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Rethinking the Financial Crisis

Alan S. Blinder, Andrew W. Lo, Robert M. Solow

Publication Year: 2012

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? In Rethinking 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 Crisis marshals 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 Crisis addresses 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.

Published by: Russell Sage Foundation

Title Page, Copyright

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pp. 1-4

Contents

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pp. v-vi

Contributors

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pp. vii-viii

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Introduction

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pp. ix-xviii

Samuel Johnson once observed that “when a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully.” 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 ...

Part I. Rethinking Macroeconomics and Finance

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pp. 1-2

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1. Some Reflections on the Crisis and the Policy Response

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pp. 3-13

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 Reserve’s 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 the...

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2. This Time, It Is Not Different: The Persistent Concerns of Financial Macroeconomics

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pp. 14-36

When the Financial Times’s Martin Wolf asked former U.S. Treasury secretary Lawrence Summers what in economics had proved useful in understanding the 2007 to 2009 financial crisis and recession, Summers answered: “There is a lot about the recent financial crisis in Bagehot.” “Bagehot” here is Walter Bagehot’s 1873 book, Lombard Street. How is it that a book written 150 years ...

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3. Credit Supply Shocks and Economic Activity in a Financial Accelerator Model

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pp. 37-72

This chapter uses the canonical “New Keynesian” macroeconomic model—augmented with the standard financial accelerator mechanism—to study the extent to which disruptions in financial markets can account for U.S. economic fluctuations during the 1985 to 2009 period. The key feature of the model is that financial shocks drive a wedge between the required return on capital ...

Part II. Rethinking Market Efficiency

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pp. 73-74

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4. The Efficient-Market Hypothesis and the Financial Crisis

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pp. 75-98

The worldwide financial crisis of 2008 to 2009 left in its wake severely damaged economies in the United States and Europe. The crisis also shook the foundations of modern-day financial theory, which rests on the proposition that our financial markets are basically efficient. Critics have even suggested that the efficient-market hypothesis (EMH) was in large part responsible for the crisis....

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5. Behavioral Finance in the Financial Crisis: Market Efficiency, Minsky, and Keynes

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pp. 99-135

We explore lessons from behavioral finance about the origins of the financial crisis of 2007 to 2009 and the likelihood of averting the next one. We argue that the crisis highlights the need to incorporate behavioral finance into our economic and financial theories. Psychology, including aspirations, cognition, emotions, and culture, is at the center of behavioral finance. We discuss this ...

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6. Why Did So Many People Make So Many Ex Post Bad Decisions? The Causes of the Foreclosure Crisis

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pp. 136-186

We present twelve facts about the mortgage crisis and argue that these facts refute the popular story that the crisis resulted from finance industry insiders deceiving uninformed mortgage borrowers and investors. Instead, we argue, borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices. We then show that ...

Part III. Rethinking Financial Innovation

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pp. 187-188

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7. Ratings, Mortgage Securitizations, and the Apparent Creation of Value

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pp. 189-209

This chapter studies the criteria used by rating agencies when they rate structured products. The criterion used by Standard & Poor’s (S&P) and Fitch aims to ensure that the probability of a loss on a structured product with a certain rating is similar to the probability of a loss on a corporate bond with the same rating. The criterion used by Moody’s aims to ensure that the expected loss on ...

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8. The Role of ABSs, CDSs, and CDOs in the Credit Crisis and the Economy

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pp. 210-234

The credit derivatives—ABSs, CDSs, and CDOs—played a significant role in the financial crisis of 2007 to 2008, affecting both the financial and real economy. This chapter explains their economic roles, using the credit crisis as an illustration. It is argued that ABSs are beneficial in that they provide previously unavailable investment opportunities to market participants, ...

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9. Finance Versus Wal-Mart: Why Are Financial Services So Expensive?

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pp. 235-246

Despite its fast computers and credit derivatives, the current financial system does not seem better at transferring funds from savers to borrowers than the I would rather see Finance less proud and Industry more content.The role of the finance industry is to produce, trade, and settle financial con-tracts 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 ...

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10. Shadow Finance

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pp. 247-266

Shadow finance refers to all financial transactions that take place outside regulated and transparent financial markets. We emphasize one important reason why a shadow financial sector exists: to prevent the dissemination of valuable information about asset values and to “cream-skim” the most valuable assets away from public, transparent exchanges. We highlight one important ...

Part IV. Rethinking Financial Regulation

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pp. 267-268

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11. The Political Economy of Financial Regulation after the Crisis

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pp. 269-302

The 2007 to 2008 financial crisis has spawned a vast and growing literature. This chapter tackles an aspect of the crisis—the political economy of financial regulation before and since the crisis—that up to now has not been extensively discussed...

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12. Pay, Politics, and the Financial Crisis

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pp. 303-344

The Wall Street bonus culture—coupled with suspicions that the culture facilitated excessive risk-taking—led to an effective prohibition on cash bonuses for participants in the government’s Troubled Asset Relief Program (TARP) and to more sweeping regulation of executive compensation as part of the July 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. ...

Index

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pp. 345-356


E-ISBN-13: 9781610448048
Print-ISBN-13: 9780871548108

Page Count: 374
Publication Year: 2012