Unformatted text preview: cy is to promote market completion within an evolutionary financial development process.68 Indeed, the set of policies designed to promote housing finance by jump‐starting the markets for new instruments such as securitization through guarantees and subsidies can be viewed as sowing the earliest seeds of the crisis. The Subprime crisis grew, in effect, in the “shadow” of the guaranteed world of Fannie Mae and Freddie Mac. While such policies can help overcome natural impediments to market development—particularly where collective action is difficult and network and scale effects are significant—they can also help promote the illusion that risk has been reduced to a point where it ceases to be a predominant concern. Public intervention also played (and continues to do so) a critical role on the way down. In a world of uncertainty and acute swings in risk aversion, only the State has the shoulders needed to function as the risk‐absorber‐of‐last‐
resort during episodes of acute, systemic failure.69 In this view, the ex‐post unfolding of unprecedented 64 As Greenspan (1998) famously declared, the “management of systemic risk is properly the job of central banks” and “banks should not be required to hold capital against the possibility of an overall financial breakdown”. 65 See Gorton (2008). 66 Uncertainty aversion came on top of (and interacted with) increased volatility. See Brunnermeier (2008). 67 Panics end when information recomposes and becomes available. Intermediary‐based finance is in this sense much more vulnerable than market‐based finance, since prices are less likely to vanish in markets that do not rely on market‐making institutions. 68 A theoretical justification for government intervention in a context of incomplete markets can be found in Geneakoplos and Polemarchakis (1986). Gale (2004) shows that in the presence of incomplete markets there exists an implicit pecuniary externality that generally requires the imposition of capital requirements. 69 The seminal contribution as regards the role of the State as the residual absorber of risk is that of Arrow and Lind (1970). See also Caballero (2009) for a recent reinterpretation of the insurance role of the State in systemic crisis conditions. An intriguing argument can however also be made that instead of spreading risk over taxpayers 38 Fed’s lender‐of‐last‐resort activity and the U.S. Treasury’s bail out operations can be interpreted as a way to drain away from the system sufficient systemic risk so as to allow markets to spring back up to life and intermediaries to continue operating. All in all, the mood swings paradigm presents a more rounded overall story than the other two paradigms, and a story with far‐reaching implications at that. Unlike the agency paradigm, it does not require a gigantic and unyielding asymmetry of information between market participants that are in‐
the‐know and those that are out. Rather, it is a democratic paradigm where everybody was fooled. And unlike the ext...
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