Main and Contributory Causes of the Recent Financial Crisis and Economic Policy Implications

Abstract

We locate the main causes of the recent financial crisis on three factors. The first two of these were financial liberalization and its associated distributional effects (redistribution from wage earners to the financial sector) in the US and elsewhere. Both of these factors gave substantial impetus to the development and extension of new forms of securitization and the use of derivatives. This financial engineering practice, the third main factor, led to the growth of the instruments labelled as collateralized debt obligations (CDOs), particularly in the form of collateralized mortgages. There were also three contributory factors, which exacerbated the process of the main causes: the international imbalances, mainly as a result of the growth of China; the monetary policy pursued by countries over the period leading to the crisis; and the role played by the credit rating agencies. We discuss the economic policy implications of the financial crisis before we summarize and conclude.

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