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The Next Financial Crisis and How to Save Capitalism pdf

  • Book Title:
 The Next Financial Crisis And How To Save Capitalism
  • Book Author:
Abbas Mirakhor, Hossein Askari
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Today the United States is saddled with economic problems that are worse than anything it has experienced in decades. Yes, national economic output is much higher than it was after the Great Depression and even much more so when compared to a century ago. Yes, the basic necessities of life—food, shelter, healthcare, and education—are more widely available. Yet there are underlying economic problems, which, if not comprehensively recognized and addressed, will undoubtedly get worse with potentially catastrophic economic, social, and political consequences.

Today, for the first time in memory, the future just does not seem bright for the vast majority of Americans and their families, and polls claim that for the majority of Americans the “American Dream” has become tarnished, less credible, and increasingly unattainable.

The problems are interrelated and are, as a result, more intransigent than problems that are not linked. The problems are: (i) “financialization,” or the growing domination of the financial sector over the real sector and their increasing divergence; (ii) stagnant real incomes for the majority of Americans since about 1980; (iii) growing income and wealth disparity; (iv) a slowdown in economic growth for the foreseeable future; (v) the adoption of a patchwork of financial reforms where fundamental reforms are needed; and as a result (vi) recurring serious financial crises that leave economic and social devastation in their wake.

We take a US perspective on the issues at hand. Much of what we have to say, but by no means all, is applicable in differing degrees to Western Europe, but much less so to developing countries that have an underdeveloped financial system. Still, in a few compelling instances, we refer to the international dimension of the problems and policies.

The policy response to these problems has been to assess and examine one issue or problem at a time, develop limited solutions, use a “bandage” approach to get over what is invariably labeled as a “bump” in the road and to repeat the same process all over again in the future whenever and wherever the next bump appears. But the bumps may be getting bigger and thus becoming more difficult to bandage. Reaction to economic and social problems, as opposed to comprehensive solutions and foundational reforms, has become the easy road to take.

Why? Simply said, in the arena of finance and economics experts have become too narrowly focused to see the full landscape, and more importantly the rise of special interest groups has become so pervasive that the US federal government and the elected politicians have become too timid to admit the full extent of the socioeconomic problems the country faces, much less propose comprehensive and essential reforms that could threaten powerful interests, especially those who support their reelection.

Our goal in this short book is to present the interrelated facets of our shared economic quagmire and the fundamental reforms that are called for. We try to do this with little or no economic jargon and few notes, with only the names of those whose ideas we have presented and a bibliography of their writings for further reference. We believe that our shared problems have not been presented as an interrelated whole, much less with the needed and essential reforms explained in an easy-to-understand language.

We hope that this short book is informative and eye opening so that we can individually decide where we stand and what to demand of our elected officials when it comes to financial and related economic reforms. In the concluding chapter we briefly sum up the problems we face and their interrelationships, why conditions will likely get worse before they could get better, outline the needed foundational reforms, and the pragmatic reasons why foundational reforms may not be easily forthcoming but only change in baby steps.

We have said much of this in different places for nearly a decade or so, especially what we see as the essential reforms to our financial system. But since others have started more recently to say some of the same things and their views have received considerable traction, we thought it is now an opportune moment in time to pull our thoughts together in one place and state our contention in a concise, yet comprehensive, volume for the concerned nonspecialists as well as for the open-minded specialists.

The Financial Sector—In Support of Growth or Financialization?

Abstract: 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.


The primary role of a financial system is to create incentives and mecha-nisms for the best allocation of financial resources with minimum waste or maximum output (efficiency) in an economy through time. In other words, an ideal financial system would facilitate the financing of the “best” investments, or the investments with the highest social return or payback, by identifying the best business opportunities, mobilizing savings, funding these investments, monitoring the performance of the selected investments and their managers, enabling the buying and selling ownership in these investments (trading), locking in a known return (hedging), providing ways to diversify associated risks, and facilitating the exchange of goods and services between producers and consumers throughout the economy.

Within a financial system, financial markets (where buyers and sellers trade currencies and the three principal finan-cial instruments, namely, stocks, bonds, and derivatives or contracts whose value is derived from the performance of the asset on which it is based) and banks facilitate the vital functions of raising capital and channeling it to entrepreneurs and companies (capital formation), moni-toring, information gathering, and facilitating the sharing of risk.

To the extent that financial markets perform these crucial tasks efficiently, individuals are spared these responsibilities and the attendant costs of channeling their savings into rewarding investments.

In further elaboration, an ideal financial system should perform a number of functions. First, the system should facilitate the efficient channeling of savings from savers to investors (financial intermediation) to reduce information gathering and allocation costs for individuals by spreading these costs among many individuals and providing them with the broad range of financial instruments and investments that they seek. It would be prohibitively expensive and wasteful for every individual to analyze the attractiveness of investments and invest in such a way as to get the type of investment that he or she wants (debt or shares, short term or long term, and size of minimum investment).

 Intermediaries can do all this on behalf of many individual investors by spreading the cost of information gathering and reducing the fallouts of information asymmetry between parties to an investment (adverse selection and moral hazard) by better assessment of borrowers’ risk and subsequent monitoring of borrowers’ performance. Moreover, as Crockett (1996) noted commercial banks by pooling risk can afford depositors’ attractive

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