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Theory and the Market after the Crisis: the Endogeneity of Financial Governance

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  • Underhill, Geoffrey R D
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    Abstract

    The inheritance of contemporary financial economics invites us to consider financial stability as integral to a liberal market setting. The crisis however demonstrated that financial markets may prove highly dysfunctional in the absence of adequate mechanisms of regulation and governance. This implies that economic theory requires an enhanced understanding of the intersection of economic rationality with the rationality of governance. This article extends the insights of institutional economics to demonstrate that the emergence of the institutions of financial governance is endogenous to the utility-maximising behaviour of competing economic agents. Utility-maximising behaviour and conflict over the terms of competition in the market generate both the formal and informal institutions and processes of governance such as regulation and dispute settlement. The model is illustrated by the case of international finance, predicting forms of policy rent seeking in a market environment: private interests embedded in public policy processes simultaneously reshaped both market and governance in line with their own perceived utility functions. The model predicts that similar policy rent seeking will dominate the reform process. Successful reform will require a conceptual understanding of this link between governance and market competition, and appropriate changes in the nature of the policy process so as to reshape markets to avoid financial instability in the future.

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    Bibliographic Info

    Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8164.

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    Date of creation: Dec 2010
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    Handle: RePEc:cpr:ceprdp:8164

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    Related research

    Keywords: endogeneity; financial governance; policy rent seeking; transaction costs;

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    1. Brian Burgoon & Panicos Demetriades & Geoffrey Underhill, 2008. "Financial Liberalisation and Political Variables: a response to Abiad and Mody," Discussion Papers in Economics 08/30, Department of Economics, University of Leicester.
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