Economic Theory and the Financial Crisis

Abstract

I want to probe in the role of the market in allocating resources in this very preliminary essay. One does not have to see study deeply to that the failure of for various kinds of derivative securities to perform properly is an essential element of the current financial crisis. Actually, financial crises are not a new phenomenon. The history of capitalism has been marked by repeated collapses of the financial system, situations in which the markets for loans disappear for extensive periods of time. The 18th century saw some bubbles, but these might not be quite modern. But from 1819 on, there have a succession of failures of banks and other financial institutions. These have typically been unpredicted and did not correspond in time to any particular exogenous event (e.g., wars). Economists from Joho Stuart Mill (1848) on did recognize the phenomenon. But the discussion was and is not at all integrated with the general exposition of classical economics. No one could be a more vigorous advocate of unrestrained than Milton Friedman; yet, to my reading, the account that he and Anna Schwartz gave of monetary developments in the United States and particularly with regard to the Great Depression emphasizes, not prices, not even interest rates, but the supply of money, and, by inference, of liquidity. (Friedman and Schwartz (1963)). I start with the neoclassical general equilibrium framework, to which I have given a good deal of attention and effort. I seek to identify a possible point at which it fails to supply a coherent theory of securities and so might possibly lead to some understanding of the repeated crises of the financial system underlying the development of capitalism.