The Influence of Uncertainty in a Changing Financial Environment

This chapter reviews a range of macroeconomic and financial sector developments leading to the Great Recession and discusses how risk perceptions affect the financial markets. It describes how several European countries went through a similar seesaw of boom and recession, largely driven by the same macroeconomic forces that caused the recession in the USA. It examines the role played by policies, regulation (or lack of it, and poor enforcement), rating agency behavior and executive remuneration incentives. It also describes how various important financial institutions were impacted by the crisis. Finally, it summarizes the timely warnings of a few prominent economists about the dangers facing the economy, which were ignored.

This chapter discusses the policy actions taken by the US Treasury and by the Fed to prevent the recession from turning into a major depression, similar to the one we had in the 1930s. It examines the support provided to Bear Sterns and to AIG and discusses the failure to bail out Lehman, which some have questioned. It looks at the assistance provided to Freddy Mac and Fanny Mae and also outlines the key actions taken to boost effective demand in general and to help the auto industry, which faced the prospect of bankruptcy during the recession. It also discusses monetary policy, including the various phases of quantitative easing, during the Great Recession and its aftermath.

This chapter provides an overview of the changes that have taken place in the financial sector in recent times and examines the role played by financial intermediaries. It argues that the growing share of financial wealth held by households makes their economic decisions more sensitive to changes in its market value, so economists need to take these changes into account in their models. This section also examines how the velocity of money has changed over time, laying the ground for the argument that it no longer is a stable function of a few key variables, as originally assumed by monetarists.

This chapter examines in summary form how the financial sector developed, in the world in general and in the US in particular. It discusses how each of the major types of institutions, including insurance companies and hedge funds, operate as well as the development of new financial instruments, such as derivatives, and explores early attempts to regulate the sector and the role played by various regulatory bodies. It also introduces the topic of financial globalization, which is further discussed later.

This chapter provides a bird’s-eye overview of milestone works that resulted in shifts in the focus of economic theory, starting with Adam Smith all the way to contemporary economics. The chapter notes the tug-of-war between the struggle for relevance and the wish to strengthen the rigor of economic analysis. An important argument in the book is that in recent times the pursuit of rigor has been at the expense of relevance, which partly explains why policymakers failed to recognize the warning signs of the Great Recession in a timely manner.

Starting already in the nineteenth century, many economists observed that business fluctuations took place with regularity, though they differed on their periodicity. This chapter discusses briefly the more important theories that have been posited to explain these fluctuations, and pays particular attention to those focusing on the role played by the financial sector, including Keynes and Minsky.

This chapter examines what is probably the cornerstone of economic theory: the notion of rationality in decision making by firms and households, which leads to the view that firms seek to maximize profits and that households allocate their resources so as to maximize the utility they derive from them. It goes on to discuss the theory of rational expectations and the contesting views posited by the behavioral school, and presents some of the latter’s key findings.

This chapter discusses the distinction between risk and uncertainty, and outlines expected utility theory, as developed by Bernoulli, followed by a presentation of the treatment of risk and uncertainty by Frank Knight and by Keynes and, later, by Markowitz and Tobin. It then proceeds to examine how the subject has been explored by the behavioral school and also highlights the contributions of Ben Bernanke.

This chapter explores how, since the late nineteenth century, the US government has increasingly intervened in the economy, starting with legislation designed to prevent monopolistic practices, going on to regulatory interventions to increase the information available to the public for their investment decisions and to protect it from predatory behaviors. It also discusses the accountability challenges posed by the divorce between ownership and management arising from the dispersion of share ownership, and examines the role of the Security and Exchange Commission (SEC) and the rationale for the Sarbanes-Oxley Act.

This chapter reviews how financial sector regulation, including the sometimes neglected insurance sector, has evolved and then examines the reactions to regulation in the latter part of the twentieth century that led to the repeal of the Glass-Steagall Act. It concludes with a review of the Dodd-Frank Act and its key provisions and provides a critical assessment of its achievements and shortcomings.

This chapter starts with a short presentation of the rationale for prudential regulation, and discusses its potential scope. It examines the ways in which banks have sought to strengthen their equity base, including issuing convertible capital instruments (CoCos), and discusses Mervyn King’s recent proposals for an alternative approach. An Appendix to the chapter explains the Basel agreements, discusses how they have evolved, and examines their key provisions.

This chapter discusses the period after the Great Recession, when the USA started to slowly emerge from it. It notes that the turmoil that had affected the financial markets had led to increased sensitivity to perceptions of risk, so when the damages caused by the subprime mortgage boom had been contained, the markets’ concerns shifted to other dangers which might be ahead, and focused on the high debt ratios of many developed countries, particularly in Europe. The problems then faced by Greece can be attributed in part to this, but the broader implication has been a questioning of the euro’s long-term viability, which affected the EU countries in general. The chapter also examines some of the potential implications of Brexit.

With an eye on the future, this chapter examines the implications of the book’s findings, and how they link to the concerns about growth raised by Gordon and by Summers, and to the warnings about the high levels of government debt raised by Rogoff. The chapter explores how all these issues will play out in the near future, resulting in several policy change recommendations, designed to reduce exposure to risk; these include the development of long-term policy frameworks and eliminating the double taxation of dividends (offsetting it with a tax increase on households with higher income levels). It also briefly discusses cybersecurity concerns.

This chapter recapitulates the main findings of the book, reminding readers that the recent focus of much of economic research has been on rigor, at the expense of relevance, resulting in a widening divide between the contents of theory and its models and the needs of policymakers. Despite the questionings presented in the book, the chapter argues that by and large the financial sector still fulfills a critical role that needs to be preserved, so the challenge is to steer it away from pursuing policies that ultimately undermine it, and with this the prosperity of the economy as a whole.