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Financial crisis: is there a need for paradigm shift?
Edited by Dr Sabur Mollah
Summary
The global financial crisis of 2008 followed by a global economic recession would not have happened with the same severity if there were up to date financial regulations and vigilant oversight in place. The crisis calls for internationally coordinated reforms in the regulatory system, which fully incorporates macro risks and reconsiders some of the products of financial engineering as well as new resolution rules for big non-bank financial institutions. The reactions of governments and the fiscal and monetary policies they followed were swift and unprecedented in size and introduced elements of a new central banking. The early signs indicate that those actions have stabilized the financial system and are on their way to getting the largest economies out of the recession. If this turn out to be the case, many parts of macroeconomic theory based on rational expectations and the efficient market hypothesis must be reconsidered and the received wisdom on the lags of fiscal policy revised. While the policy response was appropriate, its cost is staggering and will imply a retrenchment in the standards of living of the USA and, to an extent, Europe as a result of the resource-transfers to Asian creditors. Finally, the crisis of the global economy calls for a global system with appropriate locus of authority endowed with sufficient resources and suitable mandates. Consequently, reforming the international monetary and financial systems has become a pressing issue.
I. The origins of the crisis
The current financial crisis originated in the years 1999-2007 as a result of a combination of several factors. The first was the extraordinary boom in the housing market, in particular in the USA, where the overhang in the supply of housing opened up for financial institutions the possibility of extending vast numbers of mortgages at attractive rates[1] . It should be recalled that at the time, banks and other financial institutions had record liquid assets, which they sought to invest in higher earning assets. The housing boom enabled them to double their portfolio of mortgage lending over its share ten years before; mortgages reached some 50 percent of their total lending assets after 2001. The second was the historically low-interest rates put in...