The roots of the current financial turmoil in the United States lies with the rapid, and with hindsight, unjustified rise in house prices, i.e. a bubble. This happened for mainly two reasons as far as I can tell:

1. A relaxation of the regulations governing bank lending and greater risk taking by financial institutions in the belief that that modern financial techniques of cutting up huge bundles of loans into different tranches representing different levels of risk effectively sanitized enough of the risk for even rock solid institutions to invest in previously untouchable loans. For this, blame the U.S. Congress for repealing parts of certain laws meant to curb such behavior, the banks for pushing for this through lobbyists in the hopes of greater financial returns and the SEC for being asleep at the wheel and allowing these derivatives to continue being bought and sold even though no one really understood the risks they represented.
2. Historically low interest rates set in the belief that inflation was historically very low without accounting for inflation in housing prices and then Fed chairman Alan Greenspan’s willingness to set interests rates as low as necessary to revive the economy in the wake of the 2001-2002 recession from the pricking of the dot-com bubble. Greenspan refused to acknowledge that there was a bubble in the housing market until it was far too late and famously argued that bubbles are identifiable only in hindsight and after they have been pricked by the market and that the role of government isn’t to identify and prick bubbles but to manage the economy after the bubble has been pricked.

In a way, this represents a general dilemma of how governments should respond to market ups and downs. If a government identifies a bubble and tries to prick it, it would be hugely unpopular, “leaning against the wind” as Greenspan put it. If everyone is profiting from an inflating bubble, the financial authorities face immense pressure not to do anything even if they think that growth is “fake”, or “irrational exuberance”, another of Greenspan’s terms, as the previous few years of economic growth in the United States may turn out to be, not actual gains in productivity and production, but simply unrealized paper gains derived by manipulating figures on a balance sheet.

On the other hand, if a government tries to act after a bubble has already been pricked, using public money to rescue distressed institutions, it becomes a moral hazard, as one commentator on a forum I frequent put it, “privatizing profits and socializing losses”. Everyone will be screaming for action but it is already too late and becomes simply an exercise in damage mitigation.

Yes, the above represents a very gross overview of the situation only and I’d recommend anyone truly interested to read some of the Wikipedia articles on the subject. They’re surprisingly detailed and up to date.

• United States housing bubble
• Causes of the United States housing bubble
• Subprime mortgage crisis