Clear Thinkers favorite James Hamilton provides this interesting post on Princeton professor Alan Blinder’s NY Times Sunday op-ed in which Blinder makes the common sense observation that we first have to figure out what went wrong in the subprime mortgage mess before we can “even begin to devise policy changes that might protect us from a repeat performance.”
Blinder proceeds to identify six groups who might bear at least some of the responsibility for the financial fallout: (1) homebuyers who took on mortgages they couldn’t repay; (2) mortgage originators, for issuing mortgages that homebuyers couldn’t pay; (3) bank regulators, who may have dropped the ball in failing to slow down the runaway train; (4) the investors who ultimately provided the funds for the mortgages, and (5) securitization, which led to assets that are too complex for anyone truly to understand, and (6) ratings agencies that underestimated the risk.
Professor Hamilton focuses on group 4, the investors, and makes the following observation:

Blinder doesn’t seem to give us a lot to go on with understanding Finger #4, beyond the notion that these instruments were new and complicated and investors were stupid. Stupid, I might add, to the tune of hundreds of billions of dollars.
Perhaps that’s all there will ever prove to be to this story. But I can’t help looking for more, thinking there is likely to be something special that caused the usual incentive structure to break down here, something we might be able to understand with more orthodox economic methodology. In my remarks at Jackson Hole, I suggested an interaction between monetary policy and implicit government guarantees as providing one possible basis for a rational calculation on the part of investors. Jin Cao and Gerhard Illing of the University of Munich have an interesting new research paper spelling out the details of exactly how such an equilibrium might play out. Professor Illing lays out the implications for practical policy-making here.
As I also said in Jackson Hole, I am not sure why investors perceived it to be in their best interests to buy these assets. But I am sure that this is the right question, and would encourage young economic researchers seeking to make a name for themselves to take a swing at it.
Because I basically agree with Blinder– until we know the answer, it’s not clear exactly how to fix the problem.

I agree with Professor Hamilton, although I would point out that the best “fix” of the problem is to allow the market to adjust — with a minimum of regulatory interference — to what happened in the subprime meltdown. Which reminds me of a great line that Arnold Kling passed along the other day while lauding the George Mason economics department:

“I like to put it his way: at [the University of] Chicago, they say “Markets work well. Let’s use markets.” At MIT, they say “Markets fail. Let’s use government.” At GMU, they say “Markets fail. Let’s use markets.”