So what caused the financial crisis?

Now that we understand the four types of causation, we can apply them to what happened in 2008. Because if we understand how it all happened, we can apply these lessons to today. The efficient cause of the crisis was the sub-prime mortgage market. That’s what blew up in 2007 and wiped out trillions in capital.

The material cause was what made up that capital–the monetary system that underlies our financial system. It’s why some people want to reestablish the gold standard. Change the material of the financial system and you change how the system works.

The formal cause is the structure of the financial system itself. This structure creates vulnerabilities. Change the structure, and you may become less vulnerable. It’s why there have been such changes in financial regulation and ongoing monitoring recently.

The final cause–or goal–of any economic setback is to rebalance the underlying economic system. In 2002 through 2006–for many reasons–we built way too many homes. During the recession, homebuilding went down to levels not seen since the ’50s. That allowed the economy to work off the excess inventory. Because economic needs change, we’ll always have recessions. It’s the only way that a system can adjust to new circumstances.

By looking at the crisis through the lens of classical causation, we can see how and why some changes in the system might help us become less vulnerable during the next crisis. Because be assured, another crisis will come. As someone once said, we are born to trouble as the sparks fly upward.

Douglas R. Tengdin, CFA

Chief Investment Officer

In order to understand what caused the Financial Crisis, we need first to understand what it means to cause something.

Classically, causation can be classified four ways. We looked at material and efficient causes yesterday. Today we will examine formal and final causes. The formal cause of a table is the plan for a table–a horizontal plane supported by several legs. Think of it as the blueprint, or ideal structure. The formal cause of a chemical reaction would be periodic table and electro-chemical potential of various molecules.

The final cause is the purpose it serves. The final cause of a table is to lift stuff up so someone can get at it. The final cause of a car is transportation. It’s what we

So when we ask what caused the Financial Crisis, we should look at it classically, using the four causes. The efficient cause of the crisis was the subprime mortgage market; the material cause was monetary and financial flows; the formal cause was the structure of the financial system; and the final cause was to correct the imbalances and distortions that had developed in the economy.

We need to look at the crisis as fully as possible in order to understand it. Because if we don’t understand history we’ll just go through it again. We sure don’t need that.

Douglas R. Tengdin, CFA

Chief Investment Officer

What caused the Financial Crisis of 2008?

On the face of it, that’s a simple question. But it really depends what you mean by "cause." This isn’t a word game. Classically, we can look at causation in one of four ways: material cause, efficient cause, formal cause, and final cause. We’ve largely forgotten Aristotle’s notion of the four types of causation, but that doesn’t make them any less practical. If we don’t want something to repeat itself, we’d better understand what brought it about in the first place.

To understand Aristotle’s delineation of causation, it helps to think about a table, and what caused a table to be sitting in your kitchen. The material cause of a table’s presence is the wood or metal that the table is made of. It’s a pretty simple notion–material causes are created by the material something is made of. In the same way, the material cause of genetic trait would be the DNA-sequence in the cell-nucleus.

The efficient cause for a table’s presence would be the carpenter who build’s it. Efficient causes are the action or process that created something. We don’t want to fall into the "post hoc" fallacy–after this therefore because of this–but in order to cause something, it has to come before it. In order for a red billiard ball to cause a blue ball to move, the red one has to be moving first. The post hoc fallacy just mistakes sequence for causation.

These two types of causes are what people usually think of when they think of causation, but the other two are helpful as well. We’ll look at them tomorrow.

Douglas R. Tengdin, CFA

Chief Investment Officer