The Next Financial Crisis and How to Save Capitalism

DOI: 10.1057/9781137544377.0001
Also by Hossein Askari and Abbas Mirakhor

Askari, Hossein, Zamir Iqbal and Abbas Mirakhor, 2008, NEW ISSUES IN ISLAMIC
FINANCE AND ECONOMICS: Progress and Challenges
Askari, Hossein, Zamir Iqbal and Abbas Mirakhor, 2009, GLOBALIZATION AND ISLAMIC
FINANCE: Convergence, Prospects, and Challenges
Mirakhor, Abbas and Hossein Askari, 2010, ISLAM AND THE PATH TO HUMAN AND
ECONOMIC DEVELOPMENT, Foreword by Ali Allawi
Askari, Hossein, Zamir Iqbal, Noureddine Krichene and Abbas Mirakhor, 2010, THE
STABILITY OF ISLAMIC FINANCE: Creating a Resilient Financial Environment for a
Secure Future, Foreword by Sir Andrew Crockett
Askari, Hossein, Zamir Iqbal, Noureddine Krichene and Abbas Mirakhor, 2011, RISK
SHARING IN FINANCE: The Islamic Finance Alternative
Askari, Hossein, Zamir Iqbal and Abbas Mirakhor, 2014, CHALLENGES IN ECONOMIC
AND FINANCIAL POLICY FORMULATION: An Islamic Perspective
Askari, Hossein, Zamir Iqbal and Abbas Mirakhor, 2015, INTRODUCTION TO ISLAMIC
ECONOMICS: Theory and Application

DOI: 10.1057/9781137544377.0001
 The Next Financial
Crisis and How to
Save Capitalism
Hossein Askari
and

Abbas Mirakhor

DOI: 10.1057/9781137544377.0001
the next financial crisis and how to save capitalism
Copyright © Hossein Askari and Abbas Mirakhor, 2015.
Foreword © Dr Vittorio Corbo, 2015.
Softcover reprint of the hardcover 1st edition 2015 978-1-137-54695-1
All rights reserved.
First published in 2015 by
PALGRAVE MACMILLAN®
in the United States—a division of St. Martin’s Press LLC,
175 Fifth Avenue, New York, NY 10010.
Where this book is distributed in the UK, Europe and the rest of the world,
this is by Palgrave Macmillan, a division of Macmillan Publishers Limited,
registered in England, company number 785998, of Houndmills,
Basingstoke, Hampshire RG21 6XS.
Palgrave Macmillan is the global academic imprint of the above companies
and has companies and representatives throughout the world.
Palgrave® and Macmillan® are registered trademarks in the United States,
the United Kingdom, Europe and other countries.

ISBN: 978-1-137-54437-7 PDF

ISBN: 978-1-349-50712-2

Library of Congress Cataloging-in-Publication Data is available from

the Library of Congress.
A catalogue record of the book is available from the British Library.
First edition: 2015
www.palgrave.com/pivot
DOI: 10.1057/9781137544377
 Contents
Foreword vi
Dr Vittorio Corbo
Preface viii
Acknowledgments x
About the Authors xi
1 The Financial Sector—In Support of
Growth or Financialization? 1
2 Recurring Financial Crises—The Causes 16
3 Recurring Financial Crises—The Fallouts 35
4 Recurring Financial Crises—The Essential
Reforms 47
5 Conclusions and Our Financial Future 63
Bibliography 73
Index 76

DOI: 10.1057/9781137544377.0001 v
 Foreword
A properly functioning financial system plays a central role
in the process of achieving a better allocation of resources
in a market economy. However, when the financial sector
becomes impaired, the consequences are severe. Now that
we are leaving behind the Great Financial Crisis, the worst
financial crisis of the past 80 years, we have to deal with
its side effects and consequences—high unemployment,
heavy debt burden, modest prospects for medium-term
sustainable growth—and to work on controlling the
excesses that facilitated the crisis. Although the causes of
the crisis are still heavily debated, there is agreement that
the set of factors that facilitated its occurrence include the
Asian economies’ savings glut (an ex-ante excess of
savings), China’s currency policy and its excessive reserve
accumulation, a period of low variability in growth and
inflation or the so-called Great Moderation, the sudden
collapse of the heavy-leveraged American housing market,
agency problems brought about by executive compensa-
tion policies, easy monetary policy after the dotcom crisis
of 2001–2002, excessively lax financial regulation, poor
supervision, government interference in financial markets,
the corrosive influence of greed, and a number of other
related factors.
Many of the mentioned factors are only symptoms, and
many of the proposed culprits only victims. It is true, for
instance, that the Great Moderation facilitated the develop-
ment of the crisis by lulling regulators and risk managers
into a false sense of security. But this is not very different
from stating that busts unexpectedly follow booms, or that

vi DOI: 10.1057/9781137544377.0002
 Foreword vii

night follows day. An observation can be both true and not at all informa-
tive about the underlying processes that govern a system. Distinguishing
the proper causes of the crisis is crucial if we are to draft more effective
rules for economic policy.
This highly readable book by Askari and Mirakhor is a welcome
addition to the study of the causes and consequences of financial crises.
In their view the fragility of the financial system was the result of the
“process of financialization and increased debt” that results from the
preeminence of interest-rate-based debt and the role of fractional
reserve banking, which together facilitate high leverage and constitute
the root cause of the financial boom before the crisis and the financial
crisis that followed. To reduce the probability of financial crisis, they
propose to move to a financial system that relies more heavily on risk-
sharing contracts and equity finance coupled with a banking system that
is closer to 100 percent reserve banking, as opposed to risk shifting and
interest-based debt and the highly leveraged (fractional) reserve banking
system that we have today.
The authors have advocated risk-sharing contracts for a number of
years. This, their latest contribution, is a very interesting and stimulating
book that extends the recent risk-sharing proposal of Mian and Sufi from
the financing of housing to most financial contracts in the economy.

Dr Vittorio Corbo
Professor of Economics, Pontificia Universidad
Católica de Chile, Senior Research Associate of the
Centro de Estudios Públicos (Santiago, Chile), and former
president of the Central Bank of Chile (2003–2007)

DOI: 10.1057/9781137544377.0002
 Preface
Today the United States is saddled with economic prob-
lems that are worse than anything it has experienced in
decades. Yes, national economic output is much higher
than it was after the Great Depression and even much more
so when compared to a century ago. Yes, the basic neces-
sities of life—food, shelter, healthcare, and education—are
more widely available. Yet there are underlying economic
problems, which, if not comprehensively recognized and
addressed, will undoubtedly get worse with potentially
catastrophic economic, social, and political consequences.
Today, for the first time in memory, the future just does
not seem bright for the vast majority of Americans and
their families, and polls claim that for the majority of
Americans the “American Dream” has become tarnished,
less credible, and increasingly unattainable.
The problems are interrelated and are, as a result, more
intransigent than problems that are not linked. The problems
are: (i) “financialization,” or the growing domination of the
financial sector over the real sector and their increasing diver-
gence; (ii) stagnant real incomes for the majority of Americans
since about 1980; (iii) growing income and wealth disparity;
(iv) a slowdown in economic growth for the foreseeable
future; (v) the adoption of a patchwork of financial reforms
where fundamental reforms are needed; and as a result (vi)
recurring serious financial crises that leave economic and
social devastation in their wake. We take a US perspective
on the issues at hand. Much of what we have to say, but by
no means all, is applicable in differing degrees to Western
Europe, but much less so to developing countries that have

viii DOI: 10.1057/9781137544377.0003

 Preface ix

an underdeveloped financial system. Still, in a few compelling instances, we

refer to the international dimension of the problems and policies.
The policy response to these problems has been to assess and exam-
ine one issue or problem at a time, develop limited solutions, use a
“bandage” approach to get over what is invariably labeled as a “bump”
in the road and to repeat the same process all over again in the future
whenever and wherever the next bump appears. But the bumps may be
getting bigger and thus becoming more difficult to bandage. Reaction
to economic and social problems, as opposed to comprehensive solu-
tions and foundational reforms, has become the easy road to take. Why?
Simply said, in the arena of finance and economics experts have become
too narrowly focused to see the full landscape, and more importantly the
rise of special interest groups has become so pervasive that the US federal
government and the elected politicians have become too timid to admit
the full extent of the socioeconomic problems the country faces, much
less propose comprehensive and essential reforms that could threaten
powerful interests, especially those who support their reelection.
Our goal in this short book is to present the interrelated facets of
our shared economic quagmire and the fundamental reforms that are
called for. We try to do this with little or no economic jargon and few
notes, with only the names of those whose ideas we have presented and
a bibliography of their writings for further reference. We believe that
our shared problems have not been presented as an interrelated whole,
much less with the needed and essential reforms explained in an easy-
to-understand language. We hope that this short book is informative and
eye opening so that we can individually decide where we stand and what
to demand of our elected officials when it comes to financial and related
economic reforms. In the concluding chapter we briefly sum up the
problems we face and their interrelationships, why conditions will likely
get worse before they could get better, outline the needed foundational
reforms, and the pragmatic reasons why foundational reforms may not
be easily forthcoming but only change in baby steps.
We have said much of this in different places for nearly a decade or so,
especially what we see as the essential reforms to our financial system. But
since others have started more recently to say some of the same things
and their views have received considerable traction, we thought it is now
an opportune moment in time to pull our thoughts together in one place
and state our contention in a concise, yet comprehensive, volume for the
concerned nonspecialists as well as for the open-minded specialists.

DOI: 10.1057/9781137544377.0003
 Acknowledgments
We are indebted to Professor Vittorio Corbo, one of the
most gifted macroeconomists of his generation and an
important contributor to Chile’s economic success, for
honoring us with a Foreword. Vittorio Corbo has done
it all—a stellar academic record, former president of the
Central Bank of Chile, World Central Banker of the Year
in 2006, and board member of Banco Santander SA in
Madrid during 2011–2014. We thank Professor Dariush
Zahedi, Professor Donald Losman, and Rodrigo Guimaraes
for their generous endorsements. We are grateful to Kelvin
Teo, Dohee Kwon, and Anna Askari for helpful comments
on drafts of this manuscript, but we are responsible for any
and all shortfalls and errors.

x DOI: 10.1057/9781137544377.0004
 About the Authors
Hossein Askari is Professor of International Business and
International Affairs at George Washington University,
USA. He has also served on the Executive Board of the
International Monetary Fund, as special advisor to the
Minister of Finance of Saudi Arabia and as intermediary
between Iran and Saudi Arabia and Iran and Kuwait.
Abbas Mirakhor is the first holder of the Chair of Islamic
Finance at the International Centre for Education in
Islamic Finance (INCEIF), Malaysia. He worked at the
International Monetary Fund for 23 years, where he was
a member of the staff, later a member of the Executive
Board and then as the Dean of the Executive Board.

DOI: 10.1057/9781137544377.0005 xi
 1
The Financial Sector—In
Support of Growth or
Financialization?
Abstract: A stable and efficient financial sector has an
essential role in support of the real sector to facilitate
mechanisms for an efficient allocation of financial and
real resources by funding the investments with the highest
social rate of return: mobilizing savings, identifying the
best business opportunities, financing these investments,
monitoring their performance and their managers,
enabling the trading, hedging, and diversification of
associated risks, and facilitating the exchange of goods
and services. Financial institutions, by pooling risk,
should be better positioned to analyze investments and
their associated risk-return profile and to monitor the
performance of investment projects. Our financial system
has achieved some of these goals but has also been
accompanied by recurring crises.

Keywords: finance; financialization; intermediation;

investment; risk; savings

Askari, Hossein and Abbas Mirakhor. The Next Financial

Crisis and How to Save Capitalism. New York: Palgrave
Macmillan, 2015. doi: 10.1057/9781137544377.0006.

DOI: 10.1057/9781137544377.0006 
 The Next Financial Crisis and How to Save Capitalism

Introduction

The primary role of a financial system is to create incentives and mecha-

nisms for the best allocation of financial resources with minimum waste
or maximum output (efficiency) in an economy through time. In other
words, an ideal financial system would facilitate the financing of the
“best” investments, or the investments with the highest social return
or payback, by identifying the best business opportunities, mobilizing
savings, funding these investments, monitoring the performance of the
selected investments and their managers, enabling the buying and sell-
ing ownership in these investments (trading), locking in a known return
(hedging), providing ways to diversify associated risks, and facilitating
the exchange of goods and services between producers and consumers
throughout the economy. Within a financial system, financial markets
(where buyers and sellers trade currencies and the three principal finan-
cial instruments, namely, stocks, bonds, and derivatives or contracts
whose value is derived from the performance of the asset on which it
is based) and banks facilitate the vital functions of raising capital and
channeling it to entrepreneurs and companies (capital formation), moni-
toring, information gathering, and facilitating the sharing of risk. To
the extent that financial markets perform these crucial tasks efficiently,
individuals are spared these responsibilities and the attendant costs of
channeling their savings into rewarding investments.
In further elaboration, an ideal financial system should perform a
number of functions. First, the system should facilitate the efficient
channeling of savings from savers to investors (financial intermediation)
to reduce information gathering and allocation costs for individuals by
spreading these costs among many individuals and providing them with
the broad range of financial instruments and investments that they seek.
It would be prohibitively expensive and wasteful for every individual to
analyze the attractiveness of investments and invest in such a way as to
get the type of investment that he or she wants (debt or shares, short
term or long term, and size of minimum investment). Intermediaries
can do all this on behalf of many individual investors by spreading the
cost of information gathering and reducing the fallouts of information
asymmetry between parties to an investment (adverse selection and
moral hazard) by better assessment of borrowers’ risk and subsequent
monitoring of borrowers’ performance. Moreover, as Crockett (1996)
noted commercial banks by pooling risk can afford depositors’ attractive

DOI: 10.1057/9781137544377.0006
 The Financial Sector 

returns as well as the ability to redeem their deposits quickly (enhanced

liquidity). Second, with increasing globalization and demands for finan-
cial integration, it is essential that the financial system offer efficient and
liquid markets for trading assets with short maturities (Money Markets)
and markets for channeling capital to governments, businesses and
individuals (Capital Markets). And third, the financial system should
provide a well-developed market for risk trading, where economic agents
can buy and sell protection against unforeseen developments such as fire
(event risk) as well as all forms of financial risks (such as sharp declines
in share prices and interest rates).
These functions ultimately lead to the efficient allocation of resources,
rapid accumulation of physical and human capital and faster technologi-
cal progress, all of which, in turn, stimulate economic growth. A sound
financial system should be stable, reduce uncertainty, and provide the
basis for rational decision making to stimulate savings and investment.
While stability is desirable, it must not impede price flexibility (such as
changing interest rates) that signals change to market participants but
avoid excessive volatility that emanates from excessive speculation and
uncertainty (Crockett). It should be evident that an efficient, sound,
and stable financial system would be essential for promoting savings,
funding the best investments and in turn fueling economic growth and
prosperity. Thus the financial sector should support the real economy to
function more efficiently, while providing a broad array of investment
instruments with different liquidity-risk-return profiles and a market for
trading risk.
In recent years, it has become widely recognized that debt, loans or
borrowing through interest-based contracts and a banking system that
creates money from deposits and bank lending invariably promotes a
phenomenon that has become coined “financialization,” resulting in
a growing divergence between the real and the financial sectors of the
economy, or in other words tethering the linkage between the real and
financial sectors. To the extent that the financial sector simply produces
more financial instruments and promotes their trading, it does not
perform its vital function of encouraging savings and funding the best
investments. If this were the case, then real economic growth would be
impaired. How can this decoupling of the real and financial sector come
about? Interest-based debt contracts have a tendency to shift risk onto
those who cannot manage it and the end result is excessive debt buildup
and widespread defaults; the borrowers can be individuals or businesses

DOI: 10.1057/9781137544377.0006
 The Next Financial Crisis and How to Save Capitalism

that borrow too much relative to their capacity to pay the contractual
interest payments and pay back the principal.
The conventional banking system, or what is commonly referred to as
fractional reserve banking with banks creating demand deposits (check-
ing accounts that is a form of money) and then lending a large portion
of their customers’ deposits, results in the expansion of the money
supply through demand deposit creation (a form of money as checks are
money) and creating more and more debt or what is generally referred
to as leveraging. Simply said, when a depositor deposits $100 in a bank,
he or she has access to the money in the form of check-writing capacity;
his or her money (dollar bills) is there but in the form of checks (or cash
if the depositor needs cash). The bank created money by giving checks
to the depositor and then lending out a large fraction (say 80 percent) of
the depositor’s cash; the borrower from the bank then deposits his or her
borrowed money in another bank, the bank issues a checking account
and then lends 80 percent of these new deposits; and the process goes
on and on. Note that the original depositor’s cash was transformed into
demand deposits (a promise by a bank to honor checks up to the amount
that is in the account) and the banking system created money by lending
the money that was entrusted to it for safekeeping.
But banks would like to lend out more and more in order to make
more profits. Their dreams were answered by the development of
complex financial instruments, such as derivatives or financial instru-
ments that derive their value from an underlying asset and securitized
debt or loans that are bought from a lender (such as a bank) and then
used to issue shares to investors with these loans as their backing. These
innovations further encouraged credit expansion (enabling banks to
lend even more) to outpace the growth of the real sector of the economy.
As financial assets are securitized and resecuritized (debts, such as mort-
gages, are bought from banks, packaged, and sold as new securities that
pass on the mortgage interest to the buyers of the created securities), the
banks get cash for their mortgages or car loans and then they lend their
cash out again. Disproportionate risks are transferred through deriva-
tive instruments, the connection between the financial and real sectors
becomes decoupled (the financial sector growing much faster than the
real sector), and an inverted credit pyramid is created where the liabili-
ties of the economy become a large multiple of real assets (the base of the
pyramid) that support them.

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 The Financial Sector 

Mismatched assets and liabilities are another characteristic of such a bank-

ing system. Namely, a bank’s loans are largely medium and long term but its
funding is short term, from checking and savings deposits and certificates of
deposit (CDs). Deposits are very short term because depositors can retrieve
their deposits at a moment’s notice and CDs are normally short or medium
term and can be cashed with a penalty. There is a mismatch because the
maturity of their loans is long term whereas the maturity of their funding
is short term. If depositors demand cash for their deposits, a bank can be
caught short as it cannot immediately liquidate its investments and call in
its loans to honor its commitment to depositors. Although the bank may be
still solvent, such a squeeze can pose a danger, requiring the government,
or a government agency, to step in and make cash available to banks on a
short-term basis. But price shocks can be more of a problem. For instance,
if a bank has made long-term loans and invested in long-term government
and corporate bonds, then with a sharp decline in the value of its loans
and investments (from a sharp decline in price or bankruptcy) it may be
insolvent as the liability side of the balance sheet is very slow to adjust while
the asset side has declined rapidly. Such mismatches create a potential for
instability that can spread rapidly through the interlocking connection of
financial institutions, with many institutions being both borrowers and
lenders exposed to the risk of rapid price changes and defaults. The result
can be an increase in the frequency, transmission and severity of financial
and economic crises, with the resulting economic crises being more severe
than ordinary recessions because the financial industry has a widespread
impact on all sectors, including households.
Between 1980 and 1995, 35 countries experienced some degree of finan-
cial crises. These were, essentially, periods during which their financial
systems stopped functioning and, consequently, the real sectors were
adversely affected leading to economic downturns or recessions. Recent
research on financial intermediation and financial systems has enhanced
our understanding of why the financial system matters and the crucial role
it plays in economic development and growth. For example, studies have
shown that countries with higher levels of financial development grow by
an additional 0.7 percent or so per year. Although strong evidence points
to the existence of a relationship between a well-developed financial
system that promotes efficient financial intermediation (through a reduc-
tion in information, transaction, and monitoring costs) and economic
development and growth, this linkage and the direction of causation is
not as simple and straightforward as it may at first appear.

