Rethinking the Financial Crisis

Rethinking the Financial Crisis

Alan S. Blinder
Andrew W. Lo
Robert M. Solow
Copyright Date: 2012
Published by: Russell Sage Foundation
Pages: 376
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    Rethinking the Financial Crisis
    Book Description:

    Some economic events are so major and unsettling that they "change everything." Such is the case with the financial crisis that started in the summer of 2007 and is still a drag on the world economy. Yet enough time has now elapsed for economists to consider questions that run deeper than the usual focus on the immediate causes and consequences of the crisis. How have these stunning events changed our thinking about the role of the financial system in the economy, about the costs and benefits of financial innovation, about the efficiency of financial markets, and about the role the government should play in regulating finance? InRethinking the Financial Crisis, some of the nation's most renowned economists share their assessments of particular aspects of the crisis and reconsider the way we think about the financial system and its role in the economy.

    In its wide-ranging inquiry into the financial crash,Rethinking the Financial Crisismarshals an impressive collection of rigorous and yet empirically-relevant research that, in some respects, upsets the conventional wisdom about the crisis and also opens up new areas for exploration. Two separate chapters-by Burton G. Malkiel and by Hersh Shefrin and Meir Statman - debate whether the facts of the financial crisis upend the efficient market hypothesis and require a more behavioral account of financial market performance. To build a better bridge between the study of finance and the "real" economy of production and employment, Simon Gilchrist and Egan Zakrasjek take an innovative measure of financial stress and embed it in a model of the U.S. economy to assess how disruptions in financial markets affect economic activity-and how the Federal Reserve might do monetary policy better. The volume also examines the crucial role of financial innovation in the evolution of the pre-crash financial system. Thomas Philippon documents the huge increase in the size of the financial services industry relative to real GDP, and also the increasing cost per financial transaction. He suggests that the finance industry of 1900 was just as able to produce loans, bonds, and stocks as its modern counterpart-and it did so more cheaply. Robert Jarrow looks in detail at some of the major types of exotic securities developed by financial engineers, such as collateralized debt obligations and credit-default swaps, reaching judgments on which make the real economy more efficient and which do not. The volume's final section turns explicitly to regulatory matters. Robert Litan discusses the political economy of financial regulation before and after the crisis. He reviews the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which he considers an imperfect but useful response to a major breakdown in market and regulatory discipline.

    At a time when the financial sector continues to be a source of considerable controversy,Rethinking the Financial Crisisaddresses important questions about the complex workings of American finance and shows how the study of economics needs to change to deepen our understanding of the indispensable but risky role that the financial system plays in modern economies.

    eISBN: 978-1-61044-815-4
    Subjects: Economics

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-vi)
  3. Contributors
    (pp. vii-viii)
  4. Introduction
    (pp. ix-xviii)
    Alan S. Blinder, Andrew W. Lo and Robert M. Solow

    Samuel Johnson once observed that ʺwhen a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully.ʺ So does the experience of a near-total financial collapse, especially when it triggers a long and deep recession and only hastily improvised and drastic actions by the Federal Reserve and the U.S. Treasury are able to ward off an even worse catastrophe. Naturally, then, more has been said and written about the financial crisis of 2008 to 2009 than anyone can hear or read. But the research and reflections described in this book are different, and perhaps more...

    • Chapter 1 Some Reflections on the Crisis and the Policy Response
      (pp. 3-13)
      Ben S. Bernanke

      I would like to thank the conference organizers for the opportunity to offer a few remarks on the causes of the 2007 to 2009 financial crisis, as well as on the Federal Reserveʹs policy response. The topic is a large one, and today I will be able only to lay out some basic themes. In doing so, I will draw from talks and testimonies that I gave during the crisis and its aftermath, particularly my testimony to the Financial Crisis Inquiry Commission in September 2010 (Bernanke 2010). Given the time available, I will focus narrowly on the financial crisis and...

    • Chapter 2 This Time, It Is Not Different: The Persistent Concerns of Financial Macroeconomics
      (pp. 14-36)
      J. Bradford DeLong

      At the Institute for New Economic Thinking (INET) conference in Bretton Woods, New Hampshire, in the spring of 2011,Financial Timescorrespondent and columnist Martin Wolf asked: ʺDoesnʹt] what has happened in the past few years simply suggest that [academic] economists did not understand what was going on?ʺ Former U.S. Treasury secretary Lawrence Summers, in the course of his long answer, said: ʺThere is a lot in [Walter] Bagehot that is about the crisis we just went through. There is more in [Hyman] Minsky, and perhaps more still in [Charles] Kindleberger.ʺ¹

      Summers is referring here to Walter Bagehot (1826–1877),...

    • Chapter 3 Credit Supply Shocks and Economic Activity in a Financial Accelerator Model
      (pp. 37-72)
      Simon G. Gilchrist and Egon Zakrajšek

      The acute financial turmoil that raged in global financial markets following the collapse of Lehman Brothers in the early autumn of 2008 plunged the United States into the most severe recession since the Great Depression. The roots of this economic calamity can be found in the meltdown of the subprime mortgage market in the wake of an unexpected and prolonged decline in house prices that materialized in late 2006. The ensuing financial stresses caused enormous liquidity problems in interbank funding markets and ultimately led to the sudden collapse of several major financial institutions and a sharp reduction in credit intermediation...

    • Chapter 4 The Efficient-Market Hypothesis and the Financial Crisis
      (pp. 75-98)
      Burton G. Malkiel

      The worldwide financial crisis of 2008 to 2009 left in its wake severely damaged economies in the United States and Europe. Unemployment rates soared up to and in some cases above the double-digit level, and economies in Europe and the United States were still operating in 2012 well below economic capacity. Moreover, the high indebtedness of consumers, financial institutions, and governments made the severe recession unusually persistent and limited the fiscal policy responses of governments throughout the world.

