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, "Origins of the financial crisis and requirements for reform", Journal of Asian Economics, Article in Press.

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