Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture’

The main thesis of this paper is 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. The 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, the paper analyses its structural flaws. The problems discussed in order are: 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. JEL Categories:

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.

Structural Contradictions of the Global Neoliberal Regime

A revised version of this paper is published in the Review of Radical Political Economics, September 2000

The Case for Capital Controls

A revised version of this essay appears in Unconventional Wisdom, (Twentieth Century Fund Press: New York, 2000), edited by Jeff Madrick.

Trading State-Led Prosperity for Market-Led Stagnation: From the Golden Age to Global Neoliberalism

In Dymski, Gary, and Dorene Isenberg, eds., Housing Finance Futures: Housing Policies, Gender Inequality, and Financial Globalization on the Pacific Rim, M.E. Sharpe, Inc. 2000.

Proposals for Effectively Regulating the U.S. Financial System to Avoid Yet Another Meltdown

It is now clear that we are in the midst of the worst financial crisis since the Great Depression. This crisis is the latest phase of the evolution of financial markets under the radical financial deregulation process that began in the late 1970s. This evolution has taken the form of cycles in which deregulation accompanied by rapid financial innovation stimulates powerful financial booms that end in crises. Governments respond to crises with bailouts that allow new expansions to begin. As a result, financial markets have become ever larger and financial crises have become more threatening to society, which forces governments to enact ever larger bailouts. This process culminated in the current global financial crisis, which is so deep rooted that even unprecedented interventions by affected governments have thus far failed to contain it. In this paper we first analyze a series of structural flaws in the current financial system that helped bring on the current crisis, and then propose a nine point regulation policy, informed by our analysis, designed to end this destructive dynamic. We believe that if enacted and vigorously enforced, the policy could sharply reduce financial instability and minimize the problems caused by future financial cycles.

Proposals for Effectively Regulating the U.S. Financial System to Avoid Yet Another Meltdown

It is now clear that we are in the midst of the worst financial crisis since the Great Depression. This crisis is the latest phase of the evolution of financial markets under the radical financial deregulation process that began in the late 1970s. This evolution has taken the form of cycles in which deregulation accompanied by rapid financial innovation stimulates powerful financial booms that end in crises. Governments respond to crises with bailouts that allow new expansions to begin. As a result, financial markets have become ever large and financial crises have become more threatening to society, which forces governments to enact ever larger bailouts. This process culminated in the current global financial crisis, which is so deep rooted that even unprecedented interventions by affected governments have thus far failed to contain it. In this paper we first analyze a series of structural flaws in the current financial system that helped bring on the current crisis, and then propose a nine point regulation policy, informed by our analysis, designed to end this destructive dynamic. We believe that if enacted and vigorously enforced, the policy could sharply reduce financial instability and minimize the problems caused by future financial cycles. JEL Categories: