The present economic crisis: market failure or regulation failure?

Introduction

The economic crisis started on 2007 in USA has had
strong effects over several countries. However, the spread and
strength of such an effects have been different depending on how
prepared any specific country was before the crisis (Blanchard
et.al. 2010). Although there is a strong consensus about the
facts that yielded the crisis, there is not the same consensus
about the sources addressing to these facts. Meanwhile some
research focuses its explanations on market failure, other
research focuses in regulation failure in order to explain how
the facts could happen. This study intends to examine the sources
of the crisis, starting with a brief description of the facts.
Then, an explanation regard regulation failure, as most important
cause, is developed.

The Facts leading to the
crisis

We can summarize the facts which yielded the crisis for
saying that the problem was originated in the bust of the housing
bubble occurred in the housing mortgage market (Arestis et.al.
2009; Baily et.al. 2009; Blanchard et.al. 2010), in particular
the relatively little subprime market (in comparison with the
share of conforming and prime jumbo markets), created for
borrowers with a relatively high probability of eventually not
being able to repay their loan. How could this bubble generate
such a crisis?

Given the continuously increase in the house prices
because the lowest interest rate and, therefore, an increase
demand for houses, the banks left the historical criteria in
order to lend money, including borrowers highly risky because its
less probability of repaying their loans. Trusting heavily on
interlinked securities and derivatives, all related to asset
backed-securities and subprime mortgages in particular (Arestis
et.al. 2009), the financial institutions made mortgage loans.
Then, they began to sell "bonus held by mortgages" to other
financial institutions in the financial market, for instance,
banks, insurers and investment funds, thus, the securitization of
subprime mortgages exponentially (Blanchard et.al.
2010).

Figure 1

Securitization Rates by Type of Mortgage,
2001 and 2006; percent

Source: Mortgage Market
Statistical Annual; Calculations done by Baily et.al.
(2009)

In words of Baily (2009), the securitization mechanisms
were supposed to prevent any losses because their very complex
network of risk reduction, but they did not work as was expected
because banks, brokers, hedge funds, and other institutions
fuelled the demand for risky mortgages and inflated the bubble.
According to Baily (2009), the same qualities of the
securitization played against the mortgage market when the
subprime sector was widely securitized by financial institutions
because by distributing risk according to the risk appetite of
investors, an extension of credit to new borrowers who otherwise
would be shut out of credit markets was facilitated.

Meanwhile high risky borrowers acquired credits, the
houses increased their prices until 2006. Three factors have been
identified in order to explain this phenomenon. Firstly, the US
interest rate was falling down continuously during the period
1995-2006. Even though the real interest rate did not fall too
much, the mortgage market is particularly sensitive to the
nominal interest rate, therefore, the incentives for buying a
house were very strong (Arestis, 2009). Secondly, in words of
Baily (2009), when people witness price increases year after year
a "contagion" of expectations of future price increases can form
and perpetuate price increases. Finally, an increase in mean
household income happened. Unfortunately, this increase was not
as high as the increase of houses (see figure 2). In spite of
this gap, the banks continue giving credits to highly risky
people because the perception that the sustained rise in house
prices they could go nowhere but up (Baily, 2009; Blanchard
et.al. 2010).

Figure 2

Real Home Prices and Real Household
Income (1976=100); Conventional Mortgage Rate

Source: Federal Reserve; Bureau
of the Census (in Baily et.al. 2009)

As a consequence of all above, the unpaid mortgages go
into default and the houses are foreclosed. However, the leverage
(the coefficient between assets and capital) of the banks is
negatively affected because the value of the houses (assets) is
now smaller than the value of the loans which were originally
granted. Therefore, the banks make huge losses, becoming
insolvent and affecting firstly the financial markets and then
the real economics because the absent of liquidity for credits
(Blanchard, 2010).

Market Failure or
regulation failure?

