Post Keynesian Theory and Policy

Post Keynesian Theory and Policy

A Realistic Analysis of the Market Oriented Capitalist Economy

New Directions in Post-Keynesian Economics series

Paul Davidson

How did economic “experts” worldwide fail to predict the financial crisis of 2007-2008? Eminent economist Paul Davidson discusses how mainstream economic theory may not be applicable to the world of experience. Post Keynesian theory is designed to be applicable to the real world, and this book demonstrates how applying it to policy formulation could help practically resolve economic problems. Davidson goes on to demonstrate how many Post Keynesian economists warned of the impending financial crisis as early as 2002.

Chapter 8: Securitization, liquidity and market failure

Paul Davidson

Subjects: economics and finance, history of economic thought, post-keynesian economics

Extract

The winter of 2007–2008 proved to be a winter of discontent in global financial markets. Initially, the US subprime mortgage problem created an insolvency problem for major underwriters. The exotic financial instruments that they created, such as mortgage backed derivatives, lost liquidity and market value. This problem proved contagious as it spilled over to other exotic financial markets such as the auction rate securities markets and the credit default swap markets. The auction rate markets, which had seen few failures in years, suddenly experienced over a thousand failures in the early months of 2008. What caused this contagion to spill over and what was the cause for this tremendous increase in market failures? The answer to both questions is simple. Economists and market participants had forgotten Keynes’s liquidity preference theory (hereafter LPT) and had, instead, swallowed hook, line and sinker the belief that the classical efficient market theory (hereafter EMT) is the useful model for understanding the operation of real world financial markets. The EMT suggests that all one has to do is bring informed buyers and sellers together in an unregulated, free financial market and the market price will always adjust in an orderly manner to the market clearing price, where the latter is based on readily available existing information called market “fundamentals,” such as price/earnings ratios, risks of defaults and so on. This information is readily available to all via modern computer reporting of market trends and history of market behavior in the past.

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