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Unformatted text preview: umption of full rationality opens up the scope for innate biases in the way economic agents process information and make decisions (see the recent surveys of behavioral finance in Barberis and Thaler, 2003, and Della Vigna, 2007). Attempts to explore the implications of such limitations for finance and credit cycles are making some headway. For example, Shleifer and Vishny (1997) showed that inefficient asset pricing driven by noise traders can persist despite the presence of rational arbitrageurs. Lo (2004) proposed an evolutionary approach to economic interactions. De Grauwe (2008) showed that it is possible to generate endogenous cycles when agents use simple heuristic rules to interpret the dynamics of a model they do not fully comprehend. 71 For example, they may be associated with biased perceptions under bounded rationality, or shifts in risk appetite under rational expectations, a non trivial distinction since one would expect risk pricing to be biased in the first case but not in the second. Another key modeling difficulty is the extent to which uncertainty goes beyond the underlying environment to include group behavior. 39 systemic risk gazing (a theme to which we will come back in the next section)? Or was something more sinister at play, either moral hazard or non internalized externalities? In particular, absent externalities, one wonders whether uncertainty alone could pack so much punch, particularly on the way down. In sum, the overall picture one gets from systematically reviewing the three paradigms is that they all provide broadly plausible stories. Hence, they must all contain important grains of truth. Moreover, the paradigms seem to interact and feedback on each other in complex ways, one triggering the other or becoming more predominant at different stages of the cycle. Hence, a fully rounded story—one that does not leave key questions unanswered and fully accounts for the complexity of real life—requires combining the paradigms. However, multi‐dimensionality makes the challenges of policy reform that much more difficult. To these issues we now turn. Paradigms and Regulation In this section, we will briefly summarize what we perceive to have been the main failures of regulation and illustrate in broad terms how policy prescriptions to fix them will often not be independent of the paradigm of choice. The great failures of prudential regulation evidenced by the Subprime crisis can be classified into: i) failures of scope; ii) failures of focus; and iii) failures of dynamics. Take the failures of scope first. The “line‐in‐the‐sand” philosophy simply did not work. The prevailing thinking was that opening a wide room for unregulated intermediaries to thrive was of little consequence to systemic stability. Knowledgeable investors would maintain them in line. Moreover, they were too small to be systemically important. Both assumptions turned out to be deadly wrong. The failure to internalize externalities in the unregulated world c...
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This document was uploaded on 11/14/2013.

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