DOI: 10.1057/9781137544377.0006
 The Next Financial Crisis and How to Save Capitalism

Financialization

Financialization means different things to different people. The 2007–

2008 financial crisis has been explained by some as a culmination of a
long process of “financialization” of the advanced industrial economies
that was left unchecked, despite numerous warnings during the previous
three decades. Financialization has been defined in various ways that
emphasize three basic elements or characteristics: (i) a significant expan-
sion of the financial sector relative to the real sector, such as increasing
the financial sector’s share of GDP, increasing the share of financial
sector profits relative to total corporate sector profits, higher rate of
return on equity in the financial sector relative to return in the rest of
the economy, and the like; (ii) a fast expansion of financial institutions
and products outside traditional banking and traditional instruments,
without which financialization could not have thrived; and (iii) an
expansion that was not beneficial to the broader economy and may have
even turned out to be harmful for longer-term economic growth. To
some observers, besides bringing on the worst financial crisis since the
Great Depression, the economic consequences of financialization may
also be summarized as: a drop in the share of wages and nonfinancial
profits in national income, a consequent drop in real capital investment
in the nonfinancial sectors of the economy, tepid economic growth of
the real economy, heightened speculation, increasing numbers of bank-
ruptcies and economic distortions, significant economic and financial
uncertainty, and increased social inequities including a worsening of
income and wealth distributions.
In the United States (and in other major Western economies) the finan-
cial sector has been partitioned over the past 30–40 years. The financial
system embraces on the one hand traditional instruments such as shares
and bonds, and on the other hand nontraditional instruments such as
financial derivatives. The system includes deposit taking by a traditional
banking, such as or commercial banking and nondeposit shadow bank-
ing, which includes money market funds, institutional investors, hedge
funds, mutual funds, private equity funds, mortgage companies, and
insurance companies. The competition for financial resources (such
as deposits) and for income opportunities between traditional and
unregulated financial intermediaries have become intense, leading both
segments of the financial system to devise innovations that increase
their access to resources and their income-earning assets, and at times

DOI: 10.1057/9781137544377.0006
 The Financial Sector 

promoting unwarranted speculation and risk taking on their own and

on their clients’ account.
Financialization has fueled an explosion of financial activities in the
form of nonregulated financial institutions and a phenomenal growth
of financial engineering and complex financial products, incorporat-
ing the power of creating money through debt (leveraging) with little
regard for its attendant risk. Besides its traditional and beneficial role
of intermediation between savers and investors, financial institutions
ventured into trading and speculating in risky financial instruments
on their own account (proprietary trading) and speculation and in the
process became dangerously overleveraged. Financialization has also led
to the development of shadow banking, securitized or parallel banking,
with the purpose of increasing the availability of resources for the tradi-
tional banking sector. This shadow banking includes: (i) bank conduits,
namely, special investment vehicles (SIVs), special purpose vehicles
(SVPs), and limited purpose finance corporations (LPFCs) and (ii)
securitizations that cover asset-backed securities (ABSs), asset-backed
commercial papers (ABCPs), residential mortgage-backed securities
(RMBS), commercial mortgage-backed securities (CMBS), auto-loans-
backed securities, collateralized loans obligations (CLOs), collateralized
bond obligations (CBOs), and collateralized debt obligations (CDOs).
Derivatives such as credit default swaps (CDSs) were invented in order
to spread credit risk and push traditional banks into higher risk lending
and related activities. Securitization has created derivatives based on
existing debt with the purpose of increasing lending activities. However,
securitization has also turned into the practice of selling toxic loans to
investors using fraudulent practices. Opacity has replaced transparency
and investors can no longer know the “fair” price of the securities they
are buying or selling.
In short and more broadly, financialization is a process whereby finan-
cial markets, financial institutions and financial elites gain greater influ-
ence over economic policy and economic outcomes. Financialization
transforms the functioning of economic systems at both the macro and
micro levels. Again, its principal fallouts are to (i) elevate the significance
of the financial sector relative to the real sector; (ii) transfer income
from the real sector to the financial sector; and (iii) as a result increase
income and wealth inequality and contribute to wage stagnation. In
addition, there are reasons to believe that financialization may put the
economy at risk of debt deflation and prolonged recession. To Epstein

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 The Next Financial Crisis and How to Save Capitalism

(2005) financialization refers to the increasing importance of financial

markets, financial motives, financial institutions and financial elites in
the operation of the economy and its governing institutions, both at the
national and international level. Krippner (2005) defined financializa-
tion as a pattern of wealth accumulation in which profit making occurs
increasingly through financial channels rather than through trade and
commodity production. Palley (2007) contended that the notion of
financialization covers a wide range of phenomena: the deregulation of
the financial sector and the proliferation of new financial instruments,
the liberalization of international capital flows and increasing instability
in foreign exchange markets, a shift to market-based financial systems,
the emergence of institutional investors as major players on financial
markets and the cycle of boom and bust on asset markets, shareholder
value orientation and changes in corporate governance of nonfinancial
business, increased access to credit by previously “underbanked” groups
or changes in the level of real interest rates.
We add that when a financial sector is dominated by interest-rate-
based debt contracts, the financialization process creates more and
more debt as it expands throughout the economy, converting equity in
real assets into debt. This was the case in the early stages of the housing
boom in the United States where excess liquidity and low interest rates
created an incentive for homeowners to cash out equities built up in their
homes through refinancing, commonly referred to as home equity line
of credit and loans. The cashed-out equity was largely used to support a
consumption boom and masked the stagnating income growth among
middle-class households. By emphasizing debt multiplication and relax-
ing credit standards, financialization has led to rapidly growing corporate
debt-to-equity ratios and household debt-to-income ratios; acceleration
of dominance of the financial sector relative to the real sector; income
transfer from the real sector to the financial sector; deterioration of
income distribution and increased income inequality; and changes in the
orientation of the economy from saving-investment-production-export
orientation to one of borrowing-debt-consumption-import orientation.

The growth of financialization

A number of interrelated factors have promoted financialization in

the United States, including financial deregulation, lax supervision

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 The Financial Sector 

and enforcement, implicit government subsidies, and accommodating

monetary policies.
Financial deregulation in the form of the Gramm-Leach-Bliley Act (also
referred to as the Financial Services Modernization Act) in 1999 opened
the floodgates of the “anything goes” mentality in the financial sector.
Principally, the Glass-Steagall Act was repealed, enabling commercial
banks, investment banks, and insurance companies to form any combi-
nation of these activities, hitherto separated by a wall. For example, this
allowed commercial banks to take investment banking risk and invest-
ment banks to accept deposits. As the financial sector became deregu-
lated, supervision and enforcement, which should have become more
vigilant, became instead more relaxed. A number of financial entities took
unwarranted risks and leveraged their capital to unprecedented multiples.
The assumption of risk was in part promoted by the emergence of higher
funding costs as non-interest-bearing bank deposits were increasingly
supplanted by interest-bearing deposit options (such as money market
funds) for depositors and the resulting competition for funding. At the
same time, as low interest rates reduced banking profits, banks took on
more risk to enhance revenues, in part by taking greater risk with their
own capital and relaxing their prudential lending standards.
While a modest level of calculated risk might have been tolerated,
financial institutions resorted to excessive risk taking and unethical
financial practices to increase their profits. Although these practices may
have temporarily increased the profits of financial institutions, threat-
ening the stability of the entire financial system, governments allowed
all manner of financial mergers to create mega institutions and then
provided them an implicit subsidy to balloon their profits even more.
The subsidy afforded to the large financial institutions is embedded in the
notion that there are firms that can be classified as “too big to fail.” This
implicit subsidy, guaranteeing the solvency of some financial institutions
no matter the level of risk they assumed, created moral hazard (encour-
aged financial institutions to take on excessive risk because the fallout
would be absorbed by the government), had the effect of reducing the
funding costs of these institutions (as lenders thought them safe because
of government backing) and creating an important barrier to market
entry for new institutions, and thus in the process reducing competition
in the financial sector. As a result of these and other risk-taking practices,
for example, the return to equity achieved by British banks increased
from an average of 7 percent between 1921 and 1971 to an average of

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 The Next Financial Crisis and How to Save Capitalism

20 percent since that time (The Economist, June 30, 2010). In addition,
many categories of financial institutions, such as hedge funds (a financial
vehicle funded by private capital, outside the regulatory structure and
engaged in diverse financial activities to take advantage of discrepancies
across markets) escaped all regulations, while benefiting from the same
subsidy. In the case of hedge funds, in addition to escaping regulation
and receiving the protection of “too big to fail,” they have received pref-
erential tax treatment in the United States, with the managers of hedge
funds and private equity firms allowed to treat a significant part of their
compensation as capital gains (taxed at 15 percent) as opposed to ordi-
nary income (taxed at 35 percent). The special treatment of the financial
industry in the United States and attendant benefits were promoted and
protected by the intense lobbying of the financial services industry.
A defining feature of financialization has been an increase in the
volume of debt through proliferation of unregulated intermediaries
and rapid expansion in the trading of derivatives. There has been no
apparent, or perceived, limit to the increasing ratio of debt to GDP, as
if higher and higher levels of debt could be easily serviced. In other
words, a savings rate, say at 10 percent of GDP, could service any level
of debt that could be many times the size of GDP. Data for the United
States shows that nonfinancial sector debt rose from 140 percent of
GDP in 1978 to 243 percent of GDP in 2009. Household debt rose from
48 percent of GDP in 1978 to 95 percent of GDP in 2009, after peaking
at 98 percent of GDP in 2007. The debt of the financial sector ballooned
from 18 percent of GDP in 1978 to 110 percent of GDP in 2009. The finan-
cial sector debt represents nondeposit liabilities of financial institutions.
It represents essentially bonds, securitized assets, and commercial paper
issued by financial institutions. And the total debt of the nonfinancial
and financial sector rose from 158 percent of GDP in 1978 to 353 percent
of GDP in 2009. Simply imagine an individual with a fixed and limited
wealth and income taking on more and more debt. As the debt grows,
so do the payments to serve the interest on that debt. But if income does
not grow at least commensurately, then the debt cannot be serviced. It is
that simple.
Such an expansion of interest-based debt changed macroeconomic
equilibrium in a very profound way and caused widespread distortions
in the broader economy. For example, the increasing assumption of debt
enabled households to spend far above their incomes. Consumption,
both public and private, rose at very high rates. Data for the United

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 The Financial Sector 

States showed that household savings rates fell to close to zero in 2007,
while net national savings, defined as savings of households, business,
and government, excluding depreciation charges, became negative in
2009, at about 2.5 percent of GDP. The difference between consumption
and national output of real goods and services required external borrow-
ing. Thus the United States’s current account deficit (net borrowing from
abroad) widened to 6–7 percent of GDP during 2005–2007, remained at
4 percent in 2009, and was expected to be ominous for the United States
for many years into the future (Bergsten, 2009).
At the macroeconomic level, the era of financialization has been asso-
ciated with generally tepid economic growth. Gross investment spending
as a share of GDP has exhibited a declining trend. When “speculation
dominates enterprise” as Keynes put it, investment is often poorly allo-
cated and society is poorly served. Consequently, real economic growth
has slowed down in most industrial countries, with a long stagnation
in countries that used to be strong growth performers such as Japan.
Subsequent to the financial crisis, real economic growth became nega-
tive in most industrial countries. The financial and the real sector have
significantly parted ways some time ago. Today there is little association
between the growths of the two sectors, while the financial sector has
become preeminent.
Another inherent feature of financialization is speculation and
ensuing bubbles, both supported by a loose monetary policy. Without
speculation and high price volatility, financial intermediaries cannot
easily extract profits from the real sector. The unlimited expansion of
debt and credit led to pressure on prices, particularly on asset prices
such as stocks, housing, and commodities. The demand for goods
and assets has been financed by abundant credit at low interest rates,
not from income, with the result that pressure built up in asset prices.
Thus financialization has also been associated with destructive bubbles
in the 1980s, 1990s, and 2000s. Key factors leading to these bubbles
were: (i) as postulated by Keynes and Minsky, the inherent nature of
financial markets leads to speculation, herding (individuals adopting a
group’s behavior), and instability; (ii) the increasing importance of the
privatization of the savings system leads individual investors to search
for higher returns and take on riskier investments and increases their
susceptibility to rumors and misinformation; (iii) the increasing role of
institutional investors and mutual funds that increase the concentration
of information and incentives for herding; (iv) the “Greenspan put,” by

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 The Next Financial Crisis and How to Save Capitalism

which the Federal Reserve appeared to place a floor under equity prices
by injecting more money; (v) the rising power of the Wall Street financial
industry with the ability to influence regulatory and central bank policy;
and (vi) macroeconomic theory that also supported the optimistic view
of financial markets (Brainard and Tobin, 1977).
In the early stages of the growth of a debt-dominated financial system
there is a tenuous relationship between financing and real sector invest-
ment as entrepreneurs compare the expected rate of return to the invest-
ment project and the rate of interest, namely, the difference between
their expected return on investment and their cost of capital or interest
expense. As financialization proceeds and debt securitization grows in
sophistication, the relationship becomes progressively less important.
The overwhelming dominance of finance over the real sector can be
discerned by noting that the ratio of global financial assets to the annual
global output of goods and services grew from 109 percent in 1980 to
316 percent in 2005. Similarly, while the total world GDP was about $48
trillion in 2006, the value of global financial assets in the same year was
$140 trillion (nearly three times as much). As of 2007, the global financial
liquidity market was estimated to be 12.5 times global GDP, with financial
derivatives constituting about 80 percent of this liquidity.
The warning signs of an eventual implosion were around long before
the recent crisis of 2007–2008. Indeed, five years before the event, the
financial innovations of the 1990s had led to mobilization of financial
resources as well as the equally impressive growth of debt contracts and
instruments. A comparison of aggregate debt (sovereign, corporate, and
household) to the production and capital base of the global economy
reveals an inverted pyramid of huge debt piled up on a narrow produc-
tion base of real goods and services that is supposed to generate income
flows that are to serve this debt. In short, this growth in debt has nearly
severed the relationship between finance and production of goods and
services. The succeeding five years made this picture far more ominous
as debt grew further with a growth rate that dwarfed the growth of global
real economic output.
In short, financialization has transformed productive economic
activities to pursuits that resemble participation in a gambling casino, as
Keynes remarked, which use real resources but produce no real output
and no productive investment (Hirshleifer, 1971). Such an economy
produces “rolling bubbles” in financialized assets. As one bubble bursts,
finance moves to another. Such has been the case over the past three

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 The Financial Sector 

decades, as bubbles were created and then imploded in emerging market

debt, dotcom, real estate, and commodities markets. Investments in real
productive activities were not the primary objective of debt and credit
expansion in any of these financial bubble-building episodes. It was the
expectations of higher prices of financial assets that attracted participants
by the droves as they speculated to build bubbles that were destined to
burst. That this would happen was analytically demonstrated as early
as the 1980s. For example, Flood and Gerber (1980) demonstrated that
rational individuals participate in asset price bubbles if they expect rising
asset prices. Growth in liquidity, low interest rates, higher leverage, and
rapidly expanding credit, combined with regulatory-supervisory forbear-
ance and passivity, accelerate the emergence and growth of bubbles.
The process of financialization may have also in part been facilitated
by the demise of gold standard with fixed exchange rates between
currencies and the adoption of flexible exchange rates. Reserve currency
countries (whose currency is accepted by other countries as a reserve
asset) could print more money and run external deficits without losing
real resources. In turn, the surplus of foreign countries is reinvested in
the reserve currency countries (predominantly the United States) in
the form of bonds and shares and constitutes a basis for further credit
expansion. As reserve currency countries ran large deficits, principally
the United States in the financial crisis that erupted in 2007, banks had
to devise innovations to create credit and push more debt to consumers
and corporations.
The financialization process has gained momentum in a number of
advanced countries in addition to the United States. In large part because
of the rapidly rising international capital mobility after the demise of the
Bretton Woods system of exchange rates (a gold exchange standard with
fixed exchange rates) and the absence of capital controls, financial insti-
tutions, sovereign wealth funds, and ordinary investors became inter-
connected through a web of debt, securities and cash flows. Debt was
pushed not only on households and corporations in the United States
but also on households, corporations, and governments in a number
of other advanced economies. Equity and housing bubbles developed
in many countries. Many banks around the globe bought derivatives
such as mortgage-backed securities, and with the outbreak of the crisis
a number of large European banks incurred significant financial losses
in the form of toxic assets, deposits, and loans at failed banks in the
United States. The fast depreciation of toxic securities inflicted losses on

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 The Next Financial Crisis and How to Save Capitalism

sovereign funds and banks outside of the United States. The contagion
of the crisis was fast and deep. A number of banks in Europe, Japan,
and emerging market countries had to be bailed out by their respective
central banks and governments. The failure of investment banks, most
prominently Lehman Brothers, and the ensuing credit crunch curtailed
trade financing, adversely affecting the real economy.

Conclusion

A stable and efficient financial sector has an essential role in all economic
systems, namely, in support of the real sector of an economy to facili-
tate incentives and mechanisms for an efficient allocation of financial
and real resources by funding the investments with the highest social
rate of return: identifying the best business opportunities, mobilizing
savings, financing these investments, monitoring their performance
and their managers, enabling the trading, hedging, and diversification
of associated risks, and facilitating the exchange of goods and services.
An important facet of efficient financial intermediation is the ability
to reduce the problems associated with what economists have labeled
as “asymmetric information” that leads to adverse selection (among
economic and financial choices) and moral hazard (motivated to act
irresponsibly, for example, if an individual owns a fully insured home,
there is less incentive to take measures to prevent theft or fire, or when
a bank is assured of government bailout it has more incentive to take
on excessive risk). Thus financial institutions, by pooling risk, should
be better positioned to analyze investments and their associated risk-
return profile and to monitor the performance of investment projects.
Our financial system has achieved some of these goals but has also been
accompanied by recurring crises and has brought about the “financiali-
zation” of our economic system.
Financialization has been an important part of the dramatic growth in
finance over the past 40 or so years and is defined as an overexpansion
of the financial sector relative to the real sector, which in turn has turned
out to be a drag on the real sector. It has unraveled the inherent instabil-
ity of finance. It has illustrated the power of the financial system to create
money, push debt, and create bubbles and volatility in the quest to earn
greater returns and profits. It has created distortions in the economy
that have led to changes in income distribution in favor of the financial

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 The Financial Sector 

sector and long-term economic stagnation as exemplified in Japan and

in the drawn-out recession in the United States and in Europe. By creat-
ing speculative bubbles in assets and commodity markets, the financial
sector has become more apt to excise real income at the expense of the
real sector. The profits of the financial sector have remained private and
its losses have been socialized through government and central bank
bailouts. The financialization phenomenon has been supported by a vari-
ety of implicit and explicit government subsidies, financial deregulation,
lax supervision and enforcement, and bailouts that have encouraged
risk taking and moral hazard. Financialization has had an international
dimension through its propagation to leading industrial countries as
well as emerging countries.
A number of trends associated with financialization have caused
concern, including rapidly growing, unsustainable and unproductive
debt, a fall in nonfinancial sector shares in national income, grow-
ing income and wealth disparities, and stagnant growth of per capita
income. More regulation has been proposed as a way to tackle the unde-
sirable effects of financialization: regulating the unregulated financial
institutions, regulating derivatives, imposing special taxes on the profits
of financial institutions, and prohibiting proprietary trading. But as we
hope to show, simple changes in regulations may not be enough where
more foundational reforms are needed. At the same time, central banks
may have unknowingly promoted financialization through rapid money
creation and a prolonged period of low interest rates.

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 2
Recurring Financial
Crises—The Causes
Abstract: A financial crisis is manifested as a crash in any
number of asset prices or as a banking crisis and a freezing
of credit. These crises have serious economic fallout—sharp
and prolonged decline in economic output and a spike in
unemployment—as an impaired financial system spares no
sector of the economy and deleveraging takes time. There
is no shortage of explanations for financial crises: moral
failure, fraud, Ponzi schemes, lax regulations, supervision
and enforcement, prolonged period of low interest rates,
government bailouts of “too big to fail” institutions
enabling excessive risk taking, economic shocks, animal
spirits, rapid rise in debt, and the list goes on. To our mind,
the real culprits of financial crises are (i) preeminence
of interest-rate-based debt contracts and (ii) fractional
reserve banking.

Keywords: asset bubbles; contagion; debt; financial crises;

interest; leverage

Askari, Hossein and Abbas Mirakhor. The Next Financial

Crisis and How to Save Capitalism. New York: Palgrave
Macmillan, 2015. doi: 10.1057/9781137544377.0007.

