2 The origin of the crisis was closely related to financial innovation and the creation of instruments that should have diversified risks. Most of financial innovation was used to circumvent regulation, allowing credit expansion with a weak capital base. Low interest rates, search for yields and a monetary policy that promised to rescue after severe falls in asset prices prompted the creation of a housing bubble. Enormous efforts were made to price many extremely complex financial instruments, but even those efforts failed to build valuation models that realistically considered the instruments’ insolvency probabilities. No evidence is necessary to assert that these methods failed because of an extreme event that struck everything. These failures were exacerbated by severe liquidity shortages and widespread panic in the markets. It is paradoxical that while asset price theories, and their application to the real world, are based on the existence of full arbitrage (consider, for example, the CAPM), corporate finance theories are essentially dominated by information asymmetries and are plagued by frictions from principal-agent problems. This dichotomy will have to be corrected over time to ensure that more realistic models of how financial markets work become available, models which will shed more light on economic policy recommendations. On crisis prevention and management A pervasive question for the past and current crises is whether they could have been anticipated.
But, in the gestation of asset price bubbles there was the commitment that if and when the bubble burst, the Fed would take care of the mess. This is exactly the same as the build up of currency mismatches in emerging markets when authorities promise to ensure exchange rate stability. In addition, we have witnessed a messy bail out of banks, and more recently, and more worrisome, bail out of countries with weak public finances. The issue of sustainability has become very relevant, in particular on the fiscal sphere. Economies cannot live forever beyond their means, and a serious effort of fiscal consolidation must be made, in particular in fragile industrial economies. It is ironic that after going through a very complex financial crisis, we are now worried about a very traditional crisis, caused by fiscal imbalances in the context of a fixed exchange rate regime, with potentially serious financial ramifications. The type of crisis that was analyzed and modeled in international finance at the most intellectually prolific time of Pentti Kouri. He would certainly have a lot to say about this. References Bordo, M., B. Eichengreen, D. Klingebiel and M.S. Martinez-Peria (2001), “Is the Crisis Problem Growing More Severe?” Economic Policy 16(32): 51–82. De Gregorio, J. (2009), “La Macroeconomía, los Economistas y la Crisis”, Cuadernos de Economía, Latin American Journal of Economics 46(134): 149–159. English version, Economic Policy Paper No. 33, Central Bank of Chile. De Gregorio, J. (2010), “Monetary Policy and Financial Stability: An Emerging Markets Perspective”, International Finance 13(1): 141–156.