Four myths about the us financial crisis essay

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Four myths about the us financial crisis essay

In turn, this loss of confidence entailed a sharp decline in many asset prices and brought to their knees several large financial institutions with centennial traditions. This article surveys the critical moments of the crisis, presents some of the shock-amplifying mechanisms, and comments on the effectiveness of various policy measures.

We point out four conceptual myths that did not survive this crisis.

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The conclusion opens the debate on what structural changes in the existing financial architecture are required to contain such crises in the future. Published online in Wiley Online Library wileyonlinelibrary.

Unemployment reached levels not seen since the major oil shocks in the s, and the fiscal position of many developed countries deteriorated dramatically.

The situation is well summarized by Miller and Stiglitzp. From to a chain of events, beginning with unexpected losses in the US-subprime market, was destined to bring the global financial system close to col-lapse and to drag the world economy into recession.

It provided a lesson of humility for a majority of policymakers and scholars, including the author of this text, who underestimated the size of the accumulated financial imbalances and their would-be real consequences.

Four myths about the us financial crisis essay

The truth is that almost nobody had foreseen this crisis, and we do not refer here to those pessimistic scholars who see a crisis everywhere and anytime. An overwhelming process of liberalization of movements of capital was set in motion, initially in developed countries ByRadu Vranceanu Four Myths and a Financial CrisisCorrespondence to: For instance, when a firm needs to borrow to finance its de-velopment, if lenders assess the risk of default as low, they claim a small interest rate, and the chances of the borrow-ing firm to repay the loan and pay the agreed interest are high.

If, on the other hand, lenders assess the risk as high and ask for a high interest rate, the borrowing firm will find it difficult to honor its obligations and, ex post, the assessment of the risk as high will also turn out to be right.

This simplified illustration demonstrates an important development in contemporary macroeconomicsthe concept of multiple equilibria. From this perspective, eco-nomic situations that, for simplicitys sake, we can refer to as good or bad are both possible, and materializa-tion of either depends to a large extent on the beliefs of economic agents see also Stiglitz, Furthermore, a sudden deterioration of these beliefs can shift the equilib-rium from the good to the bad situation, even if nothing affected the so-called fundamentals of the economy.

From the multiple-equilibria perspective, the crisis has been characterized by sharp, rapid deterio-ration in the economic agents perception of the quality of firms in the financial sector, and the quality of the products they manufactured and sold.

It can thus be de-fined primarily as a crisis of trust or confidence. In prac-tice, the trademark of such a crisis is the disappearance of buyers for various goods and assetsand with them the liquidity so badly needed by firms to meet their short-term commitments Krishnamurthy, In turn, the shortage of liquidity stemming from pessimistic expecta-tions has dramatic consequences on financial institutions that restrain from taking risks and thus no longer fulfill their social mission.

It should be noticed from the outset that economists were victims of a dangerous myth that prevented them from properly evaluating such macroeconomic risks.

Hundreds of studies used the multiple-equilibria ap-proach to explain exchange-rate and financial crises that hurt the developing world in the last 30 years. Yet, when they look to developed countries, economists seem to have a blind faith that the bad equilibrium could never materialize, allegedly because rich countries have a much better governance than developing countries.

One specific form of multiple equilibria is an asset-price bubble. In a bubble, the price of an asset at one moment in time no longer depends on the discounted stream of future payments but on the expectation that its price will go up. If all agents form similar expectations, they buy the asset and its price goes up, thus validating the initial out-of-fundamentals beliefs.

As no price can go up indefinitely, sharp and wide downside adjustments are and then extending to developing countries. At the same time, new financial instruments such as derivatives and structured products were created, with the aim of hedg-ing against an ever-broader range of risks.

The sophisti-cation of these products grew constantly, as did trading volumes. While this powerful expansion in the financial mar-ket over the last 20 years has fostered worldwide growth through better resource allocation in time and the creation of new opportunities for risk diversification, it has also contributed to increased economic instability by calling for a more substantial role for peoples beliefs in structuring reality itself.1.

Three Myths about Quantities The –nancial crisis has also been associated with three widely held claims about the nature of the crisis and the associated spillovers to the rest of the economy. The –nancial press and policymakers have made the following three claims about the nature of the crisis.

Four Myths About the US Financial Crisis Essay Sample

1. Four Myths About the US Financial Crisis Essay Sample The United States is currently undergoing most serious economic downturn since the great depression. That evidence alone is causing great fears among the populace and leaders.

Download Citation on ResearchGate | Four Myths and a Financial Crisis | The main driving force of the financial crisis of was a rapid deterioration of the trust of private agents in the. This essay will aim to succinctly and coherently explain what happened during the financial crisis and then provide a closer look at what happens to companies affected by an economic recession.

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Four Myths About the US Financial Crisis | Essay Example