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The Asymmetric Effect of Diffusion Processes: Risk Sharing and Contagion

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Author Info

  • Gallegati Mauro

    ()
    (Università Politecnica delle Marche)

  • Greenwald Bruce

    ()
    (Columbia University)

  • Richiardi Matteo G

    ()
    (Università Politecnica delle Marche and Collegio Carlo Alberto - LABORatorio R. Revelli)

  • Stiglitz Joseph E.

    ()
    (Columbia University)

Abstract

In this paper we provide a general characterization of diffusion processes, allowing us to analyze both risk-sharing and contagion effects at the same time.We illustrate the relevance of our theory with reference to the subprime mortgage crisis and more in general to the processes of securitization and interbank linkages. We show that interdependencies in real and financial assets are beneficial from a social point of view when the economic environment is favorable and detrimental when the economic environment deteriorates. In the latter case, private incentives are such that too many linkages are formed, with respect to what is socially desirable. The risk of contagion increases the volatility of the outcome and thus reduces the ability of the financial networks to provide risk-sharing.Our analysis suggests that a likely major explanation of the subprime mortgage crisis is the process of securitization itself, in addition to the absence of transparency about the characteristics of the underlying assets that the multiple layers of financial intermediation fostered, as commonly claimed.This may call for a different emphasis on the role of public intervention. While a goal to stabilize the economy in good times should be to disrupt the channels that bring contagion, that is a positive correlation in the returns, in a period of worsening economic conditions our analysis suggests regulatory intervention aimed at disconnecting the economy at crucial nodes. Moreover, we show that policy interventions should be aimed at rescuing institutions, but not their managers. Diminishing the cost of default actually increases the inefficiency due to the divergence between the social and the individual optimum.

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Bibliographic Info

Article provided by De Gruyter in its journal Global Economy Journal.

Volume (Year): 8 (2008)
Issue (Month): 3 (September)
Pages: 1-22

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Handle: RePEc:bpj:glecon:v:8:y:2008:i:3:n:2

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Cited by:
  1. Giulio Cainelli & Sandro Montresor & Giuseppe Vittucci Marzetti, 2010. "Production and financial linkages in inter-firm networks: structural variety, risk-sharing and resilience," Department of Economics Working Papers 1017, Department of Economics, University of Trento, Italia.
  2. Soete, Luc, 2009. "Malthus' Revenge," MERIT Working Papers 030, United Nations University - Maastricht Economic and Social Research Institute on Innovation and Technology (MERIT).
  3. Joseph E. Stiglitz, 2010. "Risk and Global Economic Architecture: Why Full Financial Integration May Be Undesirable," American Economic Review, American Economic Association, vol. 100(2), pages 388-92, May.
  4. Joseph E Stiglitz & Mauro Gallegati, 2011. "Heterogeneous Interacting Agent Models for Understanding Monetary Economies," Eastern Economic Journal, Palgrave Macmillan, vol. 37(1), pages 6-12.
  5. Soete, Luc, 2009. "Malthus' Revenge," MERIT Working Papers 030, United Nations University - Maastricht Economic and Social Research Institute on Innovation and Technology (MERIT).
  6. Nuno Silva, 2010. "Inter-Sector Relations in the Portuguese Economy: an Application of Contingent," Economic Bulletin and Financial Stability Report Articles, Banco de Portugal, Economics and Research Department.
  7. Joseph E. Stiglitz, 2011. "Rethinking Macroeconomics: What Failed, And How To Repair It," Journal of the European Economic Association, European Economic Association, vol. 9(4), pages 591-645, 08.
  8. Joseph E. Stiglitz, 2013. "Stable Growth in an Era of Crises; Learning from Economic Theory and History," Ekonomi-tek - International Economics Journal, Turkish Economic Association, vol. 2(1), pages 1-39, January.
  9. Naude, Wim, 2009. "The Global Economic Crisis after One Year: Is a New Paradigm for Recovery in Developing Countries Emerging?," Working Paper Series UNU-WIDER UNU Policy Brie, World Institute for Development Economic Research (UNU-WIDER).

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