Macroeconomic Theory and its Failings
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Macroeconomic Theory and its Failings

Alternative Perspectives on the Global Financial Crisis

Edited by Steven Kates

This innovative book focuses on the current global financial crisis and the inadequacies of the economic theories being used to guide policy. In so doing, it tackles the economic theories that have been used firstly to understand its causes and thereafter to contain the damage it has brought.
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Chapter 5: Incentive Divergence and the Global Financial Crisis

J. Patrick Gunning


J. Patrick Gunning Price bubbles and cycles due to reliance on financial intermediaries are ordinary characteristics of market interaction in a market economy. So long as people are free to interact, they will often err and be misled. It is possible that such errors and mistaken reliance on others can accumulate, leading to unusually large changes in demand and supply conditions.1 The global financial crisis that began in 2007 was partly a manifestation of these ordinary phenomena. The phenomena were magnified and exaggerated in the USA, however, by a set of laws and government-created institutions. The most important were (1) regulation of financial intermediation by the Federal Reserve Bank (the Fed), the Federal Deposit Insurance Corporation (FDIC) and the Securities and Exchange Commission (SEC) and (2) the manipulation of money. This chapter explains the crisis by focusing on ‘incentive divergence’. Incentive divergence refers to a condition in which an actor’s action in his own interest causes either benefits or harm to others whom he does not take into account.2 I attribute the crisis to the incentive divergence (1) that exists under normal conditions in an otherwise pure market economy and (2) that is introduced by the regulation of financial intermediation, the manipulation of money, and other regulations related to the monetary system and monetary policy. Unfortunately, space considerations prevent a full exposition of this explanation. In this chapter, I omit discussion of monetary factors. I recognize this as a significant gap. A consequence is that I will be unable to...

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