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The financial system and roots of crisis

Financial crises have occurred for centuries, and after the Great Recession of 2008 which began in the United States (US) and spread globally, both economists and policy makers have realized that economically developed countries are not immune from such phenomena. After the Asian financial crisis that began in 1997, much literature was generated which sought to decrease the volatility of capital flows, but in most studies, these short-term flows were seen as problematic only in combination with underdeveloped financial systems. Yet at this point, we have witnessed the final death knell of the efficient-markets hypothesis (according to reasonable economists) which holds that prices immediately reflect all available information. We have also watched a key economic figurehead, former US Federal Reserve Chairman Alan Greenspan, admit that he was wrong in approaching monetary policy from a free market ideology. Free market ideology, in which markets are viewed as self-correcting and symmetric, remains prevalent in the United States, but cracks in the system can no longer be ignored. As history has shown, rather than reaching equilibrium, markets can descend into stagnation without active policy maneuvers. The correct policies are still subjects of sharp debate.

This book seeks to describe and analyze the events, causes, and outcomes of crises from the Great Depression to the Great Recession, unifying a vast amount of literature on each crisis. We start from a general discussion of the global financial system and the roots of crises, both theoretical and empirical. We then discuss crises between 1929 and 2011. We briefly discuss select events before 1929, but focus on the Great Depression and beyond since these crises were created within or bore the current policies and institutions of our current financial system. Our approach differs from what we consider the two leading texts on financial crises (in terms of comprehensive content coverage and analysis), Manias, Panics and Crashes by Kindleberger (1978),1 and more recently, This Time is Different, by Reinhart and Rogoff (2009). While Kindleberger discusses major themes in financial crises from the Dutch Tulip Crisis to the Asian financial crisis, and while Reinhart and Rogoff analyze empirically several centuries of crises, we analyze major crises separately to view them in light of the scholarly consensus on each crisis and of more recent understanding of financial fragility.

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