 DOI: 10.1057/9781137544377.0007
 Recurring Financial Crises—The Causes 

Introduction

Throughout history, recurring financial crises have been a feature of

the economic landscape. Although financial crises are not all exactly
the same, they share some common characteristics. Their fallouts are
generally more devastating than those of standard economic recessions
because finance is important for every sector of the economy and thus
no sector of the economy is spared. Financial crises are accompanied by
severe and prolonged economic downturns, high unemployment, slow
economic recovery, and, invariably, big losers and winners. Moreover, it
takes time to unwind (deleverage) the accumulated debt that brought on
the crisis. In the throws of economic pain there is much posturing and
talk of reform and better regulations and supervision, and yet very little
is ever learned or fundamentally changed in the aftermath of the crisis.
The 2007–2008 financial crisis has been aptly coined the “Great
Recession.” Since its onset and the resulting economic downturn—the
significant drop in US economic output, high and stubborn unemploy-
ment, economic stagnation, slow economic recovery, and the prediction
that slow growth would be the new normal for years to come in the
United States and in much of Western Europe (as their financial systems
are closely linked to the US system)—there has been increasing debate
over the causes of financial crises. The debate has focused on the role of
debt or interest-rate-based lending in fueling financial crises. The idea
that debt or credit may be the most important reason for financial crises
has been around since the writings of Keynes in the 1930s and in the
post–World War II era it was revived by Charles Kindleberger’s pioneer-
ing 1978 book, followed by Minsky, and more recently by the research of
Reinhart and Rogoff and Mian and Sufi. The central message that seems
to be emerging is that all financial crises have been driven by rapid
growth in debt (some focusing on public debt, others on private debt,
and a few on total debt) to unsustainable levels and no matter what label
(such as currency or banking crises) is assigned to them they are at their
core debt crises. Rapid growth in debt cannot be supported and financed
by a real economy that grows at a much slower pace. While we have said
this and more for nearly ten years with little acknowledgment, we are
delighted that at least now others are coming around to the same way of
thinking and this may be an opportune moment to present our thinking
in a form and format that may appeal more readily to nonspecialists as
well as to specialists.

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 The Next Financial Crisis and How to Save Capitalism

The debate has also shifted somewhat from analyzing the “what
happened” and the “why” of the credit crisis to questioning the entire
edifice of the economic and financial ideas developed since World War II.
This has led to new insights as to the foundational role of interest-rate-
based debt financing and the structure of a banking system, whereby
banks create money (as banks issue demand deposits, a form of money)
by keeping a small fraction of their deposits as reserves and lending the
balance and in the process assuming great risk. Extensive research has
provided empirical support for the views of Kindleberger, Keynes, and
Minsky, that debt financing creates instability in the form of cyclical
behavior of boom and bust. While there is still much convincing to be
done in the face of powerful special interests, there may be the begin-
ning of a convergence to the belief that our financial system is fragile
because of the preeminence of interest-rate-based debt and the role of
fractional reserve banking, which together facilitate high leverage and
constitute the root cause of financial crises in our contemporary market
capitalist system. In other words, rapid growth in interest-based debt is
the precursor to bubbles (in stock prices, real estate, and other assets)
and to widespread or systemic bankruptcies. The reason why debt (and
thus debt contracts) is seen to be at the heart of widespread bankrupt-
cies is that debtors assume excessive risk (risk that they cannot manage)
and when their ventures fail they ignite a chain reaction of defaults that
bring down lenders who are in turn also debtors and highly leveraged
themselves.

Definition and the varied explanations for

the causes of financial crises

A financial crisis could be envisaged as a crash in any number of asset

prices, such as real estate, stocks, gold, and numerous of other commodi-
ties, following a speculative asset boom or as a banking crisis that ensues
on the heel of a liquidity shortage and an impairment of bank assets. A
financial crisis causes defaults and bankruptcies that adversely affect the
banking system, is followed by the financial ruin of depositors (to the
extent that they do not have deposit insurance) and companies, and a
sharp decline in economic activity and employment. A web of cash flows
and money incomes links banks, firms, and consumers, as the spending
of one is the income of another. Contagion (transmission and spreading

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 Recurring Financial Crises—The Causes 

of financial volatility and risk) in financial sector is enhanced because

of interlocking claims and liabilities, and information asymmetry limits
the ability of creditors to judge risk. The risk of contagion and the wide-
spread damage of financial crises are the two principal reasons calling
for government vigilance towards regulations, supervision, and enforce-
ment (Crockett, 1996). Default by some economic agents may freeze the
payments system and trigger general default and loss of incomes. Banks
may face default on their loans and sharp depreciation of their assets
or a sudden and massive withdrawal of deposits, and as a result may
be unable to settle their liabilities. During financial crises, banks may
suspend redemption of deposits and have to be bailed out or simply fail
and close their doors.
Three mainstream explanations for major financial crises and their
ensuing fallout are: (i) a major economic shock (e.g., natural or political
disaster) that causes losses that are transmitted throughout the economy
and in turn bring on a crisis; (ii) a general credit freeze (banking crisis)
whereby banks are reluctant to lend because of heightened risk or
impaired balance sheets; and (iii) “animal spirits”—irrational exuberance
and beliefs that drive up asset prices into the bubble zone, with greed
overwhelming fear. But this is only the tip of the iceberg. The diagnoses
of the causes of financial crises have been more numerous and are truly
diverse; often causes are analyzed as effects and effects are analyzed as
causes, as well as symptoms being confused with causes.
Financial crises have been blamed on: the shock from bad harvests
as in the case of England in 1847, resulting in large gold outflows to
finance food imports; traders in stock markets and their manipulations
of stock prices, “talking up” stock returns to push stock prices to high
speculative levels, as was the case of South Sea Company in England in
1720 and the Mississippi Company in France in 1720; numerous swindles
such as the banking panic of 1907 that was precipitated by an attempt to
corner stocks, with the failed effort depressing share prices by a further
50 percent in 1907, inflicting losses on banks, and precipitating a run on
banks; and speculation, such as the case of the Barings Bank (1762–1995),
which fell in 1995 because of the lack of sufficient internal controls. Marx
(1894) attributed financial crises to low wages for labor and large surplus
value for capitalists and entrepreneurs. Low-wage incomes would not
enable labor to buy the output of goods being produced, leading to
overproduction. Owners of capital would stimulate the working class to
buy more and more of the expensive goods, houses, and durable goods,

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 The Next Financial Crisis and How to Save Capitalism

pushing them to take on more and more expensive credits, until their
debt becomes unbearable. The unpaid debt would lead to bankruptcy of
banks and thus to a financial crisis.
Still others, which included a number of renowned economists, such as
Thornton (1802), Ricardo (1817), Marx (1894), Wicksell (1898), and Hayek
(1931), pointed to an extended period of low interest rates as the catalyst
for financial crises. Thornton and Wicksell developed the doctrine of two
interest rates, the money market rate and the natural rate of interest. The
natural rate is the rate of profit or return in relation to invested capital, and
depends on innovation, factor (labor, land, and other inputs) prices, and
product prices, and may rise and decline with a change in these factors.
The money rate of interest is the cost of borrowed capital. The rate of profit
cannot be observed and can only be estimated. On the one hand, if the
rate of profit exceeds the interest rate, the demand of credit will expand,
leading to a credit and economic boom, and prices will rise, setting off a
cumulative inflationary process. On the other hand, when interest rates
rise above the rate of profit, because of tighter money or simply a fall in
the rate of profit, the demand for credit contracts and prices may decline.
Keynes (1936) advanced the notion of marginal efficiency of capital.
When the marginal efficiency of capital is higher than the interest rate,
investment demand expands, as does the demand for loans to finance the
higher level of investments. When the marginal efficiency of capital falls
below the rate of interest, the demand for credit contracts.
Many economists have argued that an extended period of low inter-
est rates can stir a credit boom (borrowing binge), leading to rising
economic growth, and then to rising prices before the onset of a finan-
cial crisis where borrowers cannot meet their debt payment obligations
and thus default. For instance, the Great Depression was preceded by
an epoch of low interest rates in the United States and England. Interest
rates fell from 8 percent in 1920 to 3 percent in 1924 and remained low
thereafter. Low interest rates reduce the cost of borrowing and thus
the cost of speculation. Thus an extended period of low interest rates
encourages speculation and as asset prices rise the herd instinct kicks
in as everyone wants to get in on the action. Moreover, as low interest
rates reduce the income of institutions and individuals who rely on fixed
income revenues, they are encouraged to take on more risk in order to
increase their revenues and incomes.
The recent financial crisis has produced its own share of explanations
for the causes of such crises. Some have blamed financial regulators for

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 Recurring Financial Crises—The Causes 

being asleep on the job as events unfolded. Many experts and politicians
have faulted bankers and financial markets such as hedge funds, mutual
funds, and equity funds for excessive risk taking and the inability of regu-
lators to understand, much less regulate, complex financial derivatives.
Securitization (packaging securities such as mortgages, credit card debt,
or automobile loans and issuing a new security that is represented by
these and other underlying securities, with the income from these loans
passed on to the buyers of the created securities) of illiquid assets such
as mortgages and multiplication of derivatives in a deregulated financial
industry were faulted for debt trading, excessive leverage, and a highly
inflated credit pyramid. Some have attributed the crisis to the increasing
number of institutions that were deemed “too big to fail,” which were
motivated to take on excessive risk knowing that they would be bailed
out in case of temporary liquidity problems and even insolvency because
of the danger attributable to the systemic damage that their failure would
ignite. Others have faulted the credit rating agencies for their incestuous
relationship because they are paid by the entities they rate; and some of
these agencies gave high credit rating to financial securities that were
junk. Still others (Gorton, 2010) put the blame on the run on banks, not
by individual depositors, as in past crises, but by institutional investors
in what he calls the parallel banking sector, with credit quality concerns,
in turn, motivating banks to withdraw from the interbank loan market.
Still others, most notably Ben Bernanke, the former chairman of the
US Federal Reserve, have argued that the crisis was a consequence of
large global macroeconomic imbalances and large savings held by the
emerging markets. The latter was itself a consequence of the financial
crisis of 1997–2000 in the emerging markets. During the crisis, these
emerging economies experienced firsthand the absence of an effec-
tive and representative global lender of last resort that could provide
balance of payment support fairly and adequately during the crises.
Consequently, they protected themselves against future occurrence of
crises by accumulating large reserves, a significant portion of which was
invested in government bonds issued by industrial countries, especially
the United States. This, in turn, led to low-, medium-, to long-term inter-
est rates, a huge expansion of debt, and rapid expansion of liquidity in
search for higher yields. Increased liquidity led to an aggressive incentive
structure for the promotion of financial innovations and engineering of
complex, opaque financial instruments. The design of instruments and
their packaging were engineered such as to create an illusion that they

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 The Next Financial Crisis and How to Save Capitalism

possessed risk-return characteristics that were more attractive than the

risk exposure attributes of their underlying assets. This process encom-
passed the entire spectrum of activity, design, origination, packaging,
trading, distribution, wholesale, and retail. Increased global demand for
financialized assets led to increasing prices for these paper assets that had
little or no connection to the real sector of the economy, thus validating
expectations of ever-increasing asset prices. Higher asset prices validated
expectations of ever-increasing asset prices and the creation of a full-
blown asset bubble. Interconnected international asset markets ensured
the spread of the US-originated crisis rapidly and globally through the
contagion process.
We now turn to three other explanations for the cause of financial
crises in more detail.
1 Keynes-Chicago Plan-Minsky
Evidence surveyed in many studies showed that every economic and
financial crisis was preceded by an expansion of credit. For example,
Irving Fisher (1933) argued that overindebtedness precedes major finan-
cial crises as enterprises borrow and expand capacity on the basis of
expectations of higher profits. Credit expansion is a multiplicative proc-
ess as the fractional reserve banking system creates money in the form
of demand deposits. If a person deposits $100 in a bank, the bank would
lend the $100 to earn interest income. But it has to keep a fraction (say
20 percent or $20) in what is called required reserves and can lend the
balance ($80). Thus the bank has created $80 of new money. A person
who receives credit of $80 will not keep it idle while paying interest. The
borrower will either spend it on consumption or invest it with the hope
of earning profits. The recipient of the borrowers of $80, namely, seller
of goods and services or a provider of assets, will deposit the proceeds in
a bank. Hence, the loan becomes a deposit in another bank and creates
excess reserves and the bank will make new loans and repeat the process,
making new loans and reducing their excess reserves. Thus credit expan-
sion takes place through what is referred to as the credit multiplier, or in
other words banks can create money in the form of demand deposits by
lending, with the reserve requirement limiting how much they can lend
and thus limiting their money creation ability. Credit expansion may
be accompanied by an economic boom and speculation. Both lead to
higher demand for credit and renewed credit multiplication. Banks then
use all available innovations to increase the volume of credit to increase

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 Recurring Financial Crises—The Causes 

their profits. They use the innovation of securitization to increase their

lending without relying solely on traditional depositors’ money. Banks
gain through loan commissions and fees and on interest rate differentials
between issued loans and issued securities.
The alternative perspective maintains that crises are internally gener-
ated (endogenous) instability episodes that inevitably arise from the
basic debt-credit-interest rate relation. Fractional reserve banking (banks
lending their deposits and keeping a fraction as reserves) and its close
relatives—in the form of money market funds and hedge funds, plus
other financial innovations operated by highly leveraged institutions—
ensure that the credit and debt creation process is amplified manifold
during the upswing phase of the financial cycle, to lead to asset bubbles.
The process works in reverse during the downswing phase, leading to a
credit crunch once the bubbles burst.
The view that the fractional reserve system is a source of instability—
creating a financial system dominated by interest-rate-based debt
in which the credit multiplier and leverage ratio mechanisms are
operative—found its most forceful expression during the years of the
Great Depression. This recognition led a major group of American
economists, including Irving Fisher (one of America’s greatest econo-
mists of all time), to submit the Chicago Reform Plan to President
Roosevelt but it was not implemented. This proposal required banks to
hold 100 percent reserves against deposits. The Plan claimed four major
advantages: (1) much better control over the major sources of business
fluctuations—sudden increases and contractions of bank credit and the
supply of bank-created money; (2) complete elimination of bank runs
fueled by illiquidity, insolvency, and rumors; (3) dramatic reduction of
the (net) public debt; (4) dramatic reduction of private debt, as money
creation no longer requires simultaneous debt creation. Recently, Benes
and Kumhof (2012) found support for all four claims. Moreover, they
found that the Plan would lead to an output gain approaching 10 percent
and that the inflation could drop to zero without resulting in a problem
for policymakers.
Whereas these American economists viewed the fractional reserve
banking system and its power of credit (debt) creation as the source of
financial instability, Keynes saw another deeper problem. He argued
that market capitalism, left alone, was inherently unstable. The core
of this argument maintained that the real phenomena of saving and
investment came from two different subsectors of the real economy:

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 The Next Financial Crisis and How to Save Capitalism

consumers and businesses. They save and invest for different reasons.
Their coordinated behavior is subject to uncertainty and even under the
best of circumstances their equality cannot be assured. The existence of a
financial system dominated by ex-ante fixed interest rate debt contracts
(a promised rate of interest to the lender in the face of uncertain future
returns that the invested funds would bring) exacerbated this coordina-
tion problem. Since the equality of saving and investment cannot be
assured, the emergence of unemployment and inflation are likely. Not
only could the equality of saving and investment not be guaranteed
because of the coordination problems, but also it was likely that not
all savings would be channeled into productive employment-creating
investment. This, Keynes argued forcefully, in his famous book General
Theory of Employment, Interest and Money (1936), was because of the
role of interest in creating a wedge between savings and investment. He
viewed interest as “rents” and those who demanded it as “rentiers.”
Keynes was neither the first nor the only economist to hold such views.
Nor was the expression of the concept confined to the twentieth century
(Ferguson, 2008). However, it was Keynes who made the relationship
between interest-rentier and the lack of coordination a centerpiece of
his explanation for why market capitalism was unable to achieve full
employment. Moreover, he argued that the rentier-interest rate relation
was responsible for another “evil” of capitalism. Keynes not only states
that “Interest today rewards no genuine sacrifice” (1936, p. 376), but
its compounding leads to wealth accumulation at an accelerated pace,
without the commensurate risk or work. This tilts income and wealth
distribution toward the rentier (more on this in the next chapter). So
convinced was Keynes of the detrimental role of the predetermined fixed
interest rates that he suggested that although unemployment and poor
income and wealth distribution were two “social evils,” the real “villain
of the piece” creating both, as well as inevitable instability that followed,
was the rentier class that finds advantage in holding liquid assets rather
than risking their holdings in employment-creating investment. They
would part with them only if they could loan them in the form of
iron-clad debt contracts that guarantee full repayment of principal and
interest. The solution he offered was the “euthanasia of the rentier.” This
was to be a gradual process that “will need no revolution” but could be
achieved by “socialization of investment” (Keynes, 1930, 1936).
One of the most perceptive, productive, and astute followers of
Keynes was Hyman Minsky, who used the Keynesian foundation to

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 Recurring Financial Crises—The Causes 

produce valuable insights into the workings of financial capitalism. As

did Keynes, Minsky considered such a system in which debt dominates
as endogenously and endemically unstable. Indeed, he argued that in
a debt-dominated financial system of contemporary capitalism, the
structure itself amplifies disturbances. His major contribution is known
as the “financial instability hypothesis” (Minsky, 1984), with its pivotal
element being debt. So important is debt that Minsky himself considered
his hypothesis as a “theory of the impact of debt on system behavior.”
This hypothesis contains two central propositions. The first states that
there are two financing structures: one promotes stability and the other
instability. The more a financial structure, as measured by debt to equity
ratio, tilts toward debt, the more fragile the system becomes. The second
proposition argues that in financial capitalism, stability is not sustain-
able because, during a prosperity phase, stability sows the seeds of
instability. Minsky refers to the second hypothesis as saying “stability is
destabilizing.”
During the stages of prosperity, businesses finance their activities
using internal funds or through equity finance (issuing new shares). If
they borrow, they do so only if their future income streams are sufficient
to meet payment commitments on both the principal and interest, over
the lifetime of the contracted debt. Minsky calls this “hedge finance,”
and when hedge finance dominates—that is, financing is mostly equity
or internal funds with minimal debt commitments that are validated
compatibly by an underlying income stream—the system is stable. As
profit opportunities intensify during prosperity, however, there is higher
reward to borrowing (taking on debt) as enterprises take on riskier invest-
ments. More and more firms and other participants tilt their financial
structure toward debt and increased leverage. Minsky calls this “specula-
tive finance,” and enterprises using this type of finance as “speculative
units” who overwhelm their financial structure with debt to the point
where their income stream becomes insufficient to pay the principal
that becomes due. They can only pay the interest but must rollover the
principal. But firms continue to borrow to the point where their finan-
cial structure is made of debt commitments that can only be validated
by more borrowing to pay both principal and interest. When firms are
in this state, Minsky referred to them as Ponzi units and their financ-
ing as “Ponzi finance.” Minsky considered contemporary capitalism as
a dynamic system with a number of dialectical processes and feedback
loops at work that created issues of instability, unfair distribution, and

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 The Next Financial Crisis and How to Save Capitalism

structural unemployment. In this, he was following Keynes, and, like

Keynes, he thought the dialectic forces within the system would lead it
into disaster if the system were left to its own devices.
In the aftermath of the recent credit crisis, many found Minsky’s
diagnoses of past crises—and his explanation of potential turbulences
ahead—to be insightful. He had warned of the growing fragility of the
system, debt buildup in the household and business sectors, as well as the
adverse consequences of securitization, debt globalization, and deregu-
lation. Minsky had observed the growing fragility of the US financial
system since 1966, as a boom and bust in one asset market was followed
by the formation and implosion of another bubble in a different asset
market. After him, his colleagues and former students saw a continua-
tion in the phenomena of bubbles of debt and credit forming and then
imploding. In Minsky’s tradition, they considered these not as isolated
incidents because of external factors, but as “rolling bubbles” signifying
the growing fragility of the financial system. George Soros (2008) too
had seen each asset bubble connected to other bubbles and all part of a
long-term formation of a “super bubble” of debt and credit that finally
imploded in 2007–2008.
2 Financialization: James Tobin and Hans Tietmeyer
The period between the second half of the 1960s and 1970s was one
of much progress in the theory of finance and laid the foundation for
derivatives and securitization. By the mid-1970s, the application of these
achievements initiated a drive for financial innovations, unmatched in
history, which gave finance a significant presence in the United States
and in most other industrial economies and with the potential to take on
a life of its own. By the early 1980s, finance was well on its way to domi-
nating the real sector of the economy. In 1984, James Tobin sounded the
alarm about the emergence of a “paper economy.” In little over a decade
later, the “paper economy” was not only dominating the real sector,
but was well on its way to decouple from it. This period coincided with
the presidency of Hans Tietmeyer at the German central bank. Much
respected, Tietmeyer used his presence in domestic and international
forums to warn about “financialization,” but seemingly to no avail.
A “paper economy” has distinct financial characteristics: (i) its finance
is speculative rather than productive; (ii) its finance is focused on the
short term, buying pieces of paper and trading them back and forth in
rapid turnover; (iii) its finance decouples from the real sector; (iv) it

