acted as de facto central banker for the last part of the 19th and the first part of the 20th century helping to prop up the U.S. Treasury and staving off the worst during the 1907 Panic. A few months after his death Congress passed the Federal Reserve Act and the system of central banking we still have came into being. But bank panics stopped being a regular threat to the financial system only when Congress began insuring depositors through the FDIC.
As the government and our financial institutions got better at managing risk, the less individuals needed to worry about sudden changes in their economic circumstances. This in turn allowed them to lower their personal reserves and take on more risk in attempts to make quick profits. In other words they could more easily speculate. And speculate they did.
When a limited number of people speculate it won’t have an impact on the general market. When speculative manias sweep up entire nations, however, it distorts the market and a correction becomes inevitable. The Fed responded to the crash following the internet bubble by lowering interest rates. This in turn allowed people to borrow money more cheaply which meant they could increase their leverage. A lot of that easy money found its way into real estate which produced increasingly good returns as more money gushed into the sector and drove prices still higher. The Fed, which had tried to stave off one contraction with interest rate cuts, contributed to a second bubble in asset prices. When the correction came the elaborate mechanisms that seventy years of financial innovation had put in place weren’t enough and today the financial system teeters on the brink.
Foremost in at least the cable networks—and apparently in many Americans’ minds—is the question: Who is to blame? Did our institutions fail by not preventing the moral hazard or did we fail by rushing to take advantage of it? Our search for a scapegoat would be funny if it weren’t so pathetic.
1. Many financial innovators, as is their wont, came [Aislabie/South Seas Bubble], to [Ivar Kreuger] a [John Law] bad [Michael Milken] end [Myron Scholes].
2. If you have ever bought an individual stock and can’t read a balance sheet you are a speculator.