FECKLESS AND FICKLE: CENTRAL AND SHADOW BANKING DURING THE GLOBAL FINANCIAL CRISIS
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Date
2014-07-31
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Johns Hopkins University
Abstract
This dissertation studies the relationship between economic ideas and financial crises. It focuses on a subset of economic ideas, economic conventions, of which there are three types: ergodicity, expert opinion, and conventional expectations. This dissertation argues that conventions account for six inter-related phenomena in financial markets. First, stable economic conventions produce stable markets. Second, some conventions are more likely to produce asset market imbalances than others are. Third, conventions sow epistemic blindness to the prospect of non-routine change in financial markets. Fourth, shocks to agents’ convention-given expectations catalyze convention uncertainty in financial markets. Fifth, given sufficient financial fragility, convention uncertainty causes agents to revert to first principles of survival, hoarding liquid capital and disrupting the market’s normal price mechanism. Sixth, conventions set the bounds of elite responses to financial crises. These six propositions emerge from a theoretical synthesis of several paradigms of understanding agent behavior in complex social systems, including Post-Keynesian asset market theory, Keynesian epistemology, Charles Doran’s power cycle theory, and economic constructivism. The study employs counter-factual, process-tracing, and econometric techniques to demonstrate empirically its causal propositions via a case study of central banking and shadow banking during the global financial crisis. The dissertation finds that economic conventions explain the Federal Reserve’s accommodative monetary policy from 2001-2006, and that conventions such as bond ratings, value-at-risk, and conventional expectations in shadow banking markets were key drivers of financial fragility ex-ante the global financial crisis. This dissertation finds that regulators’ repeated interventions in financial markets, including their orchestration of the bailout of hedge fund Long-Term Capital Management in 1998, bailout of investment bank Bear Stearns, and bailouts for the government-sponsored enterprises Fannie Mae and Freddie Mac in 2008, established a conventional expectation in financial markets that regulators would serve as de facto deposit guarantors for shadow banking conduits. It is proposed that the failure of Lehman Brothers in September 2008 eviscerated the market’s tenuous, convention-engendered stability, thus initiating a period of convention uncertainty in financial markets. Convention uncertainty disrupted the market’s normal price mechanism and explains the market’s “flight to quality” after Lehman’s bankruptcy. Regulators’ unconditional bailouts of the U.S. financial system can be understood as an attempt to restore convention certainty to wholesale funding markets. All told, the findings of this dissertation provide support for the argument that economic ideas, and in particular economic conventions, need to be taken seriously as important causal drivers of stability, fragility, and change in financial markets.
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central banking, shadow banking, conventionality, global financial crisis,