Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture’
This PERI Working Paper argues that the ultimate cause of the current global financial crisis is to be found in the deeply flawed institutions and practices of what is often referred to as the New Financial Architecture (NFA) – a globally integrated system of giant bank conglomerates and the so-called ‘shadow banking system’ of investment banks, hedge funds and bank-created Special Investment Vehicles. These institutions are either lightly and badly regulated or not regulated at all, an arrangement defended by and celebrated in the dominant financial economics theoretical paradigm – the theory of efficient capital markets. The NFA has generated a series of ever-bigger financial crises that have been met by larger and larger government bailouts. After a brief review of the historical evolution of the NFA, this paper analyses its structural flaws: 1) the theoretical foundation of the NFA – the theory of efficient capital markets – is very weak and the celebratory narrative of the NFA accepted by regulators is seriously misleading; 2) widespread perverse incentives embedded in the NFA generated excessive risk-taking throughout financial markets; 3) mortgage-backed securities central to the boom were so complex and nontransparent that they could not possibly be priced correctly; their prices were bound to collapse once the excessive optimism of the boom faded; 4) contrary to the narrative, excessive risk built up in giant banks during the boom; and 5) the NFA generated high leverage and high systemic risk, with channels of contagion that transmitted problems in the US subprime mortgage market around the world. Understanding the profound problems of the NFA is a necessary step toward the creation of a new and improved set of financial institutions and practices likely to achieve core policy objectives such as faster real sector growth with lower inequality.
|Date of creation:||2008|
|Date of revision:|
|Contact details of provider:|| Postal: 418 N Pleasant St, Amherst MA 01002|
Phone: (413) 545-6355
Fax: (413) 545-2921
Web page: http://www.peri.umass.edu/
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- L. Randall Wray, 2008.
"Lessons from the Subprime Meltdown,"
M.E. Sharpe, Inc., vol. 51(2), pages 40-68, March.
- L. Randall Wray, 2006. "Can Basel II Enhance Financial Stability?: A Pessimistic View," Economics Public Policy Brief Archive ppb_84, Levy Economics Institute.
- Janet L. Yellen, 2008.
"The financial markets, housing, and the economy,"
48, Federal Reserve Bank of San Francisco.
- Eugene Amromin & Steven A. Sharpe, 2009.
"Expectations of risk and return among household investors: Are their Sharpe ratios countercyclical?,"
Federal Reserve Bank of San Francisco, issue Jan.
- Eugene Amromin & Steven A. Sharpe, 2008. "Expectations of risk and return among household investors: Are their Sharpe ratios countercyclical?," Finance and Economics Discussion Series 2008-17, Board of Governors of the Federal Reserve System (U.S.).
- Peter Folkman & Julie Froud & Sukhdev Johal & Karel Williams, 2007. "Working for themselves? Capital market intermediaries and present day capitalism," Business History, Taylor & Francis Journals, vol. 49(4), pages 552-572.
- Carmen M. Reinhart & Kenneth S. Rogoff, 2009.
"Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison,"
Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 56(3), pages 291-299, September.
- Carmen M. Reinhart & Kenneth S. Rogoff, 2008. "Is the 2007 US Sub-prime Financial Crisis So Different? An International Historical Comparison," American Economic Review, American Economic Association, vol. 98(2), pages 339-44, May.
- Carmen M. Reinhart & Kenneth S. Rogoff, 2008. "Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison," NBER Working Papers 13761, National Bureau of Economic Research, Inc.
- Reinhart, Carmen M. & Rogoff, Kenneth S., 2008. "Is the 2007 US Sub-Prime Financial Crisis So Different? An International Historical Comparison," Scholarly Articles 11129156, Harvard University Department of Economics.
- Reinhart, Carmen & Rogoff, Kenneth, 2008.
"¿Es tan diferente la crisis financiera de sub-prime en EEUU? Una comparacion historica internacional
[“Is The 2007 U.S. Subprime Crisis So Different? An International Historical Comparison,”]," MPRA Paper 13656, University Library of Munich, Germany.
- Raghuram G. Rajan, 2005.
"Has Financial Development Made the World Riskier?,"
NBER Working Papers
11728, National Bureau of Economic Research, Inc.
- Raghuram G. Rajan, 2005. "Has financial development made the world riskier?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, issue Aug, pages 313-369.
- James Crotty, 2007. "If Financial Market Competition is so Intense, Why are Financial Firm Profits so High? Reflections on the Current ‘Golden Age’ of Finance," Working Papers wp134, Political Economy Research Institute, University of Massachusetts at Amherst.
- Caballero, R J. & Krishnamurthy, A., 2008. "Musical chairs: a comment on the credit crisis," Financial Stability Review, Banque de France, issue 11, pages 9-11, February.
- William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, 09.
- Markus K. Brunnermeier, 2008. "Deciphering the Liquidity and Credit Crunch 2007-08," NBER Working Papers 14612, National Bureau of Economic Research, Inc.
When requesting a correction, please mention this item's handle: RePEc:uma:periwp:wp180. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Judy Fogg)
If references are entirely missing, you can add them using this form.