Many reasons have been used in order to explain the
origins and consequences of the economical crisis started on
2007. Even though there are not enough consensuses about the
origins of the crisis, it is possible to find a good number of
common beliefs. For instance, most of researchers identify the
origins of the asset price bubble as being a result from some
basic forces: financial liberalization (Arestis, 2009; Baily,
2009), financial innovation (Arestis, 2009; Baily, 2009;
Blundell-Wignall et.al. 2009), easy monetary policy in a number
of countries around the globe (Arestis, 2009; Cooper, 2009;
Schwartz, 2009) and failure by the regulators to restrain
excessive risk taking (Blanchard, 2009; Baily, 2009; Schwartz,
2009). Each force is now analyzed in terms of eventually market
and/or regulation failures.

The financial liberalization has been seen as
financial deregulation based on free capital mobility. This
deregulation has been justified by the "efficient markets
hypothesis", which assumes that all unfettered markets clear
continuously thereby making disequilibria, such as bubbles,
highly unlikely (Arestis, 2009). However, the trust over the
efficient markets hypothesis was, in opinion of Cooper (2009),
the origin of the crisis. By supporting the market failure
hypothesis, he argues that, in difference of good markets, in the
finance market is not true the premise saying that the prices
should not deviate excessively from the equilibrium prices in the
form of bubbles because is not possible to contain all the needed
information into the price. Why not? Because there were
noticeable destabilizing factors operating in the financial
markets: firstly, an aggravated risk of default because higher
levels of interest were asked when the sub-prime borrowers failed
on repayment of their debts, and secondly, an destabilizing
effect of guaranteeing a return while putting the funds in risky
investments and the probability that this will lead to bank runs.
However, even though an excessive trust on the "efficient markets
hypothesis" can be seen as a market failure, the financial
liberalization let an extensive and complex network of finance
innovations which, and its lack of regulation, were the starting
point for the bubble.

About the financial innovations, its role is
central in the origin and development of the crisis. Baily
(2009), for instance, aims the asset price bubble interacted with
new kinds of financial innovations that masked risk. One of the
most important financial innovations is the Credit Default Swaps
(CDS), a particular kind of credit insurers and derivatives which
widely aided the process of securitization of subprime mortgages.
It has been widely claimed that this and others financial
innovations went beyond the point of value and created assets
that were not transparent because the compounding layers of
securitization seem to have been designed to exacerbate this
problem (Baily, 2009) through a higher complexity increased when
mortgage-backed securities were collateralized by a pool of
mortgages assuming that the pool would give the securities value
(Shwartz, 2009). The pool was not able to give guidance on how to
price the pool and the rating agencies had no formula for this
task. This is a key point because credit markets cannot operate
normally if an accurate price cannot be assigned to the assets a
would-be borrower includes in his portfolio (Shwartz, 2009) and,
therefore, the implicit risk is not clear for the investors. Such
a fact was the origin of the "toxic assets" because they appeared
much less risky than they truly were (Blanchard, 2010). The
emergency of such an assets let us thinking in terms of
regulation failure.

In terms of monetary policy, the crisis has
generated an important amount of critics about the central
banks´ role. The main idea implied on these critics is
concerning to an asset boom is propagated by an expansive
monetary policy that lowers interest rates and induces borrowing
beyond prudent bounds to acquire the asset (Schwartz, 2009). It
is claimed that when the Fed conducted an expansive monetary
policy and lower interest rates, mortgage lending and borrowing
appeared riskless and encouraged house price increases. If
monetary policy had been more restrictive, the asset price boom
in housing could have been avoided. If we analyze this premise
from IS-LM model, we can see that in fact an expansive monetary
policy address to the interest rate fall down. In a more radical
point of view, Cooper (2009) aims that in the future the
attention of central banks should be directed towards averting
excessive credit expansion and asset prices bubbles, rather than
consumer price inflation. However, in contrary to this point of
view, the acceleration of cuts on interest rate (almost reaching
values of zero in the most affected countries) done by the
central banks and the replacement of private with public demand
done by the governments, demonstrated being effective tools in
order to avoid a deeper recession (Blanchard et.al.
2004).

