A Realistic Analysis of the Market Oriented Capitalist Economy
Chapter 8: Securitization, liquidity and market failure
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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