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 Recurring Financial Crises—The Causes 

extracts, rather than adds, value from the real sector; and (v) it has only
an illusory or, at best, a tenuous (virtual) anchor in real assets. How was
the “paper economy” fairing after the crisis? Data shows that at the end
of 2011, the nominal value of paper instruments—such as interest rate
swaps, collateralized debt obligations, credit default swaps, and others—
had no connection, tenuous or otherwise, to the real economy and were
$700 trillion in the United States alone. This is 4.5 times as large as the
capitalization of the global debt and stock markets combined (Bogle,
2012). Data also reveals that stock markets too are mostly serving the
paper economy. During a recent five-year period, of the total volume
of $33 trillion annual trading in the US stock markets, on average only
$ 250 billion per year provided additional equity capital to new and
established companies. In other words, only 0.8 percent of the $33 tril-
lion was on average devoted to capital formation in the real sector. The
remaining 99.2 percent was devoted to pure finance activities: trading
pieces of paper with no additional capital provided for productive busi-
nesses. This is a paper economy! Meanwhile, debt continued to pile up
in major economies with a total debt by 2010 (government, households,
and corporate) in the United States, Japan, Canada, and 15 European
countries ranging between a low of 238 percent of GDP in Austria to 456
percent in Japan (Cecchetti, Mahonty, and Zampolli, 2010).
Importantly, credit expansion has contributed to a financialization of
the economy, that is, an increase in the relative size of the financial sector
in the total economy. Too much resource has been allocated to financial
markets, in the form of thousands of speculative entities such as private
equity funds, structured investment vehicles, and hedge funds. In turn,
the growth of these institutions and instrument innovations for specula-
tion and hedging added substantially to the opacity and complexity of
the financial system, leading to greater uncertainty. Moreover, traders
(with a short-time horizon), instead of investors, dominate the financial
markets. With very low interest rates, speculators, in search of yield,
engineer structured products to increase monetary returns and play
games against one another. All in all, the result of these activities has
been the growth of complexity in the financial system with increased
volatility, risk, and vulnerability.
Credit expansion on the basis of cheap money causes distortions in the
allocation of financial resources, particularly those that adversely affect
long-term investment in the real economy. Projects with very low return
are undertaken. Credit finances household demand that has shifted to

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 The Next Financial Crisis and How to Save Capitalism

housing, automobiles, and durable goods. A large capacity is installed

to meet this demand. However, when the credit process goes bust, this
debt-financed demand vanishes. Companies face large inventories of
unsold real estate, durable goods, and excess production capacity, and
find themselves in financial trouble.
3 The Financial Crisis as “Moral Failure”
There is a third alternative explanation for the credit crisis as a major
sign of a massive “moral failure” plaguing contemporary society. There is
a view that considers finance as “a profoundly moral issue, as it involves
the creation of relationships of trust, often with very high stakes indeed”
(Davies, 2012). This is perhaps the reason why the revelation of the
extent of fraud and other financial and economic crimes committed
by financial institutions created intense moral outrage reverberating
in the “occupy” protest movement. Thus, in an expression of moral
outrage, Zuboff (2009) argued that while there is merit in technical
explanations of the credit crisis, what is ignored in these analyses is “the
terrifying human breakdown at the heart of the crisis.” She maintained
that at its “heart,” what drove the crisis was a sense of “remoteness and
thoughtless-ness compounded by a widespread abrogation of individual
moral judgment.” This is promoted by the “business model” that domi-
nates, and is characterized by, the self-centeredness of its practitioners,
who operate at an “emotional distance” from their victims and from the
“poisonous consequences” of their actions. Zuboff found to be appro-
priate the philosopher Hanna Arendt’s formulation of “the banality of
evil,” in her observation of Adolf Eichmann in his trial in Jerusalem.
Arendt observed that Eichmann did not appear “perverted and sadistic,”
but “terribly and terrifyingly normal” (Arendt, 2006; Zuboff, 2009).
Accordingly, Eichmann was motivated by nothing except “an extraor-
dinary diligence in looking out for his personal advancement.” The
same motivation animated the practitioners of the “narcissistic business
model” operative in the runup to the crisis. Zuboff argues that “the crisis
has demonstrated that the banality of evil concealed within a widely
accepted business model can put the entire world and its people at risk.”
She concludes: “In the crisis of 2009 the mounting evidence of fraud,
conflict of interest, indifference to suffering, repudiation of responsibil-
ity and systemic absence of individual moral judgment produced an
administrative massacre of such proportion that it constitutes economic
crime against humanity.”

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 Recurring Financial Crises—The Causes 

The crisis and its aftermath have led to a debate about the need to
consider the role of ethics and morality in the economic and financial
workings of contemporary capitalism (Citizen Ethics in a Time of Crisis).
In this regard, it should be noted that Adam Smith, considered to be
the father of Western economics, wrote his book The Theory of Moral
Sentiments a decade and a half before his Wealth of Nations and an
argument can be made that his propositions regarding the workings of
market capitalism must be placed within the institutional framework of
The Theory of Moral Sentiments that provides the mooring. His earlier
book provides the moral anchor for his more famous second book, The
Wealth of Nations. The decoupling of the two books, in effect, cut off
economics and finance from the ethics of the system that was essential
for its successful operation as envisioned by Smith.

The culprits—inflexible interest-based debt and

fractional reserve banking
The financial system is characterized by financing (financial intermedia-
tion between savers or capital surplus entities and investing entities or
capital deficit entities) through interest-rate-bearing debt contracts and
to a lesser degree equity contracts and fractional reserve banking (along
with investment banking and mutual funds). The core of this financial
system is the transfer of risk (with a lender entering into a contract and
is assured of a return without taking the risk that the borrower’s invest-
ment will not perform) on the basis of a predetermined interest rate
and fractional reserve banking (banks risking their depositors’ money).
Under certain conditions risk transfer may, without warning or concur-
rence (stealthily and without the concurrence of the parties exposed
to risk), switch over to risk shifting (arising if a company or a bank in
financial difficulties and with significant debt takes on more risk, with
the potential extra profits accruing to its shareholders and the downside
risk of bankruptcy falling on the holders of debt, that is, risk shifted from
the former to the latter). Controlling and abating risk transferring to risk
shifting requires thoughtful regulation, vigilant supervision, and strict
enforcement; and in the absence of these measures (normally opposed
by the financial industry), financial crises are sure to always follow.
The interest-rate-based debt contract system that transfers risk, in
addition to transferring excessive risk to those who cannot handle it,

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 The Next Financial Crisis and How to Save Capitalism

and more importantly shifting risk “stealthily” to others who are not
even aware of the shifting risk and who have not given their consent
and ultimately resulting in a financial crisis, has a number of other
deleterious fallouts. It leads to financialization (financial capital over-
riding real capital). It decouples the real economy from the financial
sector (noting that the main purpose of the financial sector is to provide
desired instruments for savers and to efficiently intermediate between
them and investors in the real economy). Fixed and predetermined
interest on lending and its compounding and risk transfer coupled with
massive transfers of inheritance have in large measure created a rentier
class and a highly skewed wealth and income distribution in the United
States. In turn, the financial crises resulting from risk transfer and risk
shifting lead to massive economic loss in the form of reduced output,
high unemployment, and slow economic recovery, which adversely and
disproportionately affect the less fortunate members of society.
Keynes (Economic Journal, 1931) argued that interest-based risk trans-
fer system created the two “evils” of capitalism, namely, preventing full
employment in the capitalist market economy and creating large income
and wealth inequalities. Keynes went on to argue that the “villain of
the piece” was the interest rate mechanism. Minsky clearly considered
a debt-dominated financial system as endogenously and endemically
unstable. Kindleberger was a pioneer in getting to the core and address-
ing the reasons for recurring financial crises (rapid runup in debt). More
recently, Reinhart and Rogoff have added valuable data and insights, as
have Mian and Sufi in recommending risk-sharing contracts.
The Mian and Sufi thesis is that a big rise in household debt is the
root cause of severe financial crises and recessions. Recessions may be
triggered by a collapse in asset prices (such as housing prices) and access
to large and unsustainable external borrowing (current account deficits)
that abruptly end in large banking sector losses with credit freezing up.
But invariably severe crises are preceded by large runup in household
debt. What makes banking-financial sector crises exceptional, or severe,
is when it is preceded by a rapid rise in household debt, with the sever-
ity of ensuing recession largely determined by the extent of the increase
in household (private) debt. A big runup of household debt leads to a
decline in household spending (with the bigger the runup in debt, the
bigger the decline in household spending) during a recession because of
defaults and loss of wealth. Households cannot service the money they
have borrowed from banks resulting in losses for banks, leading to job

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 Recurring Financial Crises—The Causes 

losses. At the same time, businesses incur losses and run into financial
difficulties as household demand declines and they lay off more workers.
The financial problems of businesses reverberate further on banks and
business activity declines even more followed by a banking crisis with
credit freezing up.
The important element to Mian and Sufi is household debt. The facts
lead Mian and Sufi to conclude that the lending boom fueled the rapid
rise in housing prices and not the other way round. As households then
borrowed more, home prices rose. All asset price bubbles are a result of
excessive supply of credit. Timing indicates that the fall in household
consumption (not a decline in investment) is the catalyst and the root
cause of the initial big fall in GDP. Only later is there a fall in fixed invest-
ment because of job losses and lower private consumption and demand.
Thus GDP falls further. All of these factors feed on one another, reduc-
ing demand and in turn output. Because of the large runup in household
debt leading to such crises, financial crises hurt the poor more adversely
and this in turn exacerbates the recession, job losses, and the crisis. The
reason is that in the event of bankruptcies borrowers with debt contracts
(especially mortgages) end up losing some, or all, of their initial down
payment (equity). Foreclosures are a result of debt and lead to housing
prices going down even further. Lenders (ultimately the wealthy who
own financial assets, including bank shares) have contracts that impose
all initial losses (the down payment equity) on the borrower. Thus,
depending on the extent of the asset price collapse, the borrower may be
forced to absorb most, if not all, of the losses.
Moreover, the monetary and fiscal authorities invariably bail out lend-
ers. As a result, severe financial crises and recessions exacerbate wealth
inequalities by exposing borrowers (the less fortunate) and protecting
lenders (the fortunate). Because of the deteriorating distributional
wealth effect of debt contracts and job losses, it is the expenditures of
poorer households that get specially affected because they have a higher
marginal propensity to consume from housing wealth. This impact is
further corroborated by the fact that the Tech Bubble did not lead to
the same decline in spending, job losses, and recession. There is fraud
in both debt and equity markets but it is more prevalent in debt markets
and because lenders feel that they have a senior claim in debt contracts
and they don’t think fraud is as important. The proper policy response
should have been to restructure household debt, given levered losses,
and not to bail out bank shareholders.

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 The Next Financial Crisis and How to Save Capitalism

The bursting of asset bubbles, in turn, affects the banking sector.

First, credit losses from debt default or depreciation of assets may create
a large divergence between assets and liabilities that remain fixed in
nominal value. This in turn puts pressure on bank capital. For banks that
are highly leveraged, losses that may at first appear not to be excessive
relative to total assets can wipe out a bank’s capital and thus render it
insolvent. Second, in the conventional system bank credit has no fixed
relation to real capital in the economy and bears no direct relation to
the real rate of return. Credit expansion through the credit multiplier is
a fundamental feature of conventional banks. Cash flow could fall short
of expectations and force large income losses on banks, especially when
the cost of funds is fixed through a predetermined interest rate (the
classic asset-liability mismatch we discussed in the previous chapter).
Third, banks caught in a credit freeze with a drying up of liquidity may
default on their payments. Fourth, banks are fully interconnected with
one another through a complex debt structure; in particular, assets of
one bank become instantaneously liabilities of another, leading to fast
credit multiplication. A credit crash may cause a domino effect that may
impair even the soundest of banks.
Credit (debt) has other ominous implications. Credit can be issued to
finance consumption, and hence may rapidly deplete savings and invest-
ment, whereas equity finance finances investments. The depletion of
savings could be significant if credit finances large fiscal deficits. Hence,
credit is no longer directly related to the productive base as in the equity-
based system, and the income stream from credit is no longer secured by
real output as shown for the equity system. Credit expands through the
credit multiplier, leading to increased default risk, whereas equity in the
equity-based system cannot expand more than real savings. And with
securitization, credit can expand theoretically to an infinite degree as
debt can be packaged and sold with the proceeds used to finance new
loans.
In the financial system, we see that credit expansion may have no
bearing to the real capital base and to the real cash flow in the economy
that may be required for debt servicing. If lending were extended to
finance higher levels of consumption (as opposed to investment), then
credit could erode the capital base and economic growth. According
to the recently launched Fiscal Monitor of the International Monetary
Fund (IMF), the average debt per working age person in advanced
economies will increase from $27,600 in 2007 to $62,000 in 2016, and

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 Recurring Financial Crises—The Causes 

from $1,500 to $2,200 in emerging markets. In 2009, the IMF estimated

that gross general government debt in high-income advanced G-20
economies is expected to grow from 78 percent of their GDP in 2007
to 120 percent in 2014, an increase of 40 percent over a seven-year
period. These countries suffer from high unemployment, fiscal instabil-
ity, low capacity utilization, and high debt and leverage. The stress and
strain on the international trade and financial system and its associated
arrangements did not suddenly become apparent after the recent crisis;
in the 1990s, Japan, Russia, Argentina, Brazil, and Mexico were sending
distress signals. Neither the signals nor the lessons of these crises made
any noteworthy impact on the way the world economic system and its
policies were being steered.
There is a palpable anxiety and growing concern leading to the search
for an alternative to the present interest-based debt-financing regime
and fractional reserve banking. To avoid crises, the prevailing systemic
risk transfer regime has to be gradually married to a risk-sharing system
of contracts and the fractional reserve banking by a movement toward
a level closer to 100 percent reserve banking. Renowned economists at
different times and places have said much of this in bits and pieces since
the Great Depression.

Conclusion
A financial crisis is manifested as a crash in any number of asset prices
following a speculative asset boom, or as a banking crisis that ensues
on the heel of a liquidity shortage and an impairment of bank assets
and invariably leading to a banking crisis and a freezing of credit. These
crises have more serious economic fallout—sharp decline in economic
output, a spike in unemployment, slow and prolonged recovery—than
simple recessions as an impaired financial system spares no sector of
the economy and deleveraging (winding down excessive debt buildup)
takes time. There is no shortage of explanations for financial crises. They
run the gamut from moral failure, embezzlement, fraud, Ponzi schemes,
lax regulations, supervision and enforcement, prolonged periods of low
interest rates, government bailouts of “too big to fail” institutions enabling
excessive risk taking, economic shocks, excessive foreign savings, animal
spirits or irrational exuberance, to a rapid rise in debt. Some believe that
reforms or policy initiatives to address financial crises and ensure the

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 The Next Financial Crisis and How to Save Capitalism

smooth workings of institutions and markets would succeed if market

discipline were maintained and efficiency was applauded by allowing
inefficient firms to go out of business and indebted individuals and insti-
tutions lose their money.
To our mind, the real culprits of financial crises are (i) the prevalence
of interest-rate-based debt contracts and (ii) fractional reserve banking,
which compounds the debt burden by more and more lending or lever-
aging. While debt, or credit, is the seed of financial crises, it has other
implications such as financing excessive consumption and depleting
savings with ominous implications for future growth; the unemployment
that ensues financial crises is more likely to affect the disadvantaged;
and defaults and loss of equity are more concentrated among the less
fortunate members of society. Moreover, the US financial system favors
the more fortunate members of society and this coupled with massive
transfers of inheritance exacerbates income and wealth inequalities.

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 3
Recurring Financial
Crises—The Fallouts
Abstract: The fallouts of financial crises are severe.
The problems are intertwined and the process of
financialization and the runup in debt is an important
cause of stagnant real wages, increasing income, wealth
disparity, slower economic growth and the fuel for
recurring financial crises. These are in large measure
because of the changes wrought by financial sector interests
and are related to the structure of the economy, economic
policy, and the behavior of corporations. The dissipation
of savings, the growth effects of increased indebtedness,
increased share of financial sector profits, shifts in
income away from workers, and lower retained profits of
corporations tend to reduce long-run equilibrium growth.
They have to be addressed in a comprehensive manner to
be effective.

Keywords: bank failures; deleverage; foreclosures;

recession; unemployment

Askari, Hossein and Abbas Mirakhor. The Next Financial

Crisis and How to Save Capitalism. New York: Palgrave
Macmillan, 2015. doi: 10.1057/9781137544377.0008.

DOI: 10.1057/9781137544377.0008 
 The Next Financial Crisis and How to Save Capitalism

Economic downturn, unemployment, and

associated costs

As we have said a number of times earlier, the adverse economic impact of

a severe financial crisis is much more pronounced than that of a run-of-
the-mill economic recession. This has been the case throughout modern
history and has been corroborated in numerous studies. The basic reason
is that in a financial crisis the financial system—banks, financial markets,
and capital markets—becomes impaired, and financing to all sectors of
the economy, including households, is adversely affected. In essence,
financial crises are much more pervasive than ordinary recessions
because no sector is spared their wrath! In addition, because financial
crises are fueled by leverage (a big debt buildup) it takes time to reverse
the process or deleverage (reducing the burden of debt at the expense of
current spending) with continuing adverse economic fallouts while the
deleveraging process continues. As a result, the economic downturn is
generally more severe and prolonged, and with economic recovery at a
slower pace.
In the case of the recent crisis, a number of fallouts have been attributed
to the crisis. The unemployment rate in the United States jumped from
5.0 percent in December of 2007 to a peak at 10.1 percent in October
of 2009 with 15.4 million who could not find jobs. The unemployment
rate had not recovered to its precrisis level even by the end of 2014. But
this statistic tells only a part of the story as, in addition, many work-
ers became so discouraged that they simply gave up looking for jobs
(persons who are not counted in the official unemployment statistic)
and thus labor force participation (even after adjustments for the aging
population) had not recovered to its precrisis level. From 2007 to 2010,
median family income fell from $49,600 to $45,800. The number of
families falling below the poverty line climbed steadily. In 2010, over 11
million homeowners owned homes worth less than their mortgages, and
a total of more than 4 million homes have already been lost to foreclos-
ure since the crisis began.
There are numerous ways to assess the economic cost of the 2007–
2008 financial crisis. One way is to estimate where the economy, or more
precisely national output, might have been if it had stayed on its historical
trend and had not been thrown off course and adversely affected. Such
estimates are by necessity not exact and can be best presented by a range
because one has to make an assumption about when in the future the

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 Recurring Financial Crises—The Fallouts 

economy would get back on the path that it was on before the financial
crisis. In the case of the recent crisis, the economy at the end of 2014
was still below its historic trend and thus the estimate would have to be
in a range that depends on when we get back on the trend line (a more
accurate estimate could be obtained when and if the economy gets back
on its precrisis path). In September of 2013, the Federal Reserve Bank of
Dallas estimated the loss in economic output (or GDP) resulting from the
crisis in the range of $6–$14 trillion.1 Again, the range depends on when
the economy gets back on track, and if the economy were to be perma-
nently on a lower path, then the economic output loss could even exceed
$14 trillion. Now what do these figures mean? To put them in context,
these figures represent an average output loss of $50,000–$120,000 per
American household; note that this is an average figure and as we reason
later on in this chapter the loss is likely to be skewed more against poorer
households, a result that would increase wealth and income disparities.
These losses are losses in the sense that they are lost for the United States
and its residents, into thin air. They are gone. We cannot get them back!
But the crisis had other implications as reported in the Dallas Federal
Reserve study. The net worth of US households fell by $16 trillion (24
percent of total household net worth) from the third quarter of 2007 to
the first quarter of 2009—largely losses in financial assets and in real estate
values. The Dallas Federal Reserve then adds human capital losses (current
wage income and discounted future income). These losses (what they refer
to as path-of-consumption approach to assessing the impact of the crisis),
in net worth and in human capital, are not permanent losses in the same
sense as the lost output figures mentioned in the previous paragraph. The
cost of the crisis would jump to $15–$30 trillion if these losses were added
to the permanent losses. There are also losses that are even harder to quan-
tify and thus even less precise. The two major categories here are “national
trauma and lost opportunity” and “extraordinary government support.”
These were estimated as $14 trillion and $12–$13 trillion, respectively. The
national trauma and opportunity costs include stress, diminished sense
of self-worth, family turmoil, all manner of psychological problems and
frustration with finding a job, and ultimately just giving up.
To get a better idea of what the figures mean, these loss figures should
be compared to the GDP figure of $15 trillion (national economic output
for an entire year) for the United States in 2007 given in this study. The loss
figures are impressive in any comparison to annual GDP. Taking the aver-
age (of the low end and the high end) of estimated output loss, it represents

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 The Next Financial Crisis and How to Save Capitalism

about 66 percent of GDP; the average of the path-of-consumption figure

represents 145 percent of GDP; the national trauma effect represents up
to 90 percent of GDP; and extraordinary government support 80–85
percent of GDP. If the output loss figure is combined with the trauma and
lost opportunity and government support figures (all losses that cannot be
recaptured), then the loss is 210–265 percent of GDP! If the approach of the
path-of-consumption loss (admittedly some of which may be recaptured)
is combined with trauma and lost opportunity and government support
figures, then the loss is 270–365 percent of GDP!!
Even these total losses, which on a stand-alone basis are simply eye
popping, cannot tell the full societal story. Some families, invariably
always the less fortunate, have been simply devastated. Trust in the
government and in government institutions, a crucial part of the social
fabric and an important factor for economic growth, has been eroded. A
large segment of the US population believes that the government exists
primarily to support the big financial institutions and their rich stock-
holders. The notion that hard work and sacrifice will be justly rewarded
in the United States has been tarnished. The American optimism about
the future and dream of a better life has been dented for years, if not for
generations, to come (according to multiple surveys including a survey
conducted by the New York Times and reported on December 11, 2014).

