TITLE:
Financial Crisis in Retrospect: Bad Luck or Bad Policies?
AUTHORS:
Gregory M. Dempster, Justin P. Isaacs
KEYWORDS:
Financial Markets; Volatility; Soft Budget Constraints; Institutions
JOURNAL NAME:
Theoretical Economics Letters,
Vol.4 No.1,
February
18,
2014
ABSTRACT:
It is generally
acknowledged that many recent financial crises, in both emerging and mature
markets, are characterized by large scale coordination problems with common
origins. Despite minimal consensus on their primary causes, most prominent
theories suggest that these financial crises can be classified as either the
result of bad policies or bad luck. In this paper, we attempt to outline the
sources of coordination failure in financial markets due to the “soft budget
constraints” produced by time-inconsistent policies in combination with elastic
expectations on the part of financial investors. Thus, in our framework,
financial crisis is conceived as the result of both bad policies and bad luck. That
is, it results from a mismatch of institutional arrangements to the realities
of human behavior.