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The financialization of the economy has brought a number of interrelated problems which have contributed to growing income and wealth inequality. Askari and Mirakhor assert that it is time to make a bold change by putting our financial house in order and on a better path, advocating for a fundamental reform of the financial system.



1. The Financial Sector—In Support of Growth or Financialization?

A stable and efficient financial sector has an essential role in support of the real sector to facilitate mechanisms for an efficient allocation of financial and real resources by funding the investments with the highest social rate of return: mobilizing savings, identifying the best business opportunities, financing these investments, monitoring their performance and their managers, enabling the trading, hedging, and diversification of associated risks, and facilitating the exchange of goods and services. Financial institutions, by pooling risk, should be better positioned to analyze investments and their associated risk-return profile and to monitor the performance of investment projects. Our financial system has achieved some of these goals but has also been accompanied by recurring crises.

Hossein Askari, Abbas Mirakhor

2. Recurring Financial Crises—The Causes

A financial crisis is manifested as a crash in any number of asset prices or as a banking crisis and a freezing of credit. These crises have serious economic fallout—sharp and prolonged decline in economic output and a spike in unemployment—as an impaired financial system spares no sector of the economy and deleveraging takes time. There is no shortage of explanations for financial crises: moral failure, fraud, Ponzi schemes, lax regulations, supervision and enforcement, prolonged period of low interest rates, government bailouts of “too big to fail” institutions enabling excessive risk taking, economic shocks, animal spirits, rapid rise in debt, and the list goes on. To our mind, the real culprits of financial crises are (i) preeminence of interest-rate-based debt contracts and (ii) fractional reserve banking.

Hossein Askari, Abbas Mirakhor

3. Recurring Financial Crises—The Fallouts

The fallouts of financial crises are severe. The problems are intertwined and the process of financialization and the runup in debt is an important cause of stagnant real wages, increasing income, wealth disparity, slower economic growth and the fuel for recurring financial crises. These are in large measure because of the changes wrought by financial sector interests and are related to the structure of the economy, economic policy, and the behavior of corporations. The dissipation of savings, the growth effects of increased indebtedness, increased share of financial sector profits, shifts in income away from workers, and lower retained profits of corporations tend to reduce long-run equilibrium growth. They have to be addressed in a comprehensive manner to be effective.

Hossein Askari, Abbas Mirakhor

4. Recurring Financial Crises—The Essential Reforms

The recent financial crisis devastated the global economy and the lives of millions of individuals and families around the world. Debt contracts are inflexible, do not accommodate sharing of risk and losses, and eventually lead to defaults and financial crises. Almost 80 years ago, Irving Fisher and other renowned economists cautioned against fractional reserve banking and the creation of money by the banking system. The application of risk sharing in corporate and public finance and a banking structure closer to 100 percent reserve banking are important as a package to reduce the likelihood of future financial crises in both the private and public sector. The powerful financial industry benefits from debt contracts, fractional reserve banking, subsidies, and preferential treatment and opposes serious reforms.

Hossein Askari, Abbas Mirakhor

5. Conclusions and Our Financial Future

The financialization of the economy has brought a number of interrelated problems: financial crises that have led to severe economic downturns with high unemployment, declining economic opportunities, stagnant real wages, and reduced economic growth and thus growing income and wealth inequality. It is time to make a bold change by putting our financial house in order and on a better path. Higher capital requirements for banks, better regulations, supervision and enforcement, and the like are invariably helpful, but at best they will only delay the inevitable, another devastating financial crisis. The prevalence of debt financing is at the heart of the problem. We need more fundamental reform of our financial system that reduces the supremacy of debt, encourages risk-sharing finance, and increases the fraction of reserves in fractional reserve banking.

Hossein Askari, Abbas Mirakhor


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