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The Ongoing Financial Upheaval: Understanding the Sources and Way Out

Working paper #654
Susan M. Wachter

The present period of financial instability is also likely to become known as the end of an era, an era of economic calm and of policy consensus on how to maintain market stability. After World War II, the federal government operated on the Keynesian principles that the right mix of spending, regulation, and interest rates could tame economic cycles and eliminate surges of unemployment. In this period, now known as the Great Moderation, we assumed we knew how to prevent economic crises, such as the recurrence of the Great Depression. However, it is clear that those principles were erroneous as the economy has entered a lesser, but still severe downturn, the Great Recession. This paper looks at the sources of the ongoing economic crisis and points to the unique role in its origins of real estate asset bubbles and mispriced credit, not only in the origin of this crisis but of many financial crises. An analysis of the data points to the role of mispriced mortgage backed securities (MBS) in the spread of aggressive mortgage products and the unwarranted price speculation that resulted in massive foreclosures. In turn, the paper addresses the source of mispriced risk in MBS as incomplete markets in real estate and non-tradability of MBS and related securities which ultimately led to the collapse of financial system, threatening global economic health. The paper also suggests corrective measures that can and should be taken to assist the short and long term recovery.

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