Income and wealth distributions

During the decades of the 1980s, 1990s, and the 2000s, observers increas-
ingly commented on the widening gap between the rich and the poor to
levels not seen since the days of the “Robber Barons” in the late nine-
teenth and early twentieth centuries. Financialization and financial crises
may have played an important role, but by no means an exclusive role,
in the recent growing income and wealth disparity in the United States.
There are many other candidates for the growing income inequality in
the United States (and elsewhere in the world): stagnant and eroding real
wage, declining labor union power, technical change that discriminates
against labor, especially less educated labor, and tax policies that favor
owners of capital (the wealthy). But financialization has also had a hand
in this. As far as income distribution is concerned, growing financializa-
tion means an increase in the income share of rentiers, in particular, a rise
in the rentiers’ interest income (on bonds, mutual funds) and dividends

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 Recurring Financial Crises—The Fallouts 

(stocks and mutual funds), at the expense of firms’ retained profits or

households’ wage income. A financial crisis does not diminish the income
and wealth of this class of citizens because most have remained in their
jobs, and their vast holding of financial assets is largely preserved because
of government bailouts. This concentration of wealth in favor of those
who own capital is further reenforced by the “magic” of compounding,
something that has been identified by many noted economists.
Mian and Sufi in their book have put forth another mechanism to
explain the adverse impact of the crisis on the poorer members of soci-
ety, which in turn exacerbate income and wealth inequalities. Because of
the large runup in household debt leading to financial crises (discussed
earlier in Chapter 2), financial crises hurt the poor disproportionately
and this in turn exacerbates the recession, job losses, and the crisis. The
reason is that in the event of bankruptcies, borrowers with debt contracts
(especially mortgages) end up losing some or all of their initial down
payment (equity). Foreclosures are a result of debt contracts (mortgages)
that in turn lead to housing prices going down even further. Lenders
(ultimately the wealthy who own financial assets, including bank shares)
have contracts that impose all initial losses (the down payment equity) on
the borrower. Thus, depending on the extent of the asset price collapse, the
borrower may be forced to absorb most, if not all, of the losses, while the
lenders’ equity (the rich) is senior and may be totally, but at least partially,
protected. Moreover and importantly, the monetary and fiscal authorities
invariably bail out lenders. As a result, severe financial crises and recessions
exacerbate wealth inequalities by exposing borrowers (the less fortunate)
and protecting lenders (the fortunate). The prevalence of debt essentially
magnifies the fall in asset prices because of foreclosures and concentrating
losses on the indebted, invariably the poorer segment of our society.
The increasing concentration of wealth and capital in the hands of a
few, as implied in the foregoing discussion, has been significantly illumi-
nated by Thomas Piketty in his widely and rightly acclaimed book (2014),
Capital in the Twenty-First Century. Piketty essentially argues that owners
of capital (the wealthy) have fared much better than the vast majority of
society over the recent three–four decades, and will continue to do so,
because the rate of aftertax return on capital has been, and will continue
to be, higher than the rate of growth of the economy (GDP) that affects
the average person. Namely, this favors those who derive their income
from wealth (dividends and interest) as compared to those whose
income comes from work, that is, the wealth and income of rentiers

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 The Next Financial Crisis and How to Save Capitalism

(the wealthy) has grown, and will grow, faster than for those whose
income is primarily derived from work; and we say primarily because
there are also a new class of super financial and general mangers whose
pay packages are simply eye popping. Moreover, it should be noted that
wealth is much more highly concentrated among the rich than is income
from labor; thus, the higher the share of income from wealth, the more
unequal the distribution of income.
In turn, the past and predicted higher rate of return to investments
(capital) than the economy’s growth rate is magnified by the financial
crisis because such crises adversely affect the economy’s overall growth
rate (disproportionately impacting the poor); and in the aftermath of
the 2007–2008 crisis it is predicted that future economic growth will
continue to be below the precrisis trend and some even predict that
future growth may have been permanently impaired. This may be in
part because debt finances consumption, and excessive debt financing
can erode savings that are needed for investment and capital formation.
We can add that this effect may be further even reenforced by financial
crises because, as argued by Mian and Sufi, such crises hurt the poor
much more as they stand to lose a larger percentage of their capital. The
concentration of wealth is further reenforced by the limited progressivity
of US income tax laws, preferential treatment of capital gains, dividend
income and other financial incomes, and inheritance taxes and inherit-
ance tax loopholes that enable the truly wealthy (top 0.01 percent) to
avoid most, if not all, inheritance taxes.
As a result of all of these factors—low economic growth relative to
the return on capital, the magic of compounding, financial crises that
affect the poorer segments of society more adversely, and tax laws (in
addition to the oft other cited reasons of stagnant and eroding real wage,
declining labor union power, technical change that discriminates against
labor, especially less educated labor)—income and wealth distribution
has become increasingly unequal over the past 30–40 years. Today, the
United States has the most unequal income distribution among industrial
countries. Emmanuel Saez provides what is arguably seen by academics
as the most respected analysis of the changing income distribution in the
United States. Briefly taking from a popularized version of his results:
In 2008, the top decile [defined as 10 percent of income earners] includes all
families with market income above $109,000. The overall pattern of the top
decile share over the century is U-shaped. The share of the top decile is around
45 percent from the mid-1920s to 1940. It declines substantially to just above

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 Recurring Financial Crises—The Fallouts 

32.5 percent in four years during World War II and stays fairly stable around
33 percent until the 1970s . . . After decades of stability in the post-war period,
the top decile share has increased dramatically over the last twenty-five years
and has now regained its pre-war level. Indeed, the top decile share in 2007 is
equal to 49.7 percent, a level higher than any other year since 1917 and even
surpasses 1928, the peak of stock market bubble in the “roaring” 1920s. In
2008, the top decile share fell to 48.2 percent, approximately, its 2005 level,
and is still higher than any other year before 2005 (except for 1928) . . . the top
percentile has gone through enormous fluctuations along the course of the
twentieth century, from about 18 percent before WWI, to a peak almost 24
percent in the late 1920s, to only about 9 percent during the 1960s–1970s, and
back to almost 23.5 percent by 2007, and then to 20.9 percent in 2008. Those
at the very top of the income distribution therefore play a central role in the
evolution of U.S. inequality over the course of the twentieth century.2

Such dramatic movements toward more unequal income distribution

may have been masked for quite a while in part by inflating housing
prices, access to home equity finance (borrowing on the basis of rising
house prices to finance a higher level of consumption than possible from
income alone), and increased indebtedness of the household sector.
Figures on wealth concentration, a more meaningful and stable indica-
tor of income distribution, are even more alarming. In 2007, the richest
1 percent of Americans owned about 35 percent of its wealth and the
richest 20 percent owned more than 85 percent of its wealth, meaning
that the bottom 80 percent of Americans owned about 15 percent while
the top 1 percent owned 35 percent.3
In a more recent paper, Saez and Zucman examine the concentration
of wealth in the United States since 1913:
Wealth concentration has followed a U-shaped evolution over the last 100
years: It was high in the beginning of the twentieth century, fell from 1929 to
1978, and has continuously increased since then. The rise of wealth inequality
is almost entirely due to the rise of the top 0.1 wealth share, from 7 in
1979 to 22 in 2012—a level as high as in 1929. The bottom 90 wealth share
first increased up to the mid-1980s and then steadily declined. The increase
in wealth concentration is due to the surge of top incomes combined with an
increase in saving rate inequality. Top wealth-holders are younger today than
in the 1960s and earn a higher fraction of total labor income in the economy.

While many object to the growing inequality of income and wealth on

moral grounds, there is evidence that growing inequality is also harm-
ful to economic growth. In a 2014 study, the Organization for Economic

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 The Next Financial Crisis and How to Save Capitalism

Cooperation and Development (OECD), the group representing 34 rich

countries, concluded that inequality in its member countries was at its high-
est in 30 years. The OECD reported that income inequality has a statistically
significant negative impact on economic growth; and in the 20-year span
from 1990 to 2010, rising inequality resulted in lost output (GDP) equiva-
lent to 7 percent of GDP for the United States and nearly 9 percent for the
United Kingdom. While some may argue that higher taxation and income
redistribution has a negative effect on economic growth, the OECD study
emphatically disputes such assertions. In the United States a significant
change in tax regimes to address such disparities in income and wealth is
unlikely in the near future. In the twenty-first century the United States has
been moving in the opposite direction by taking the bite out of inheritance
taxes and continuing policies that afford a lower income tax rate for those
running hedge funds than those in the middle class of Americans.

Financialization, the decoupling of real and financial

sectors, and the fallouts

Financialization has been accompanied by rising management salaries

at the expense of the wages of ordinary workers. Assuming different
propensities to save from rentier, management, and worker incomes,
income redistribution in turn will affect consumption, and investment
through different channels. Thus, the distributional effects of financiali-
zation could have a significant impact on growth. Data for the United
States confirms that from 1959 to 1979 wages grew roughly in line with
productivity, but thereafter the two have diverged, with wages flat while
productivity has continued growing. In other words, the benefits of
productivity growth have not accrued to workers but to those who own
capital. In sum, wages of US production and nonsupervisory workers,
who constitute over 80 percent of the employed, have become detached
from productivity growth during the era of financialization. The effect of
this for income distribution is evident.
Crotty (2005) reported that, for the United States, the profits of finan-
cial institutions rose dramatically relative to the profits of nonfinancial
corporations after 1984. In the case of the US economy, financialization
has had a profound and largely negative impact on the operations of
nonfinancial corporations (NFCs). This is partly reflected in the increas-
ing incomes extracted by financial markets from these corporations.

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 Recurring Financial Crises—The Fallouts 

Crotty showed that the payments of NFCs to financial markets as a

share of their cash flow more than doubled from the period 1960–1980
to 1980–2000. NFCs came under increasing pressure to make payments
as well as increase the value of their stock prices. Financial markets’
demands for more income and more rapidly growing stock prices
occurred at a time of stagnant economic growth and increased product
market competition, making it increasingly difficult to earn profits.
Nonfinancial corporations responded to this pressure in three ways, none
of them healthy for the average citizen: (i) they cut wages and benefits to
workers; (ii) they engaged in fraud and deception to increase apparent
profits; and (iii) they moved into financial operations to increase profits.
Crotty argued that financialization in conjunction with neoliberalism and
globalization has had a significantly negative impact on the prospects for
economic prosperity. Epstein and Jayadev (2005) presented a profile of
similar distributional issues in a larger group of countries. They showed
that rentiers—financial institutions and owners of financial assets—have
been able to greatly increase their shares of national income in a number
of OECD countries since early 1980s.
In an article in The Economist (July 17, 2010), a related question was
framed in the following words: “How has finance done so well for itself
and why haven’t its returns been competed away?” The answer that
is given comes from a number of papers in a report published by the
London School of Economics (The Future of Finance: The LSE Report, July
2010). Quoting one of the authors, the magazine reports that the success
of finance has been “as much mirage as miracle.” The summary answer
in The Economist is not at all surprising:

The financial industry has done so well for itself, in short, because it has been
given a license to make leveraged bet on property. The riskiness of that bet was
underestimated because almost everyone from bankers through regulators to
politicians missed one simple truth: that property prices cannot keep rising
faster than the economy or the ability to service property-related debts. The
cost of that lesson is now being borne by the developed world’s taxpayers.

In other words, the financial sector’s contribution to financial inter-

mediation has not been enhanced in recent years. If this had been
the case, it would have been reflected in real economic performance
indicators, such as more rapid economic growth as opposed to a slow-
down. Instead, the financial sector has grabbed a bigger slice of the
economic pie through leveraged speculation that has been supported

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 The Next Financial Crisis and How to Save Capitalism

by governments and ultimately paid for by ordinary taxpayers in the

advanced countries.
The financialization thesis is that these developments—increased debt,
changes in the functional distribution of income, wage stagnation, and
increased income inequality—are in large measure because of changes
wrought by financial sector interests. These changes concern the structure
of the economy, economic policy, and the behavior of corporations. The
growth effects of increased indebtedness, increases in the share of profits,
shifts in income away from workers, and lower retained profits of corpora-
tions will tend to reduce long-run equilibrium growth rate. However, this
conclusion is sensitive to assumptions concerning the response of aggre-
gate demand to changes in the share of profits. In particular, if investment
responds strongly to an increased share of profits and consumption is little
affected by a lower share of wages, then growth can increase as a result of a
higher share of profits. This positive effect has not been evident.
There is no doubt that a sophisticated economy, such as the economy
of the United States, requires a sophisticated financial sector to interme-
diate and efficiently allocate the savings of millions of savers to millions
of productive business investments while providing protection against
risk. But the issue is whether finance and the process of financialization
has gone too far and is more focused on extracting rewards for rentiers
as opposed to supporting the real sector. Has diminishing returns to
finance become so ominous that its presumed returns are dwarfed by its
almost certain negative fallout in the form of another financial crisis? As
Robert Solow asks himself:
Yes, it is hard to imagine that the Hedge Fund Operator of the Year does
anything that is remotely socially useful enough to justify the enormous (and
lightly taxed) compensation that results; but that is not really an argument.
Much more significant is the fact that the bulk of incremental financial activ-
ity is trading, and trading, while it may provide a little useful public informa-
tion about market opinion, is largely a way to transfer wealth from those with
inferior information and calculation ability to those with more. There is no
enhancement of economic efficiency to speak of.4

Conclusion
This summary presentation of some of the fallouts of financial crises
clearly underscores the economic and social costs of financial crises. They

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 Recurring Financial Crises—The Fallouts 

are overwhelming and could be getting more severe and burdensome

with each ensuing crisis. Moreover, as we have outlined in the chapter,
the problems are intertwined and the process of financialization and
increased debt is an important cause of stagnant real wages, increasing
income and wealth disparity, slower economic growth, and the fuel for
recurring financial crises. These are in large measure because of changes
wrought by financial sector interests and are related to the structure of
the economy, economic policy, and the behavior of corporations. The
dissipation of savings, the growth effects of increased indebtedness,
increases in the share of profits, shifts in income away from workers, and
lower retained profits of corporations tend to reduce long-run equilib-
rium growth. They have to be addressed in a comprehensive manner as
opposed to a little here and a little there.
The attempts by finance industry lobbyists notwithstanding, it cannot
be legitimately denied that the value of foundational reforms and a
stronger and more comprehensive regulatory system that could mitigate
such crises is huge. The benefits include sparing our economies and soci-
eties the devastating consequences that another financial collapse and
economic crisis would bring, in the form of monetary losses and human
suffering, both of which may in part become a permanent fixture.
We endorse much of what has been said since the Great Depression by
economic giants such as Fisher, Keynes, and Kindleberger. We welcome
the Mian and Sufi book of 2014 as an important contribution by alert-
ing the public to the dangers of interest-rate-based debt contracts and
endorsing the benefits of moving toward risk-sharing contracts, some-
thing that we have said in numerous books and articles over a period
of nearly ten years. We have no disagreement with them as far as they
go but we don’t think that they go far enough. Mian and Sufi do not
advocate a comprehensive risk-sharing financial system for the private
and public sectors coupled with a banking system that does not create
money, which results in its own insolvencies.
We believe that risk sharing should be the norm, not the exception,
in financial contracts. Risk-sharing contracts are important not only for
mortgage, car, and other consumer purchases, but also for corporate
and government financing; default in these categories could also lead to
severe economic downturns. Moreover, we believe that fractional reserve
banking left to itself can also lead to systemic and serious financial crises.
On the basis of their data, Mian and Sufi might argue that by controlling
household debt severe economic downturns would be avoided but we

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 The Next Financial Crisis and How to Save Capitalism

are not so sure as other debt (corporate and government) and leveraging
by financial institutions could also lead us down the same familiar road.
We address the issue of essential and comprehensive reforms, as opposed
to more bandages on top of bandages, in the next chapter.

Notes
1 http://www.dallasfed.org/research/eclett/2013/el1307.cfm
2 http://www.docstoc.com/docs/48716353/Striking-it-Richer-The-Evolution-of-
Top-Incomes-in-the-United-States-
3 http://sociology.ucsc.edu/whorulesamerica/power/wealth.html
4 http://www.newrepublic.com/article/112679/how-save-american-finance-itself

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 4
Recurring Financial Crises—
The Essential Reforms
Abstract: The recent financial crisis devastated the global
economy and the lives of millions of individuals and
families around the world. Debt contracts are inflexible,
do not accommodate sharing of risk and losses, and
eventually lead to defaults and financial crises. Almost 80
years ago, Irving Fisher and other renowned economists
cautioned against fractional reserve banking and the
creation of money by the banking system. The application
of risk sharing in corporate and public finance and a
banking structure closer to 100 percent reserve banking are
important as a package to reduce the likelihood of future
financial crises in both the private and public sector. The
powerful financial industry benefits from debt contracts,
fractional reserve banking, subsidies, and preferential
treatment and opposes serious reforms.

Keywords: Chicago Plan; equity finance; fractional

reserve banking; risk sharing

Askari, Hossein and Abbas Mirakhor. The Next Financial

Crisis and How to Save Capitalism. New York: Palgrave
Macmillan, 2015. doi: 10.1057/9781137544377.0009.