      The crisis also shook the very foundations of modern-day financial theory, which rests on the hypothesis that our financial markets are basically...

    • Chapter 5 Behavioral Finance in the Financial Crisis: Market Efficiency, Minsky, and Keynes
      (pp. 99-135)
      Hersh Shefrin and Meir Statman

      The financial crisis that peaked in 2008 is still roiling us in the Great Recession, in which the economy is barely growing and the unemployment rate is frighteningly high. What inflicted this crisis? And what, if anything, can we do to prevent the next one? We argue that behavioral finance offers some answers to these questions. The answers are rooted in the psychology underlying the sometimes baffling uncertainty in which we live, including our aspirations, cognition, emotions, culture, and perceptions of fairness. We discuss this psychology and its reflection in the institutions that bring us together, including corporations, markets, and...

    • Chapter 6 Why Did So Many People Make So Many Ex Post Bad Decisions? The Causes of the Foreclosure Crisis
      (pp. 136-186)
      Christopher L. Foote, Kristopher S. Gerardi and Paul S. Willen

      More than four years after defaults and foreclosures began to rise sharply in 2007, economists are still debating the ultimate origins of the recent U.S. mortgage crisis. Losses on residential real estate touched off the largest financial crisis in decades. Why did so many people—including home buyers and purchasers of mortgage-backed securities—make so many decisions that turned out to be disastrous ex post?

      The dominant explanation is that well-informed mortgage insiders used the securitization process to take advantage of uninformed outsiders. The typical narrative follows a loan from a mortgage broker through a series of Wall Street intermediaries...

    • Chapter 7 Ratings, Mortgage Securitizations, and the Apparent Creation of Value
      (pp. 189-209)
      John Hull and Alan White

      The traditional business of rating agencies is the rating of corporate and sovereign bonds. Between 2000 and 2007, another part of their business, the rating of structured products, grew very quickly, so much so that by the end of this period it was accounting for close to half of their revenues. This chapter examines whether the growth of the market for structured products was influenced by the rating criteria used by rating agencies. We do not examine whether the ratings criteria were correctly applied (this is considered in Hull and White 2010). Instead, we examine whether the ratings criteria, assuming...

    • Chapter 8 The Role of ABSs, CDSs, and CDOs in the Credit Crisis and the Economy
      (pp. 210-234)
      Robert A. Jarrow

      To understand the role of asset-backed securities (ABSs), credit default swaps (CDSs), and collatoralized debt obligations (CDOs) in the economy, one needs first to understand their role in the credit crisis. To help the reader follow the subsequent discussion, figure 8.1 provides a diagram of the credit crisis. In this respect, three issues and their relation to these credit derivatives need to be understood:

      1. Incentive problems: agency problems in the management of various financial institutions and investment funds; the fee structure of the rating agencies; and the effect of ABSs and CDOs on the mortgage originatorsʹ lending standards.

      2. Errors made...

    • Chapter 9 Finance Versus Wal-Mart: Why Are Financial Services So Expensive?
      (pp. 235-246)
      Thomas Philippon

      The role of the finance industry is to produce, trade, and settle financial contracts that can be used to pool funds, share risks, transfer resources, produce information, and provide incentives. Financial intermediaries are compensated for providing these services. Total compensation of financial intermediaries (profits, wages, salaries, and bonuses) as a fraction of gross domestic product (GDP) is at an all-time high, around 9 percent of GDP. What does society get in return? In other words, what does the finance industry produce?

      I measure the output of the finance industry by looking at all issuances of bonds, loans, and stocks (initial...

    • Chapter 10 Shadow Finance
      (pp. 247-266)
      Patrick Bolton, Tano Santos and José A. Scheinkman

      One of the most important functions of financial markets is indeed to provide ʺa means of price discovery of assets.ʺ This is an essential step in the process of capital allocation, risk-sharing, and the provision of liquidity. But price discovery—the determination of an assetʹs value—requires skill, talent, and information, which are all in scarce supply. Implicit in Floyd Norrisʹs analysis is the view that price discovery ought to be a public good provided by financial markets. This is consistent with a long tradition in finance scholarship that holds that financial markets are on average ʺinformationally efficient.ʺ That is,...

    • Chapter 11 The Political Economy of Financial Regulation after the Crisis
      (pp. 269-302)
      Robert E. Litan

      There are so many alleged ʺcausesʺ of the great financial crisis of 2007 to 2008 that it is easy to lose count. The official body charged with explaining how the crisis happened, the Financial Crisis Inquiry Commission (FCIC), was specifically instructed by the Congress that created it to investigate at least eighteen causes. The final report of the commission did not disappoint.

      But this should not be surprising because, in fact, like the multiple culprits in Agatha ChristieʹsMurder on the Orient Express, there actually were many ʺbut forʺ causes of the financial crisis. (That is, ʺbut forʺ each particular...

    • Chapter 12 Pay, Politics, and the Financial Crisis
      (pp. 303-344)
      Kevin J. Murphy

      In early 2009, with the United States still enmeshed in the financial crisis and reeling from the government bailouts to the banking sector, Congress shifted its attention to the critical task of finding someone (or something) to blame.¹ The most obvious culprit—or perhaps scapegoat—was the ʺWall Street bonus culture,ʺ the tradition in which traders, brokers, and executives receive most of their compensation not in base salaries but rather in bonuses paid at the end of the fiscal year. Since this tradition rewards success but (allegedly) imposes no real penalties for failure, the Wall Street culture (allegedly) provides incentives...

  9. Index
    (pp. 345-356)