Financial Bubbles, Real Estate bubbles, Derivative Bubbles, and the Financial and Economic Crisis

TL;DR

This paper analyzes the 2008 financial crisis, attributing it to interconnected bubbles in various markets, and argues that many interventions may be misguided due to underlying systemic issues and unsustainable artificial wealth creation.

Contribution

It provides a comprehensive framework for diagnosing the crisis as a result of multiple reinforcing bubbles and critiques current policy responses based on this systemic understanding.

Findings

Multiple bubbles contributed to the crisis and reinforced each other.

Interventions aimed at liquidity may be risky without proper reserves.

The crisis presents both opportunities and challenges for future policy.

Abstract

The financial crisis of 2008, which started with an initially well-defined epicenter focused on mortgage backed securities (MBS), has been cascading into a global economic recession, whose increasing severity and uncertain duration has led and is continuing to lead to massive losses and damage for billions of people. Heavy central bank interventions and government spending programs have been launched worldwide and especially in the USA and Europe, with the hope to unfreeze credit and boltster consumption. Here, we present evidence and articulate a general framework that allows one to diagnose the fundamental cause of the unfolding financial and economic crisis: the accumulation of several bubbles and their interplay and mutual reinforcement has led to an illusion of a "perpetual money machine" allowing financial institutions to extract wealth from an unsustainable artificial process. Taking stock of this diagnostic, we conclude that many of the interventions to address the so-called liquidity crisis and to encourage more consumption are ill-advised and even dangerous, given that precautionary reserves were not accumulated in the "good times" but that huge liabilities were. The most "interesting" present times constitute unique opportunities but also great challenges, for which we offer a few recommendations.