DOI: 10.1057/9781137544377.0009 
 The Next Financial Crisis and How to Save Capitalism

Introduction

The historic quest for financial stability is motivated by a desire to

avoid, economic downturns, and their attendant economic and social
costs. Here, we present a brief history of financial crises to establish the
attraction of a financial system that relies more heavily on risk-sharing
contracts and equity finance coupled with a banking system that is closer
to 100 percent reserve banking, as opposed to risk shifting and interest-
based debt and highly leveraged (fractional) reserve banking. We hope
to show that debt, that is, the transfer (and shifting) of risk and fixed rate
of interest, has been at the foundation of financial crises and will likely
continue to be so in the future unless radical change in financial struc-
ture is introduced—toward a financial system that relies more heavily on
risk sharing and closer to 100 percent reserve banking, a system that is
stable, requires no bailouts, and does not impose attendant costs on the
real sector of the economy.
While there have been a number of proposals and ideas that are based
on the benefits of reducing risk shifting in favor of risk sharing (explained
in earlier chapters), such as the Chicago Reform Plan, Kotlikoff ’s Limited
Purpose Banking, and the ideas of Mian and Sufi, none of them in our
opinion goes far enough. The system that is closest to our recommended
financial system is that which may be deduced from Islamic teachings—
something that has been developed since the mid-1970s and coined as
Islamic finance. We acknowledge and underscore that any change should
be gradual and deliberate but toward an end that meets the goals of stabil-
ity and financial efficiency. A number of the best economic minds in the
United States created the Chicago Reform Plan to abolish fractional reserve
banking over time because such banks expand and contract the money
supply through the money multiplier, create excessive debt (leverage), and
lead us down the path of bank failures and financial crises. More recently,
Maurice Allais published (1999) a book, La Crise Mondiale d’Aujourd’hui, in
support of the Chicago Reform Plan, and Milton Friedman endorsed the
plan in various forums including congressional testimony in 1975.
The Chicago Reform Plan would replace the fractional reserve bank-
ing system by banks that engaged in two principal activities, namely,
safekeeping and intermediation: (i) banking that took in deposits for
safekeeping convenience and charged depositors a small fee, eliminating
the ability of banks to create money through the money multiplier and
to spike the volume of household and corporate debt and (ii) investment

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 Recurring Financial Crises—The Essential Reforms 

banking that invested funds entrusted for investment (much as a mutual

fund) and charged a fee for such services and also invested some of the
bank’s capital that had been contributed by its stockholders and supple-
mented over time by profits for this purpose. Importantly, banks would
no longer be exposed to the risk of the asset and liability mismatch
(borrowing short and lending long). On the one hand, they would keep
deposited money safe, allowing depositors to write checks; on the other
hand, they would assess investments and invest or channel investor funds
to the best investment projects. Yes, they could invest some of their own
capital (on behalf of their stockholders) in investment projects but they
would not be leveraging (lending safekeeping deposits) and facing insol-
vency if some of the projects failed; and importantly, failure of projects
would not reverberate throughout the economy as they do under our
contemporary financial system with interlocking financial institutions
(lending to one another). While the Chicago Reform Plan went a long
way to moderating the creation of debt through the banking system and
leveraging, it did not fundamentally address the benefits of risk-sharing
finance. While Mian and Sufi acknowledge the benefits of risk-sharing
contracts, especially its mitigation of a big runup in household debt and
their flexibility, they do not embrace risk sharing more widely to include
government and corporate financing and they do not address the prob-
lems associated with fractional reserve banking; they may argue that
risk sharing already addresses the problems associated with fractional
reserve banking but it does not do so completely.
We have argued that the present financial system is inherently unsta-
ble, often shaken by periodic crises and requiring massive bailouts, for
essentially two reasons: (i) it is a debt-interest-based system and (ii)
creates excessive (mispriced) debt with leveraging through the credit
multiplier of the fractional reserve banking system and through other
channels associated with financial innovations. The assets of financial
institutions (loans and investments) may decline in value while liabilities
(deposits and accrued interest) are obligations that are fixed in value.
Such a financial institution can face two different types of financial
difficulties: be insolvent or be solvent and face short-term liquidity
crisis (insufficient cash on hand). These institutions require some form
of government support (subsidy) to reduce the negative impact of bank
failures and liquidity crises. Increased regulation after each severe
financial crisis, though usually helpful, has not prevented recurrence of
even more severe crises that have followed. Moreover, regulations have

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 The Next Financial Crisis and How to Save Capitalism

been in part undermined by financial innovations, with regulators and

supervisors always in a catch-up role.
Financial innovations have in turn led to financialization of the
economy as discussed earlier in Chapter 2. The number of unregulated
financial institutions has mushroomed along with the number of finan-
cial products. Speculation and debt trading have intensified creating asset
bubbles, excessive volatility, and heightened uncertainty. The inverted
credit pyramid has become overleveraged and vulnerable to small
shocks, with even a small shock sending the credit pyramid tumbling
into bankruptcies, and with a freezing of the entire banking and financial
system, the frequency, transmission, and severity of crises have increased.
Financial instability has been accompanied by abnormal exchange rate
instability with implied disruption to international trade. In view of
significant economic losses inflicted by recurring financial crises—higher
unemployment and lost output, slower economic growth, and social
inequities and pain—the quest for financial stability has become ever
more urgent. By briefly examining the history of financial crises, we hope
to show that a financial and banking system that is founded on risk shar-
ing and equity financing can deliver stability and enable the integration,
or reintegration, of the financial and real sectors of the economy.

Inherent instability of conventional banking

Today, the banking system in the United States and in most, if not all,
other countries is primarily based on interest-bearing debt. This is to
be contrasted to an equity-based system, which is a profit-loss-sharing
arrangement. Historically, debt-based banking has been prone to bouts
of instability, threatening its very existence, in the absence of massive
government guarantees (in the case of loss of confidence and deposit
withdrawals culminating in a run on banks that require deposit insur-
ance) and bailouts (for insolvent banks, especially for those that are
deemed “too big to fail”).
By definition, fractional reserve commercial banks do not maintain 100
percent of their deposits in the form of reserves and are as a result vulner-
able to being caught short when many of their depositors demand their
deposits at the same time. More precisely, a bank that keeps a fraction
of its assets in the form of reserves is vulnerable to sudden panic (from
rumors about pending insolvency) withdrawals of deposits by depositors.

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 Recurring Financial Crises—The Essential Reforms 

It can be immunized from such panic withdrawals if deposits are guaran-

teed by the government or by a quasi-government agency, invariably on
a subsidized basis. It was for this reason that after a number of destruc-
tive panics, ensuing withdrawals, and runs on banks, deposit insurance
became a part and parcel of conventional (fractional reserve) banking.
While deposit insurance can deter runs on solvent banks that may be
temporarily facing a liquidity crisis (not having enough cash on hand)
from an asset and liability mismatch, banking crises come about also
because of insolvency resulting from bad (mispriced) loans, speculation
(excessive risk taking), and even fraud on the part of banks. Insolvencies
can either be allowed to run their course, leading to bankruptcy, clos-
ing bank doors and loss of shareholder value and creditor loans, or the
government can bail out insolvent banks. Bailouts could be ominous and
shift bank losses to the taxpayers. For instance, the bailout of the savings
and loan associations in the United States in the late 1980s cost taxpayers
$130 billion. Bailouts are said to socialize private losses, while gains are
not and are in fact privatized! While public bailouts have become the
norm, the rescue of the hedge fund Long-Term Capital Management
(LTCM) in 1998 was an exception in that it was coordinated by the New
York Federal Reserve with 12 commercial banks, with no public funds at
risk. The failure of LTCM (which had used $2 billion in capital to buy $125
billion in securities with which it had entered into transactions exceeding
$1 trillion) could have had serious implications for financial markets.
The need for bailouts has become imbedded in the interest-based
system and has been implemented by governments with a view to
protecting banks (especially banks that are deemed “too big to fail” as
they might threaten the entire financial system and in turn the broader
economy), debtors, and to reinflate asset prices to their pre-crisis levels.
Recent reassurances about asset prices (referred to as the “Greenspan Put”
because the former chairman of the Federal Reserve repeatedly injected
more money or liquidity into the financial system to support asset prices)
created moral hazard and led financial institutions to indulge in risky
speculation. Consequently, bailouts have become all too frequent.

Regulation and financial crises

Financial tremors have, over time, devastated economic activity and
forced governments to renew their search for stronger regulations to

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 The Next Financial Crisis and How to Save Capitalism

avert future crises. The recent crisis is no different. But more regula-
tions on a system that some have dubbed a “Grand Casino” would not
be reassuring. Besides traditional and regulated banking system, there
are thousands of shadow banking institutions such as hedge funds,
mutual funds, and private equity funds that are unregulated and do not
fall under banking or any other regulatory system. The regulated and
unregulated financial institutions compete for profit opportunities and
are prone to excessive risk taking. Unregulated intermediaries do not
face capital requirements and may indulge in excessive leverage and risk
taking. Besides the multiplication of nonregulated intermediaries, there
is a far-reaching multiplication of increasingly complex and exotic finan-
cial products. Speculation has become an increasingly prominent activ-
ity, and volatility and uncertainty have reached unprecedented historical
levels and have heightened the risk of sizeable losses from asset price and
exchange rates instabilities. While Schumpeterian technical innovations
are conducive to greater economic growth, financial innovations have
at times turned out to be susceptible to greater instability, volatility, and
economic uncertainty and disruption.
In the United States, the banking panic of 1907 led to the establish-
ment of the US Federal Reserve System in 1913 with a view to prevent-
ing the recurrence of financial crises of the past. Unfortunately, the
Federal Reserve was not able to prevent the worst financial crisis in
modern history, namely, the Great Depression. In the wake of financial
collapse, hallmark reforms were introduced with the renewed objective
to restore financial stability. The National Credit Corporation (1931) and
the Reconstruction Finance Corporation (1932) were created to provide
loans to banks, for mortgages, agriculture, and industry. The 1933 Glass-
Steagall Act, subsequently repealed in 1999, separated deposit taking
from investment banking and created the Federal Deposit Insurance
Corporation. The separation of investment banking and deposit taking
was designed to maintain the safety of deposits and prevent deposit-
taking banks from taking excessive risk with depositors’ funds entrusted
to them for safekeeping. Government deposit insurance became neces-
sary in the United States and in many other countries if banks were
to attract depositors.1 The US Securities and Exchange Commission
was created in 1934 to regulate stock and derivative markets. The 1933
Banking Act, transferring policymaking from New York Federal Reserve
Bank to the Federal Reserve Board of Governors in Washington,
established the Federal Open Market Committee. Those reforms were

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 Recurring Financial Crises—The Essential Reforms 

considered to have afforded the US financial system a long period of

stability until mid-1960s. Instability grew in the 1970s with the failures
of Real Estate Investment Trusts and built further momentum in the
1980s with the failure of Savings and Loans Associations and a number
of banking corporations. The reemergence of increasing instability since
the mid-1960s, in turn, led Hyman Minsky (1986) to qualify the banking
system as inherently unstable and to conclude that long-term stability
builds the stage for instability, calling it “unstable stability.”
Despite far-reaching structural changes in the banking system, the
drive to reform the banking system in the early 1930s fell short of the
Chicago Reform Plan. The Chicago Reform Plan was designed to address
the essence of financial instability. It recognized two distinct roles for
money: (i) money as a medium of exchange and store of value and (ii)
for financial intermediation between savers and investors. As explained
earlier, banks have the power of creating and destroying money through
the credit multiplier. The expansion of credit and money is coupled with
rising prices and activity. The contraction of credit and money is coupled
with bankruptcies, loss of wealth, deflation, and economic crisis. Such
was the typical pattern of bank credit and monetary cycles in the past two
centuries. Consequently, the Chicago Reform Plan sought to isolate the
money function of money from its intermediation function. The money
function is carried by 100 percent reserve banking (thus banks do not
create money but only accept money for safekeeping), and intermedia-
tion is carried by investment banking (such as mutual fund opportunities
in a variety of companies and business ventures) with close matching of
assets and liabilities. Thus financial bankruptcy and illiquidity are side-
stepped. Over time, the authors of the Chicago Reform Plan have gained
followers as the same factors that precipitated the Great Depression
continue to remain in play; uncertainty and volatility have gone beyond
tolerable limits, making investment decisions difficult to analyze and
assess. With innovations such as financial derivatives and securitization,
the powers of creating money and leverage have become boundless and
have furthered the increasing divergence of the real and financial sector.
Financialization in the form of multiplication of unregulated money
funds and multiplication of complex financial products has diverted
wealth in favor of speculators and others in the financial sector and at the
expense of real producers and workers. Large financial gains have led to
obscene pay packages and bonuses in the financial industry, something
that is also prevalent in the sport and entertainment industry.

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 The Next Financial Crisis and How to Save Capitalism

As in the past, the immediate reaction to the recent crisis was to

strengthen the regulatory apparatus with the objective of achieving
financial stability and preventing the recurrence of the devastating
financial crisis. In May 2010, the US Senate passed the bank reform
bill, titled “Restoring American Financial Stability,” or alternatively,
the so-called Dodd-Frank Act, designed to strengthen the regulation
of banks and nonbank financial institutions, create a sound economic
foundation for job growth, protect consumers, rein in Wall Street, end
the policy of “too big to fail,” and ultimately to prevent another financial
crisis. The bill also introduced the Volcker Rule, which would force
deposit-taking banks to spin off their proprietary trading arms (trading
on their own account) and sell ownership interests in hedge funds and
private equity firms. After a Senate House conference committee ironed
out differences between the two houses of Congress, President Obama,
on July 21, 2010, signed into law the Dodd-Frank Wall Street Reform and
Consumer Protection Act. The major provisions of the Act are: a new
consumer watchdog, a financial early warning system, breakup author-
ity of financial institutions, tighter leash on banks and financial firms to
limit their excessive risk-taking activities (such as trading of derivatives),
and mortgage reform.
However, in December of 2014 as a part and parcel of passing the
federal spending bill, the provision that prohibited banks from trading
derivatives (possibly their most risky activity but one with high profit
potential) was eliminated from the bill. In our opinion, the Dodd-Frank
Act, which some politicians have hailed as the most significant set of
financial reforms since World War II, does little to prevent the next
financial crisis. In December of 2014, about four and a half years after
the president signed the Dodd-Frank Act, some of the details have still
not been fully written and it is assumed that the report, the bill, and its
details could run close to 20,000 pages! But this was not all. The 114th
Congress that opened for business in January of 2015 immediately
started to consider further revisions in the Dodd-Frank Act in a special
rapid process that eliminates debate for uncontroversial legislations. The
new elements in a bill introduced by Representative Michael Fitzpatrick
would roll back three other provisions:
First, it would let large banks hold on to certain risky securities until 2019,
two years longer than currently allowed. It would also prevent the Securities
and Exchange Commission from regulating private equity firms that conduct
some securities transactions. And, finally, the bill would make derivatives

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 Recurring Financial Crises—The Essential Reforms 

trading less transparent, allowing unseen risks to build up in the system.

Of course, you wouldn’t know any of this from the name of the bill: the
Promoting Job Creation and Reducing Small Business Burdens Act. Or from
the mild claim that the bill was intended only “to make technical corrections”
to the Dodd-Frank legislation of 2010.2

If all of these elements are adopted, then the bill will achieve almost
nothing in preventing future financial crises. But this process of chipping
away at this legislation is likely to continue until every tooth has been
pulled from what was already a highly compromised attempt at financial
reforms.
More generally, during a banking crisis, there are calls for increas-
ing bank capital requirements (something that is also in line with the
premise of 100 percent reserve banking). Of course as capital to asset
ratio is increased (holding more capital on hand to meet contingencies)
banks become increasingly immunized from failure and bankruptcy.
But the banking industry opposes higher capital requirements because
it decreases earnings, although higher capital requirement is designed to
increase safety and mitigate bank failure, which should be the overriding
goal.
In November of 2014, the Financial Stability Board (FSB), a group of
international officials that oversee international financial regulations,
took measures that might make it easier for banks to fail without being
bailed out by governments, and in the process motivating banks to
assume less risk. Under the new rules, the biggest banks will have to hold
“buffers,” or “total loss-absorbing capacity” (TLAC), equivalent to 16–20
percent of their assets—a figure that significantly exceeds the capital ratio
that was the norm during the 2007–2008 crisis. Moreover, banks must
hold more equity (contributed by their shareholders) relative to assets.
Also, bondholders (lenders to the banks) would be expected to share in
any losses arising from bank failure but after shareholders’ capital contri-
butions are depleted. Certain types of bonds will count toward TLAC
if they are explicitly designated as loss absorbing if things go wrong.
For example, “Contingent-Convertible Bonds,” also known as Cocos,
while resembling bonds during normal operating environment, would
automatically convert into equity if capital ratios were to decline below
a certain threshold level, is a type of bond that would qualify as TLAC.
The TLAC rule, which comes into force in 2019, would apply only to 27
“systemically important” global banks. The TLAC is envisaged to prevent
systemic failure and not individual bank failure. These measures, though

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 The Next Financial Crisis and How to Save Capitalism

helpful, may be still insufficient to prevent financial crises because the

safety cushion that is provided for banks may be inadequate and also
because only the biggest of banks are covered.

Risk sharing and financial crises

Financial innovations have created opportunities and instruments for

risk shifting—where risk could be stealthily shifted to investors, borrow-
ers, depositors, and, ultimately, to taxpayers (Sheng, 2009)—rather than
risk sharing. We say stealthily in this context because a bank with signifi-
cant debt that is facing financial difficulties may be motivated to assume
excessive risk, with the potential extra profits accruing to its sharehold-
ers and the downside risk of bankruptcy falling on the holders of debt,
that is, risk shifted from the former to the latter without the concurrence
of its creditors. As the banking system pushed more and more interest-
based debt to finance consumption and speculative investments, the
financial sector became increasingly decoupled from the real sector
with the growth of the former outpacing that of the latter by double-
digit multiples (Epstein, 2005; Mirakhor, 2010; Menkhoff and Tolksdorf,
2001). Emergence of a crisis was inevitable since it was the real sector
that had to resolve the mountain of debt sitting on top of a relatively
small hill of real output. Ultimately, much wealth was destroyed, many
people became unemployed, and substantial fiscal costs were imposed
on governments and taxpayers the world over.
At the outset, we note that the universal application of risk-sharing
contracts and the prohibition of interest-rate-bearing debt in the
context of 100 percent reserve commercial banking (banks that provide
safekeeping deposit services) and investment banks that invest investor
funds on a pass-through basis, as a mutual fund, essentially eliminates
the possibility of default and thus reduces the likelihood of severe finan-
cial crises. The losses on any contract are shared between the parties
to the contract; creditors (investors) are not simultaneously debtors
(borrowers); the failure of an investment project for an investor does not
in turn adversely impact a lender; and as a result, financial losses of one
entity do not ripple through the financial system as they would do in a
system that is predominantly interest-rate-debt based with a high degree
of leverage (with a chain of loans in the economy). Debt fueled asset
bubbles and banking crises are almost eliminated as banks can invest

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 Recurring Financial Crises—The Essential Reforms 

their clients’ money only in projects on a pass-through basis, akin to a

mutual fund. Banks cannot take risk with deposits, leverage, and then
become insolvent when loans sour, affecting in turn the overall financial
system. Fraud and other dishonest behavior can still bring about a finan-
cial crisis and sound regulations, supervision, and enforcement will as
always be needed. Risk-sharing contracts and banking that is closer to
100 percent reserve banking are both needed to prevent financial crises.
On the one hand, if only interest-based bank lending is prohibited, banks
could still risk the safekeeping money of their depositors through their
investments (on the banks’ own account) and be caught insolvent when
the business venture failed. On the other hand, if only fractional reserve
banking is prohibited, the investment-banking component of the bank-
ing system could fund investments through borrowing and leverage that
could result in a financial crisis.
Given that all financial assets in such a financial system (risk sharing
and 100 percent reserve banking) are contingent claims and there are no
debt instruments with fixed predetermined rates of return, the returns
to financial assets are primarily determined by the rate of return in the
real sector. In the absence of speculation arising from dysfunctional debt
markets, equity prices would tend to show less volatility. Essentially,
dividends from successful real (as opposed to purely financial) invest-
ment projects and real savings would drive demand for equity shares. It
cannot be fueled by fictitious credit to speculate and bid up asset prices.
The supply would be influenced by initial public offerings. Hence, both
the demand for and supply of equity shares are influenced by stable vari-
ables in the absence of interest rates and debt, and equity prices would
tend to display a stationary pattern. Two elements explain the absence of
systemic risk. The deviation between the expected return and the market
return would be very small and result from nonsystemic factors, such as
the scale of the firm, the efficiency of its labor force, or its entrepreneur-
ship. Second, the performance of one firm would be influenced by its
competitiveness, cost-efficiency, promotional efforts, and investment
plans. In the absence of common systemic risks, the correlation of
a firm’s return with the market portfolio would be very low. The pool
of real savings rather than credit would determine asset demand. The
supply of equity shares would be determined by real investment plans.
The rate of return would essentially comprise dividends.
However, conventional (fractional reserve) banks fail to meet inherent
stability conditions even in the presence of prudential regulations. First,

