Deregulated financial markets are self-correcting. Complex financial instruments like mortgage-backed securities distribute risk safely throughout the system.

The deregulation of American finance proceeded across three decades with the confidence of settled science. The efficient market hypothesis, the idea that prices incorporate all available information and that markets self-correct, was not just an academic proposition but an operating assumption of regulatory philosophy. If markets processed information efficiently, then additional rules were friction, not protection. The 1999 repeal of Glass-Steagall's separation of commercial and investment banking, the Commodity Futures Modernization Act of 2000 that exempted derivatives from oversight, the SEC's 2004 decision allowing investment banks to increase their leverage ratios, these were not accidents but policies that reflected a coherent worldview taught in economics and business schools across the country.

The mortgage-backed security was presented, in this framework, as a triumph of financial engineering. By bundling thousands of individual mortgages into tradable instruments and then slicing those bundles into tranches of varying risk, banks could supposedly distribute risk throughout the system rather than concentrate it. The mathematics of the rating models, built on the assumption that housing prices across different regions would not all fall at once, appeared to validate the innovation. Credit default swaps would further distribute any remaining risk to parties willing to hold it.

What the models could not account for was their own influence on the system they modeled. As mortgage origination became a volume business, lenders selling mortgages immediately to be bundled rather than holding them, the incentive to assess borrower quality evaporated. The chain of parties between the original borrower and the ultimate holder of the risk grew so long that no single actor needed to care about the whole picture. Risk had not been distributed; it had been hidden.

Lehman Brothers collapsed on September 15, 2008. Within days, the credit markets froze. AIG, which had sold $441 billion in credit default swaps it could not cover, required an $85 billion government rescue. The Treasury and Federal Reserve improvised responses to a crisis for which no playbook existed, because the crisis was one that the prevailing theory had declared impossible.

The final tally: $11 trillion in household wealth erased, 8.7 million jobs lost, millions of foreclosures, and a Great Recession that scarred employment prospects for a decade. Alan Greenspan, who had presided over much of the deregulatory era as Fed chairman, testified before Congress that he had found "a flaw" in his ideology, that he had been wrong about whether institutions would protect their own shareholders. The framework that had been taught as economics was revealed as a set of assumptions that happened to be catastrophically wrong.