Finally, the regulation failure is seen as
creating the necessary conditions in order to let the crisis
rise. An example of regulation failure could be found in Baily
et.al. (2009) who suggests that one of the crisis" origin is the
lack of regulation over the CDS. This lack let to financial
institutions to trade in CDS for an amount of almost US$ 62
trillion, even though these financial innovations there were no
minimum capital or asset requirements for the protection seller,
so there was no guarantee that in the case of default the seller
will have adequate funds to make full payment. Even though many
other financial innovations has been seen as creating the
necessary complexity that let the crisis arose, most researchers
agree that the most important missed regulation was related to
manage the risk. Blundell-Wignall et.al. (2009) aims that these
kinds of regulations are useful in order to create incentives in
financial markets that encourage a better balance between the
search for return and prudence with regard to risk. The finance
market "should not lose sight of the fact that this crisis is the
result of regulatory failure to guard against excessive risk
taking in the financial sector" (Arestis et.al. 2009, pp.
15).

Conclusions

Most research concerned on determining the origins of
the current financial crisis have concluded a significant lack of
regulation as the main reason explaining the crisis. From the
market failure point of view, an excessive trust on "efficient
markets hypothesis" is the most important origin of the crisis
claimed. However, even though there is a strong consensus about a
higher regulation in the previous stages of the financial crisis
would have implied a higher control of the bubble generated in
the subprime mortgage market, there is not the same consensus
about what kind of regulations should have been implemented and
how.

This work concludes the necessity for introducing
regulations over two main topics related to financial market:
risk management criterion and a higher control over the
complexity and transparency of financial innovations, especially
the securitization tools and the mechanisms to price them. The
pending question will remain being how we can decrease the
fragility of the financial system without impeding too much its
efficiency (Blanchard, 2010).

Finally, in terms of policy, even though an expansive
monetary policy by the FED has been blamed in some senses as
generating the crisis, the recent experience has demonstrated
that they were useful in order to avoid a stronger recession (the
Polish case is a proof), however, the cost in terms of higher
inflation and higher public debt remain yet hidden and it will be
noted on the next years.

Bibliography

Arestis, Philip and Karakitsos, Elias. 2009, "Subprime
Mortgage Market and Current Financial Crisis", Cambridge
Centre for Economic and Public Policy, CCEPP
WP08-09.

Baily, Martin; Litan, Robert and Johnson, Matthew. 2009,
"The Origins of the Financial Crisis", Fixing Finance
Series, Paper 3, Initiative on Business and Public Policy at
Brookings.

Blanchard, Olivier. 2009, "The Crisis: Basic Mechanisms,
and Appropriate Policies", IMF Working Paper, WP/09/80,
International Monetary Fund.

Blanchard, Olivier; Amighini, Alessia and Giavazzi,
Francesco. 2010, "Chapter 20: the crisis of 2007–2010",
Macroeconomics: A European Perspective, Pearson
Education, London.

Blundell-Wignall, Adrian and Atkinson Paul. 2009,
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Cooper, George. 2009, "The Origin of Financial Crisis:
Central Banks, Credit Bubbles and the Efficient Market Fallacy",
J.KAU: Islamic Economics, Vol. 22 (2), pp:
271-275.

Schwartz, Anna. 2009, "Origins of the Financial Market
Crisis of 2008", Cato Journal, Vol. 29 (1), pp:
19-24.

Autor:

Rodrigo Valdivia Lefort

PAPER DUE FOR COURSE OF MACROECONOMICS
ANALYSIS

MASTER OF SCIENCES IN BUSINESS
ECONOMICS

KINGSTON UNIVERSITY OF LONDON

MAY 2011