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 The Next Financial Crisis and How to Save Capitalism

credit losses from debt default or depreciation of assets may create a large
divergence in relation to liabilities that remain fixed in nominal value.
This in turn puts pressure on bank capital. For banks that are highly
leveraged, losses that may at first appear not to be excessive relative to
total assets can wipe out a bank’s capital and thus render it insolvent.
This cannot happen in 100 percent reserve banking. There are no loans.
All investments (that could sour) are channeled through the bank on a
pass-through basis. Essentially, banks cannot become insolvent unless
there is embezzlement. Second, in today’s banking system, bank credit
has no fixed relation to real capital in the economy and bears no direct
relation to the real rate of return. Credit expansion through the credit
multiplier is a fundamental feature of conventional banks. Cash flow
could fall short of expectations and force large income losses on banks,
especially when the cost of funds is fixed through a predetermined inter-
est rate (the classic asset-liability mismatch). Third, banks caught in a
credit freeze with a drying up of liquidity may default on their payments.
Fourth, banks are fully interconnected with one another through a
complex debt structure; in particular, assets of one bank become instan-
taneously liabilities of another, leading to fast credit multiplication. A
credit crash causes contagion and a domino effect that may impair even
the soundest of banks.
Debt has other ominous implications. Debt can be issued to finance
consumption, and hence may rapidly deplete savings and investment, in
turn adversely affecting economic growth. The financing of consump-
tion could just as easily be prohibited. The financing of consumption
could be another reason for the prolonged downturn that follows on
the heel of severe financial crises. The depletion of savings could be
significant if debt finances large fiscal deficits. Hence, debt is no longer
directly related to the productive base as in an equity-based system,
and the income stream from debt is no longer secured by real output as
shown for the equity system. Debt expands through the credit multiplier,
which is determined by the reserve requirement, whereas equity in the
equity-based system cannot expand more than real savings. Debt can
expand through leverage to an unsustainable multiple of real national
income, increasing default risk. In case of financial derivatives debt can
expand theoretically by an infinite degree, or in the case of securitiza-
tion as loans can be packaged and sold as new securities allowing banks
to continue lending from the proceeds of the securities assets (loans
that were packaged). In a system of 100 percent reserve banking and a

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 Recurring Financial Crises—The Essential Reforms 

separate investment banking system, financial intermediation consists of

redeploying real savings into real investment.
When we compare a banking system that has two components—100
percent reserve (or something close to it) banking for deposits and invest-
ment banking for investors on a pass-through basis—to our present-day
banking system, we note that in the system in practice today credit
expansion may have no bearing to the real capital base and the real cash
flow that may be required for debt servicing. When financing is extended
to consumption, credit could erode savings and economic growth. The
equilibrium interest rate that clears money markets may instantaneously
have no direct relation with the real rate of return in the economy. Such
a deviation (between the real rate of return and the market clearing, or
equilibrium, rate) has been acknowledged by the classical economists
and was seen to be a cause of booms and busts and excessive speculation
in commodities and assets. Banks are obliged to pay the face value of
their liabilities in case of credit loss and fully absorb losses from their
capital reserves or recapitalization. Governments may be compelled to
extend large and costly bailouts to rescue impaired banks and prevent a
total collapse of the financial system.
Besides the inability to reach full-employment output, the prevailing
financial system can suffer from interest rates distortions in relation
to a natural interest rate and can suffer from the absence of direct link
to a real capital base that generates cash flow for servicing debt. As we
have said earlier, Minsky (1986) described the conventional system as
endogenously unstable, evolving from temporary stability to periods of
crisis. Credit losses play havoc with the real economy and cause massive
unemployment. The resulting unemployment may be persistent and
stubborn because the required time for deleveraging (both public and
private debt) may be significant and the ensuing financial uncertainty
may result in a slow recovery of investment expenditures that is neces-
sary for growth and employment.
The issue of instability in conventional finance is not limited to the
role of commercial and investment banks. In the financial system,
a critical role of the central bank is to act as a lender of last resort. In
the absence the central bank assuming such a role, conventional banks
would risk simultaneous failure, as banks are interconnected through
loans. Banks are exposed to credit and interest rate risk and may become
illiquid. In order to fulfill their obligations, borrowing from the central
bank is necessary for the smooth functioning of conventional finance. In

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 The Next Financial Crisis and How to Save Capitalism

100 percent reserve banking, banks cannot have or cause any liquidity
mismatch and are not dependent on the central bank finance to maintain
their liquidity. Moreover, as all deposits are in safekeeping, investors will
not panic and cause a run on the banking system; thus there is no need
for deposit insurance. In sum, in such a financial system, the financial
sector functions to support the real sector. Financial assets are based
on risk and return sharing and are contingent claims. Real as well as
monetary forces determine the rate of return.
If risk sharing and in turn risk-sharing contracts have such benefits—
especially reducing the likelihood of severe financial crises and ameliorat-
ing societal cohesion—why have they not been more readily adopted? The
answer is evident. The powerful financial industry in the United States is
opposed to risk-sharing finance. They do not see it in their financial inter-
est, especially when they have managed to secure a number of important
subsidies (and structural concessions) for debt and its proliferation—
preferential tax treatment for debt servicing, subsidized deposit insur-
ance, leveraging through fractional reserve banking, lender of last resort,
and “too big to fail” bailouts. As major campaign donors, the financial
industry has clout with US politicians and it uses it to its advantage. This
fact was most vividly in display in December of 2014, when the big New
York banks managed to delete an important provision of the Dodd-Frank
Act that prevented them from trading risky financial derivative instru-
ments, and yet again in January of 2015 as the new Congress opened for
business by considering further modifications to the Act.
Moreover, and more broadly, we should note that risk sharing reduces
human angst and increases societal trust, cooperation, and social capital
to bring humankind ever closer together. There is much room for the
expansion of risk-sharing contracts in student loans (contingent on
employment after graduation, salary), mortgages (contingent on appre-
ciation-depreciation of house prices, employment, salary), business loans
(contingent on return on investment), automobile loans (contingent on
employment, salary), and much more. Some may want to keep the gains
and share the losses but that is not risk sharing.

Conclusion

For years, the late Charles Kindleberger had said that excessive credit
(debt) is the fuel of manias, asset price bubbles, and the resulting panics.

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 Recurring Financial Crises—The Essential Reforms 

Academics, much less policymakers, did not take heed. Kindleberger

then wrote it all in his book in 1978. Paul Samuelson, among the hand-
ful of American economic giants of all time, hailed it as a book that all
should read and heed. They did not. It could be that humans may be
reluctant to change tracks unless absolutely forced. The unknown, the
path not taken, may appear scary. Or society may be collectively unable
to get on the path not traveled because of selfish interests and a broad
decline in morality and compassion.
The recent financial crisis devastated the global economy and the
lives of millions of individuals and families around the world. Mian
and Sufi pulled together the data and made a convincing case that a big
runup in household debt fueled the 2000–2008 housing price bubble
(not vice versa); foreclosures resulted in the less fortunate losing their
equity, while the lenders (and in turn, bank shareholders) lost little; the
big drop in demand caused massive layoffs and the great recession. Debt
contracts are inflexible, do not accommodate sharing of risk and losses,
and eventually lead to defaults and financial crises. Still policymakers are
not listening and are unlikely to take notice. There is no serious reform
on the horizon. Almost 80 years ago, another Irving Fisher (and other
renowned economists with him) cautioned against fractional reserve
banking and the creation of money by the banking system. Fisher (1936)
endorsed 100 percent reserve banking (100% Money). Policymakers did
not listen and take action, while banking (financial) crises have occurred
and reoccurred many times over with devastating human and economic
consequences.
Risk-sharing contracts combined with 100 percent reserve bank-
ing almost eliminate the likelihood of severe financial crises as long
as markets are supervised and fraud and other acts of malfeasance are
prevented. The application of risk sharing in corporate and public finance
and 100 percent reserve banking are important as a package to reduce
the likelihood of future financial crises in both the private and public
sector. While we are convinced that these changes to the financial system
would enhance financial stability and in turn reduce the likelihood of
severe economic downturns, we recognize that reforms, no matter how
desirable, must also be pragmatic. Thus we would recommend steps to (i)
increase reserve banking with the goal of achieving one day in the very
distant future something much closer to 100 percent reserve banking
and (ii) eliminating the tax incentives for debt financing to encourage

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 The Next Financial Crisis and How to Save Capitalism

risk-sharing contracts and reduce the predominance of interest-based

debt. Still, even the concept of 100 percent reserve banking and encour-
aging risk-sharing contracts are unlikely to be broadly embraced in the
near future in the United States. The powerful special interest group, the
financial industry, benefits from debt contracts, fractional reserve bank-
ing, and their subsidies and preferential treatment. So financial crises
will assuredly recur as they have in the past unless a broad segment of
society begins to take interest and demand essential financial reforms or
if the adverse fallouts of the next financial crisis create social fissures that
cannot be bandaged.

Notes
1 Deposit insurance is not provided in all countries; see http://mitpress.mit.edu/
sites/default/files/titles/content/9780262042543_sch_0001.pdf
2 http://www.nytimes.com/2015/01/11/business/kicking-dodd-frank-in- . . . h.
html?emc=edit_th_20150111&nl=todaysheadlines&nlid=47951886&_r=0

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 5
Conclusions and Our
Financial Future
Abstract: The financialization of the economy has brought
a number of interrelated problems: financial crises
that have led to severe economic downturns with high
unemployment, declining economic opportunities, stagnant
real wages, and reduced economic growth and thus
growing income and wealth inequality. It is time to make
a bold change by putting our financial house in order and
on a better path. Higher capital requirements for banks,
better regulations, supervision and enforcement, and the
like are invariably helpful, but at best they will only delay
the inevitable, another devastating financial crisis. The
prevalence of debt financing is at the heart of the problem.
We need more fundamental reform of our financial system
that reduces the supremacy of debt, encourages risk-sharing
finance, and increases the fraction of reserves in fractional
reserve banking.

Keywords: economic growth; income and wealth

inequality; reforms; regulations; return to capital

Askari, Hossein and Abbas Mirakhor. The Next Financial

Crisis and How to Save Capitalism. New York: Palgrave
Macmillan, 2015. doi: 10.1057/9781137544377.0010.

DOI: 10.1057/9781137544377.0010 
 The Next Financial Crisis and How to Save Capitalism

In the United States of 2015, we face a number of interrelated problems

that have roots in a financial sector that has been growing much more
rapidly than the real sector. This financialization of the economy with its
decoupling from the real sector has, in our view, gone too far with finance
drifting further and further away from its main function of intermedia-
tion between savers and investors and affording mechanisms to manage
risk. But the financial sector has gone in the direction of trading paper
with one party extracting big gains from another, with little or no posi-
tive effect on the real economy. The financialization of the economy has
brought about a number of interrelated problems: beginning with finan-
cial instability, leading to financial crises, resulting in severe economic
downturns with high unemployment, declining economic opportuni-
ties, stagnant real wages (the benefits of productivity accruing to owners
of capital), and reduced economic growth in part because of enhanced
uncertainty, and the erosion of savings to finance consumption, with
the after tax real return to capital exceeding economic growth and in
turn growing income and wealth inequality. These economic difficulties
could in time lead to societal fissures. We believe that a reversal of the
financialization process, which requires serious reforms of the financial
system, is an essential step in reversing this ominous trend.
Financial crises have been a recurring phenomenon in the United
States and in many other countries around the world. While crises have
been attributed to factors that include “financialization,” unchecked
speculation, lax regulations, supervision and enforcement, economic
shocks, prolonged periods of low interest rates, lax monetary policies,
inadequate level of bank capital, greed, outright fraud, and more, we
believe that at the heart of financial crises, the problems are two: the
prevalence of interest-rate-based debt contracts and fractional reserve
banking. In our opinion, this conclusion is supported by an examination
of past crises and their propagation. A rapid buildup of debt and leverage
invariably results in default and bankruptcies, where debtors, especially
highly leveraged debtors, cannot meet their financial obligations. The
severity of a crisis is made more ominous the greater the debt buildup
or leverage. As defaults occur, they reverberate on to lenders (largely
commercial banks), who in turn cannot honor their obligations to their
depositors and to their other creditors—banks and nonbank financial
institutions. Banks stop lending, resulting in widespread credit freeze
with a drop in consumer and investment expenditures followed by a
severe economic downturn and a sharp spike in unemployment. Debt

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 Conclusions and Our Financial Future 

and leverage are the essential fuel for financial crises. In the absence of
interest-based lending by commercial banks (lending that is financed by
depositors who have deposited their funds for safekeeping), defaults and
their transmission across the economy would be dramatically reduced
because the web of debt would be more limited. Instead, with no debt-
financed consumption expenditures, the decline in consumer spending
would be more limited, and while there would still be investment losses,
their reverberation (contagion) throughout the economy would be more
contained.
If we replaced our financial system with a system that reduced the role
of debt relative to equity finance (i.e., risk-sharing contracts) and a bank-
ing system that is closer to 100 percent reserve banking, the likelihood
of financial crises and financial contagion would be almost eliminated.
The losses on any contract would be shared between the parties to the
contract and would not reverberate throughout the economy as in the
case of leveraged debt. Debt-fueled asset bubbles and banking crises
would be significantly reduced as investment banks, or investment-
banking divisions of banks, could invest their clients’ money only in
projects on a pass-through basis, akin to a mutual fund, and their own
shareholders’ capital. Banks could not take risk with deposits; leverage
and become insolvent when loans sour, in turn impairing other banks
that had lent them and affecting the overall financial system. Fraud and
other dishonest behavior could still bring about a financial crisis; sound
regulation, supervision, and diligent enforcements would as always be
needed.
Risk-sharing contracts and a banking structure closer to 100 percent
reserve banking are both needed to prevent financial crises. On the one
hand, if only interest-based bank lending is prohibited, banks could still
risk the money of their depositors through their investments (on the
banks’ own account) and be caught insolvent when the business venture
failed. On the other hand, if only fractional reserve banking is prohib-
ited, the investment-banking component of the banking system could
fund investments through borrowing and leverage that could result in
a financial crisis. Simply said, if all business ventures were financed by
risk-sharing contracts (equity), then in the event of the bankruptcy of
the investment or project, the partners in the business would simply
lose their invested capital; and as there are no interest-bearing borrowed
funds, there would be limited impact on banks and reverberation
throughout the economy. The resulting economic downturn and adverse

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 The Next Financial Crisis and How to Save Capitalism

fallout would be limited, with more tolerable economic and social

consequences. Moreover, and more broadly, there is evidence that risk
sharing reduces human angst and increases societal trust, cooperation,
and social capital to bring humankind ever closer together.
While we are convinced that these changes in the financial system
would enhance financial stability and in turn reduce the likelihood of
severe economic downturns, we recognize that reforms, no matter how
desirable, must also be pragmatic. We would recommend increasing
reserve banking in steps with the goal of achieving one day, in the very
distant future, close to 100 percent reserve banking and eliminating the
tax incentives for debt financing to encourage more risk-sharing contracts
and reduce (as opposed to eliminate) the supremacy of interest-based
debt. We also underscore the belief that risk-sharing contracts would
also benefit the financing of public projects and reduce the likelihood of
financial stress for many governments.
Still, even anything approaching 100 percent reserve banking and
eliminating the tax subsidies for debt to encourage risk-sharing contracts
are unlikely to be broadly embraced anytime soon in the United States.
A powerful special interest group, the financial industry, benefits from
debt contracts, fractional reserve banking, and their implicit subsidies
and preferential treatment. The financial industry is happy with the way
things are. It will fight tooth and nail to maintain the status quo. So the
only practical approach may be reforms in baby steps but with a clear
utopia as the target.
Some may raise other questions about such a proposal to restore finan-
cial stability. How would these equity contracts be financed? Investment
banks and mutual funds would do the financing. Recall that banks would
engage in two broad activities: (i) keep depositors’ deposits (safekeeping)
and (ii) engage in investment banking (intermediation), that is, channel
investors’ capital and their own shareholders’ capital into their desired
risk-return category of investment in the form of equity investment and
charge a fee for their services. Here the bank is not taking risk by invest-
ing its depositors’ deposits. Yes, the bank could also invest a portion of
its own capital in businesses and projects. The bank would monitor these
investments and earn a fee, a fixed fee, or a fee contingent on the project’s
success, from investors. An entrepreneur instead of borrowing from a
bank would get partners through the bank as the intermediary, partners
who had channeled their capital through the bank to finance investment
projects. Banks in their investment-banking mode would continue to do

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 Conclusions and Our Financial Future 

what should be their main function now, namely, reducing the fallouts of
asymmetric information (adverse selection and moral hazard) by assess-
ing the risks associated with projects, monitoring management decisions,
and charging a commensurate fee for their services. We should note that
the failure of these investments would have limited effect on investors,
the bank and its stockholders, and on the rest of the economy. It would
reverberate little throughout the economy, as leveraging is limited.
If the business does well, investors benefit (and the bank if its continu-
ing fees are contingent on business success). If the business fails, investors
lose their capital (note that it is their own capital as it is not borrowed
from a bank or other financial institutions) and the bank is left unscathed
and intact. There is limited transmission to the broader economy. There
is little likelihood of a total credit freeze. There would be significantly
less chance of a severe and widespread financial crisis and its attendant
negative fallouts even with reduced (not eliminated) interest-based debt
contracts and something less than 100 percent reserve banking.
Again, we repeat that such a system could not be established overnight.
There should be a well thought-out transition period of say 10 years to
replace a significant percent of debt-based transaction in favor of risk-
sharing contracts and increasing greatly the percentage of reserves in
fractional reserve banking. In this way disruptions are minimized and
familiarization nurtured. Banks will still make money. Businesses will
be still financed. Severe financial crises and their fallouts will become a
thing of the past. And the process of financialization with the growing
domination of the financial sector over the real sector would begin to be
reversed.
Focusing on the United States, we can confirm that financial crises
have had deleterious economic impacts in the form of bankruptcies,
significant fall in output (GDP), spike in unemployment, stagnant
wage incomes, rising income and wealth inequality, costly government
bailouts, and a decline in future economic growth. The economic cost
of the most recent crisis is simply astounding, a figure in the vicinity of
US GDP for one whole year, with attendant and additional psychological
and social damage. The negative economic impact of a financial crisis
can be expected to be more severe and prolonged than that of a run-of-
the-mill recession. This is because financial crises are accompanied by an
environment of heightened uncertainty that impair decision making, by
credit freezes with no sectors of the economy spared, and by leveraging
(runup in debt) that takes time to unwind (deleverage). The attendant

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 The Next Financial Crisis and How to Save Capitalism

costs and fallouts of financial crises, economic as well as social, appear

to be growing with each subsequent crisis. The essential reforms we have
outlined would reverse this trend.
Financialization, or the growing domination of the financial sector
over the real sector, and in turn financial crises may have played an
important role in the recent growing income and wealth disparity
in the United States. Financialization has favored those in the finance
industry and those with capital at the expense of the rest of the economy.
Financialization has increased the share of rentier income in total
income, in particular, a rise in rentiers’ income from interest (on bonds,
mutual funds) and dividends (stocks and mutual funds), at the expense
of the nonfinancial industry’s retained profits and wage income. This
concentration of wealth in favor of those who own capital is further
reenforced by the “magic” of compounding, something that has been
identified in the past by many noted economists. Financial crises have
resulted in widespread bankruptcies, and borrowers with debt contracts
(especially mortgages) end up losing some or all of their initial down
payment (equity). Foreclosures are a result of debt leading to housing
prices going down even further. Lenders (ultimately the wealthy who
own financial assets, including bank shares) have contracts that impose
all initial losses (the down payment equity) on the borrower (Mian and
Sufi, 2014). Thus, depending on the extent of the asset price collapse, the
borrower may be forced to absorb most, if not all, of the losses, while the
lenders’ equity (the rich) is senior and may be totally protected or bailed
out by the government. As a result, severe financial crises and recessions
exacerbate wealth inequalities by exposing borrowers (those whose capi-
tal ownership is small) and protecting lenders (the fortunate with surplus
capital). The preeminence and prevalence of debt essentially magnifies
the fall in asset prices because of foreclosures and concentrating losses
on the indebted, invariably the poorer segment of society.
Growing income and wealth inequality is not only a social issue. The
OECD (2014) has reported that growing income inequality has had a
statistically significant negative impact on economic growth; and in the
20-year span from 1990 to 2010, rising inequality resulted in lost output
equivalent to 7 percent of GDP for the United States and nearly 9 percent
for the United Kingdom. The OECD claims: “[W]hat matters most for
growth are families with lower incomes slipping behind.” Clearly, the
financial sector’s contribution to financial intermediation has not been
enhanced in recent years. If this had been the case, it would have been

