Understanding Financial Crises

By Franklin Allen; Douglas Gale | Go to book overview

6
Intermediation and markets
In the preceding chapter we studied financial fragility from the point of view of positive economics, that is, trying to understand the factors that give rise to financial crises and the reasons why a financial system might be sensitive to small shocks. We noted in passing that financial crises might be inefficient, but this was not the focus of our analysis. Now it is time to turn to normative questions and try to understand why financial crises are a [bad thing.]To understand why financial crises are a [bad thing,] we begin by asking a different question [Under what circumstances are financial crises efficient?] We take this indirect approach for several reasons.
First, we want to challenge the conventional wisdom that financial crises are always and everywhere a [bad thing.] It may well be true that financial crises impose substantial costs on the economy. Certainly there have been many historical episodes in many countries that suggest the costs of financial crises can be very substantial. At the same time, any regulation of the financial sys- tem involves costs. The most important of these costs are the distortions imposed on the financial system by a regulatory regime that restricts what financial institutions may and may not do. To measure the costs and bene- fits of any policy, we need to have a clear understanding of the conditions for efficiency in the financial system, including the conditions for efficient financial crises.
A second reason for studying the conditions under which crises are efficient is that knowledge of these conditions may suggest techniques for managing crises and reducing their costs. Casual observation suggests that the central banking techniques developed over the past two centuries are mainly the result of trial and error, without much rigorous theory behind them. The first step in developing an optimal financial stability policy is to carry out a thorough welfare analysis of financial crises, including the conditions for efficient financial crises.
A third reason for adopting the proposed approach is that economists have a well developed set of tools for studying optimal economic systems. So

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