Financial market meltdown and a need for new financial regulations

The financial crisis, triggered by the subprime and real estate crisis in the US, has become global. It is deeply rooted in a decade-long misuse of the financial market for rent-seeking. The financial industry has largely abandoned its role as a service industry, supposedly charging reasonable fees for the services of spreading risk and allocating capital and credit. Instead it provides a market for speculation, corporate control – mergers and acquisitions – and a casino for betting on or hedging practically any kind of risk – the derivatives market. Finance, broadly understood, has gone from a low share in GDP of the American economy to 20% since the early 1990s – yet there is little or no evidence that the value of its services to consumers and businesses are worth one-fifth of GDP; for details see Nell and Semmler (2009). The growth of finance seems to be largely due, on the one hand, to deregulation, leading to liberalization of capital accounts all over the world, and to financial innovations on the other. But this innovation has led to the development of new financial instruments that are not well understood by their users or even their initiators. Financial derivatives, Mortgage Backed Securities (MBS), Collaterized Debt Securities (CDS), Collaterized Debt Obligations (CDOs), and so on, have clearly been misused. But besides that, some critics argue that they were misconceived as well: there was substantial mis-pricing, since the formulas for pricing and using them rested on relative pricing and unacceptable assumptions about the distribution of probabilities; see Platen and Heath (2006); Platen and Semmler (2009) and further literature discussed there.

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