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 Conclusions and Our Financial Future 

reflected in improvements in real economic performance indicators,

such as more rapid economic growth as opposed to a slowdown. Instead,
the financial sector has grabbed a bigger slice of the economic pie
through leveraged speculation that has been supported by governments
and ultimately paid for by ordinary taxpayers in the advanced countries.
Again, as we have said before, finance has become increasingly focused
on trading as opposed to efficient intermediation.
Now here are some obvious questions. If the costs of financial crises
are so high and if fixing the system so transparent, why hasn’t it been
done before? Why don’t we do it now? First, and foremost, the financial
industry does not want it. The industry is quite happy with the way
things are. Fractional reserve banking allows the industry to create
money and leverage. They are receiving government support and subsi-
dies—subsidized deposit insurance, guaranteed bailouts for the biggest
institutions, and preferential tax treatments—to take unwarranted risks
and make money for themselves and their stockholders at the expense of
taxpayers. Moreover, they never lose much as a result of financial crises
and may even gain relative to the rest of the economy. From the financial
industry’s perspective, there is no reason to change. How do they get
away with it?
The financial industry has invested to become arguably the most
influential and powerful lobby in the United States in support of the
candidacy of politicians who will do its bidding. During the period
1998–2010, the financial industry (finance, insurance, and real estate)
contributed $4.27 billion to lobbying or 15 percent of all contributed
funds for lobbying, closely followed by healthcare.1 As a recent confir-
mation of the financial industry’s power over the US Congress, one of
the most touted provisions in the Dodd-Frank Act, namely, restrictions
on banks’ ability to trade risky derivatives, was rescinded by the House
on December 10, 2014, and by the Senate three days later as a part and
parcel of getting an acceptable spending bill passed. This was done to
satisfy Wall Street’s biggest banks, including Citigroup and JPMorgan
Chase. Lawmakers inserted a line that repealed this provision, Section
716, which required banks to separate and put the riskier trading of
derivatives (such as credit default swaps and commodities trading) into
holding companies not to be insured by taxpayers. “This bill is a one-two
punch at middle-class voters,” said Representative Steve Israel of New
York, a member of the Democratic leadership (as reported in the New
York Times, December 12, 2014). “It weakens financial regulation on big

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 The Next Financial Crisis and How to Save Capitalism

banks and rewards Congress for doing so by increasing donation limits

of big donors. This is exactly why middle-class voters have a contempt
of Congress.” The new Congress, in January of 2015, picked up from the
last Congress by considering the elimination of three other important
provisions of Dodd-Frank.
In addition to the power of the financial industry, the “unknown”
is invariably scary for most of us. There is a reluctance to take a road
not taken and to venture into the unknown, no matter how safe and
visible the road. Consumers love to borrow and banks love to lend. It is
a marriage of convenience until a financial crisis raises its ugly head. The
way things stand in the United States, even simple regulations cannot
be adopted anytime soon, let alone an overhaul of the financial system.
The US Congress appears to be willing to increase the likelihood of
crushing economic and social costs in order to satisfy the greed of a few
large financial institutions, their managers, and stockholders. Members
of Congress appear to be more interested in financing their re-election
campaigns than in advocating and pursuing the greater good. It is policy
and regulatory adoption at its worst. It would be cheaper for the nation
if the Congress simply gave cash handouts to its favorite “too big to fail”
banks every year and avoided another $14 trillion in direct economic
costs and even more in related human and social costs.
So what can we expect in the future? One thing is certain. If things
are left the way they are, there will be future financial crises and with
increasing financialization the interrelated fallouts could be worse than
anything we have seen, posing an existential threat to the pure market
capitalist system. We say this for at least four reasons. First, the credit-
debt-leverage-crisis nexus has not been broken. It maybe even stronger
than it was before the recent crisis. Second, and as many observers have
said before us, the adverse economic and social fallouts are intertwined
and appear to be getting increasingly more ominous: recall simply the
estimated loss in output from the recent crisis that could run to over
$14 trillion, a figure comparable to the US national economic output for
one whole year; prolonged periods of unemployment, a regular fallout,
are taking a heavier and heavier toll on the social fabric of society; and
the worsening income and wealth distribution, which has roots in finan-
cialization and financial crises, will continue and in turn impair future
economic growth. Third, and to us just as important, are the devastating
social fallouts of recurring crises and their prolonged duration. Fourth,
the path that we are on, a path that has nourished the financialization

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 Conclusions and Our Financial Future 

of our economy, will eventually lead to catastrophic social consequences

with diminishing opportunities, psychological hysteresis, and the
marginalization of millions of families and individual lives. The prob-
lems we face—financial instability and financial crises, stagnant wage
incomes, declining economic opportunities, growing income and wealth
inequality, reduced economic growth, and societal fissures in the form of
high unemployment and more—are interrelated and are best addressed
as such. Our proposed financial reforms by reducing the likelihood of
severe financial crises would reduce and reverse financialization and all
that it entails, enhance long-term economic growth, reduce the periods
of sustained unemployment, reverse the trend of growing income and
wealth inequality, and reduce the need for government subsidies and
bailouts that have socialized the cost of crises at the expense of average
taxpayers.
These interrelated problems, which include recurring financial crises,
pose an increasing threat to the capitalist market system. We believe that
Adam Smith, the acknowledged father of modern economics, envisaged
a different system from the one we have today. Smith touted the benefits
of efficient markets for the allocation of resources across space and time.
And he envisaged markets with rules, regulations, and supervision and
founded on the bedrock of effective institutions. All of this and more
he espoused in his most famous book, An Enquiry into the Nature and
Causes of the Wealth of Nations (1776). But in his earlier book, The Theory
of Moral Sentiments (1759), Smith provided the anchor or the mooring
for his Wealth of Nations. The two books are to us inseparable. If the two
books are not taken as inseparable, then a reasonable person would
either conclude that the two tomes were written by two very different
individuals or by one who was a serious schizophrenic! Adam Smith was
a moral philosopher who clearly saw that unfettered markets could not
guarantee outcomes that were socially defensible. Market participants
had to translate the love of self into sympathy for others; otherwise the
result could be a socially indefensible one. Today, especially in the after-
math of the recent financial crisis and its devastating fallouts, the capital-
ist market system may have lost its moral mooring and may be drifting
into dangerous territory. We believe that serious financial reforms are at
the foundation of a positive turnaround.
It is time to make a bold change by putting our financial house in
order and on a better path. Yes, higher capital requirements for banks,
better regulations, supervision and enforcement, and the like are always

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 The Next Financial Crisis and How to Save Capitalism

helpful, but at best they will only delay the inevitable, another devas-
tating financial crisis with devastating fallouts. We need to anchor our
economic system on morality as envisaged by the father of the capitalist
market system, Adam Smith; and adopt more fundamental reform of our
financial system that reduces the supremacy of debt and debt financing,
encourages risk sharing or equity finance, and increases the percentage
of reserves in fractional reserve banking.

Note
1 http://en.wikipedia.org/wiki/Lobbying_in_the_United_States

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 Index
adverse selection, 2, 14, 67 traditional/conventional,
asset-backed commercial 6–7, 52, 57–9
papers (ABCPs), 7 see also fractional reserve
asset-backed securities (ABSs), banking; investment
7 banking/banks; reserve
asset-liability mismatch, 5, 32, banking (100 percent)
49, 51, 58 bankruptcy, 5, 6, 18, 20, 29, 31,
asset markets, 8, 22, 26 39, 50, 51, 53, 55, 56, 64, 65,
boom and bust cycle in, 8, 67, 68
18, 26 Bernanke, B., 21
asset/asset price bubbles, 13, 15, bonds, 2, 5, 6, 10, 13, 21, 38,
18, 19, 22, 23, 26, 31, 32, 50, 55, 68
56, 60, 65 Contingent-Convertible
asset prices, 11, 13, 18, 19, 20, Bonds/Cocos, 55
22, 30–1, 33, 39, 51–2, 57, borrowers, 2–5, 18, 20, 22, 29,
60, 68 31, 39, 51, 56, 64, 68
asymmetric information, 2, 14, bubbles, 11–13, 14
19, 67 asset, 13, 15, 18, 19, 22, 23, 26,
Atif, M., 17, 30–1, 39, 40, 45, 48, 31, 32, 50, 56, 60, 65
49, 61 of debt and credit, 26
equity and housing, 13, 61
bailouts, 14, 15, 19, 21, 31, 33, 39, “rolling bubbles”, 12, 26
48–51, 55, 59, 60, 67–9, 71
bank failures, 14, 48–9, 53, capital formation, 2, 27, 40
55–6, 59, 67 Capital in the Twenty-First
Banking Act (1933), 52 Century, 39
banking system capital markets, 3, 36
and demand deposit central bank/banks, 12, 14, 15,
creation, 4 26, 59–60
instability of conventional, certificates of deposit
50–1 (CDs), 5
and mismatched assets and Chicago Plan/Chicago Reform
liabilities, 5, 32, 49, 51, 58 Plan, 22–6, 48–9, 53
nondeposit shadow, 6, 7, 52 collateralized bond obligations
parallel, 7, 21 (CBOs), 7

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 Index 

collateralized debt obligations (CDOs), deposit insurance, 18, 50–2, 60, 62n1,
7, 27 69
collateralized loans obligations Dodd-Frank Act, 54–5, 60, 69
(CLOs), 7
commercial banks, 2, 9, 50, 51, 64–5 economic downturns, 5, 17, 36, 45, 48,
commercial mortgage-backed 61, 64–6
securities (CMBS), 7 see also recessions
Consumer Protection Act, 54 economic growth, 3, 6, 11, 20, 32, 38,
consumption, 8, 10–11, 22, 31–2, 34, 41, 40–3, 45, 50, 52, 58, 59, 64, 67–71
42, 44, 56, 58–9, 64 Epstein, G., 7, 43
contagion, 14, 18–19, 22, 58, 65 equity, 6, 8–10, 12–13, 25, 29, 31–2, 34,
contracts, 2 39, 50, 54–5, 57–8, 61, 65–6, 68
credit, 20 see also equity finance; equity funds
debt, 3, 8, 12, 18, 24, 29, 31, 34, 39, 45, equity finance, 25, 32, 41, 48, 65, 72
61, 62, 64, 66, 67, 68 equity funds, 6, 21, 27, 52
equity, 29, 66 Europe, 13–14, 15, 17, 27
interest-based, 3, 4, 29, 34, 45, 64, 67 extraordinary government support,
risk-sharing, 30, 33, 45, 48–9, 56–7, 37–8
60–2, 65–6
credit default swaps (CDSs), 7, 27, 69 fallouts, 2, 7, 9, 17, 19, 30, 33, 36, 42–4,
credit expansion, 4, 13, 22, 27–8, 32, 62, 66–8, 70–2
58–9 Federal Reserve System, 52
credit freeze, 19, 30–3, 50, 58, 64, 67 financial capitalism, 25
credit losses, 32, 58–9 financial crises, 5, 11
credit multiplication, 22–3, 32, 49, 53, causes of, see financial crises, causes of
58 characteristics of, 17
Crockett, A., 2, 3, 19 impact of, 36–8, 40, 67
Crotty, J., 42–3 reasons for, 17–18
regulations and, 51–6
Dallas Federal Reserve study, 37–8 risk sharing and, 56–60
debt, 2–4, 7, 12, 27, 32–3, 46, 56, 58 financial crises, causes of
household, 10–11, 12, 13, 26–7, 30–1, financial regulators, 20–1
39, 45, 49, 61 fractional reserve banking, 29–33
interest-based/ interest-rate-based, household debt, 30
10, 18, 29–34, 45, 49, 50, 56, 62, institutions, 21
64, 67 interest-based debt, 29–33
see also debt contracts; leveraging Keynes-Chicago Plan-Minsky, 22–6
debt contracts, 3, 8, 12, 18, 24, 29, 31, 34, low interest rates, 20
39, 45, 61, 62, 64, 66, 67, 68 low-wage incomes, 19–20
debtors, see borrowers macroeconomic imbalances, 21–2
decoupling, 4, 26, 30, 42–4, 56, 64 moral failure, 28–9
deleverage, 17, 36, 67 paper economy, 26–8
see also deleveraging shock from bad harvests, 19
deleveraging, 33, 36, 59 financial deregulation, 8–9, 15, 26
defaults, 3, 5, 18–20, 30, 32, 34, 45, 56, financial instability hypothesis, 25
58, 61, 64–5 financial institutions, 5–10, 13–15, 28,
demand deposits, 4, 18, 22 38, 42–3, 46, 49–52, 54, 64, 67, 70

DOI: 10.1057/9781137544377.0012
 Index

financial instruments, 2–4, 7, 8, 21–2 Great Depression, 6, 20, 23, 33, 45, 52, 53
financial intermediation, 2, 5, 14, 29, Great Recession, 17, 61
43, 53, 59, 68 “Greenspan Put”, 11, 51
financial markets, 2, 7–8, 11–12, 21, 27,
36, 42–3, 51 hedge funds, 6, 10, 21, 23, 25, 27, 42, 51,
financial sector, 3–4, 6–9, 11, 12, 14–15, 52, 54
27, 30, 50, 53, 60, 64, 68 hedging, 2, 14, 27
debt, 10 herding, 11
losses, 13–14 household debt, 10–11, 12, 13, 26–7,
see also decoupling; financial 30–1, 39, 45, 49, 61
crises; financial crises, causes of; households, 5, 8, 31, 36
financial systems; financialization American, 37
Financial Services Modernization Act, debt, see household debt
see Gramm-Leach-Bliley Act spending, 30–1
Financial Stability Board (FSB), 55 wage income of, 39
financial systems
complexity of, 27 income and wealth inequality, 7–8,
debt-dominated, 12, 30 38–42, 44, 64, 67, 68, 71
functions of, 2–3 information asymmetry, see
market-based, 8 asymmetric information
role of, 2, 5 insolvency, 5, 21, 23, 32, 45, 49–51, 57–8,
financialization, 3, 6–8 65
and bubbles, see bubbles investment banking/banks, 9, 14, 29,
characteristics/features of, 6, 10–12 48–9, 52–3, 56–7, 59, 65, 66
and decoupling of real and financial investments, 2–3, 5, 11, 20, 23–4, 29, 32,
sectors, 42–4, see also decoupling 40, 44, 49, 56–9, 65, 66
economic consequences of, 6 see also investment banking/banks;
fallouts of, 7, 42–4, see also fallouts investors
growth of, 8–14 investors, 2, 4, 7, 13, 27, 30, 49, 53, 56,
and income and wealth distribution, 59, 60, 64, 66–7
38–42 individual, 2, 11
problems of, 64 institutional, 6, 8, 11, 21
regulations to tackle, 15 Islamic finance, 48
Fisher, I., 22, 23, 45, 61 Israel, S., 69
Fitzpatrick, M., 54–5
foreclosures, 31, 36, 39, 61, 68 Japan, 11, 14, 15, 27, 33
fractional reserve banking, 4, 18, 22–3,
29–34, 45, 48–9, 51, 57, 60–2, 64–7, Keynes, J. M., 11, 12, 17, 18, 20, 23–6, 30, 45
69, 72 Kindleberger, C., 17, 18, 30, 45, 60–1
fraud, 7, 28, 31, 33, 43, 51, 57, 61, 64, 65
Friedman, M., 48 lenders, 4–5, 9, 18, 21, 24, 29, 31, 39,
55–6, 59–61, 64, 68
General Theory of Employment, Interest leverage, 7, 9, 13, 18, 21, 23, 25, 32, 33,
and Money, 24 36, 43, 48, 50, 52, 53, 56–8, 64–5,
Glass-Steagall Act, 9, 52 69–70
Gramm-Leach-Bliley Act, 9 see also leveraging

DOI: 10.1057/9781137544377.0012
 Index 

leveraging, 4, 7, 34, 46, 49, 60, 67 Reconstruction Finance Corporation,

Limited Purpose Banking, 48 52
limited purpose finance corporations regulations, 15, 51–6
(LPFCs), 7 reforms, 15, 17, 33, 45–6, 52–6, 61–2, 64,
liquidity, 2–3, 8, 12, 13, 18, 21, 32, 33, 49, 66, 68, 71–2
51, 58, 60 see also Chicago Plan/Chicago
loans, 3–5, 7–8, 13, 19, 20–4, 32, 49, Reform Plan
51–3, 56–60, 65 rentiers, 24, 30, 38, 39, 42, 43, 44, 68
Long-Term Capital Management reserve banking (100 percent), 33, 48,
(LTCM), 51 53, 55, 57–9, 60–2, 65–7
losses, 13, 15, 19, 30–2, 34, 37–9, 45, residential mortgage-backed securities
50–3, 55–6, 58–61, 65, 68, 70 (RMBS), 7
return/returns, 2–3, 6, 9, 11–12, 14, 19,
marginal efficiency of capital, 20 20, 22, 24, 27, 29, 32, 39, 40, 43, 44,
market capitalism, 23–4, 29 57–60, 64, 66
Minsky, H., 11, 17, 18, 24–6, 30, 53, 59 return to capital, 64
money market funds, 6, 9, 23 risk sharing, 45, 48–50, 56–60, 61, 66,
money markets, 3, 59 72
moral hazard, 2, 9, 14, 15, 51, 67 see also risk-sharing contracts
mortgages, 4, 7, 13, 21, 31, 36, 39, 45, 52, risk-sharing contracts, 30, 33, 45, 48–9,
54, 60, 68 56–7, 60–2, 65–6
mutual funds, 6, 11, 21, 29, 38–9, 49, 52, risk shifting, 3, 29–30, 48, 56
53, 56, 57, 65, 66, 68 risk taking, 7, 9, 15, 21, 33, 51, 52, 54
risk trading, 3, 7, 60, 69
National Credit Corporation, 52 risk transfer, 29–30, 33
national trauma and lost opportunity risks, 3, 4, 9, 18, 21, 29–30, 44, 67
effect, 37–8 see also risk sharing; risk-sharing
nonfinancial corporations (NFCs), 42–3 contracts; risk shifting; risk
taking; risk trading; risk transfer
Obama, B. (President), 54
Organization for Economic
Saez, E., 40–1
Cooperation and Development
savings, 2, 3, 5, 8, 11, 14, 21, 23–4, 32, 34,
(OECD), 41–3, 68
40, 44, 45, 51, 57–9, 64
paper economy, 26–8 Securities and Exchange Commission,
parallel banking, 7, 21 52, 54
path-of-consumption loss, 37–8 securitization, 7, 12, 21, 23, 26, 32,
Piketty, T., 39 53, 58
Ponzi finance, 25, 33 shadow banking, 6, 7, 52
Ponzi units, 25 Smith, A., 29, 71–2
proprietary trading, 7, 15, 54 special investment vehicles (SIVs),
7, 27
real sector, 4–8, 11–12, 14–15, 22, 26–7, special purpose vehicles (SVPs), 7
44, 48, 50, 56–7, 60, 64, 67–8 speculation, 3, 6, 7, 11, 19, 20, 22, 27, 43,
see also decoupling 50, 51, 52, 57, 59, 64, 69
recessions, 5, 7, 15, 17, 30–1, 33, 36, 39, stocks, 2, 11, 18, 19, 27, 39, 68
61, 67, 68 Sufi, A., 17, 30–1, 39, 40, 45, 48, 49, 61

DOI: 10.1057/9781137544377.0012
 Index

tax/taxes/taxation, 10, 15, 38, 39, 40, debt, 21, 50

42–4, 60, 61, 64, 66, 69 see also risk trading
see also taxpayers
taxpayers, 43–4, 51, 56, 69, 71 unemployment, 17, 24, 26, 30, 33–4, 36,
The Theory of Moral Sentiments, 29, 71 50, 59, 64, 67, 70–1
Tietmeyer, H., 26
Tobin, J., 26–8 Volcker Rule, 54
“too big to fail” institutions, 9–10, 21,
33, 50, 51, 54, 60, 70 wage stagnation,
total loss-absorbing capacity (TLAC), 7, 44
55–6 Wealth of Nations, 29, 71
trading, 2, 3, 10, 14, 22, 26, 27, 54–5,
64, 69 Zuboff, S., 28

DOI: 10.1057/9781137544377.0012