April, 03, 2010

SINCE the onset of the financial crisis in 2007, three major narratives have emerged to explain it. The first lays the blame squarely on economic theory - in particular on the myth of "efficient markets" and the failure of pro-market neoclassical economics to acknowledge that financial markets are prone to speculative booms and busts. The assumptions of market efficiency and rational agency which underpinned the "ideology" of free-market fundamentalism provided the intellectual justifications for governments to liberalise their financial industries throughout the 1980s and 1990s, setting the stage for the crisis.

The second narrative takes a different tack. It emphasises the innovations, incentive structures and firm-level practices in the financial industry. Long chains of securitisation created moral hazard as the ones issuing the debt were not the ones that held the risks of default. This diminished incentives for debt issuers to undertake proper scrutiny of the borrowers. Many of the incentives in the financial industry amplified, rather than dampened, the risks that were building up in the financial system.

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