Endogenous Developments in the financial sector that led to th.docx

Endogenous Developments in the financial sector that led to the
2007-9 crisis
The financial crisis of 2007-2009 was not a typical credit
crunch crisis as the ones we have seen in
the modern capitalist era. It wasn’t a crisis solely driven by the
irrationality of market participants or
the result of an overvalued market system; it was in fact a much
more complex phenomenon. The
development and alternations in the financial sector through the
last 20 years is undoubtedly
significant. With the collapse of Keynesianism in the 1970’s
and the emergence of Neoliberalism the
economy was to change page from a state-led mechanism to an
autonomous factor. Although
favoured by a period of high degree market liberalisation with
policies of a laissez faire doctrine, the
financial sector achieved its rapid development and expansion
endogenously. Within the
frameworks of the financial system, a new set of institutions
emerged to supply the excess demand
for credit without however being compliant to the typical
legislative requirements of a commercial

bank; this practise of regulatory and financial arbitrage was
performed by the so-called “shadow
banking system”1. Rating agencies, mainly Standard & Poor’s
and Moody’s became part of this
system undermining thus their actual role as exogenous
regulatory forces2. Moreover, the
construction of new financial products such as asset-backed
securities and their exchange in the
over-the-counter markets was a pivotal step towards a volatile
financial system that relied heavily
on mortgages handed on non-creditworthy borrowers3; the burst
of this bubble system was thus
inevitable.
From the end of the 1990’s up to 2007 the banking system had
created an image of euphoria,
where credit was granted with less and less collateral
requirements as the demand for loans had
increased dramatically and banks found a way to instantly
increase their profits. It’s worth to
mention that commercial banks for example in Greece, which
today operate under a capital control
scheme, in 2006 had started issuing ‘holiday’ loans to the
public4. From the beginning of the 2007

economic crisis up to 2016 the Greek central bank has
recapitalized the domestic commercial banks
thrice as the country was facing the threat of bankruptcy5. In
the US, the heart of the global capital
markets, the government had to step in the financial markets
and through direct spending to save
financial giants, such as AIG and restore the liquidity shortage
that had resulted6. The complex
nature and architecture of this new financial order was depicted
by the domino-like collapse of its
branches in contrary to previous typical credit crisis, as the
dotcom bubble of 2001. But what really
made this new order so complex and interdependent within its
spheres?
As mentioned before, because of the widespread climate of
over-optimism in society people and
firms were triggered to borrow money and designed their lives
under a fictitious world of credit
money. From their side banks, as profit generating entities
wanted to take advantage of this
increased demand for credit and thus supplied loans as much as
possible. Nonetheless, commercial
banks were constrained by specific rules concerning the ratio of
capital they could lend and the

money they hold as reserves. More to the point, in most
countries, with the exception of the UK for
1 McCulley, Paul. "The Shadow Banking System and Hyman
Minsky’s Economic Journey." p. 257
2 Wolfson, Josh, and Corinne Crawford. "Lessons from the
Current Financial Crisis: Should Credit Rating Agencies be Re-
Structured?". p.87
3Palan, R. & Nesvetailova, A. “ Elsewhere, Ideally Nowhere:
Shadow Banking and Offshore Finance”. p. 31
4 Από τα εορτοδάνεια στα...τυροπιτοδάνεια. Το πικρό χιούμορ
του διαδικτύου για τα δέλεαρ των τραπεζών και την
κατάρρευση της "Ισχυρής
Ελλάδας".<http://www.mixanitouxronou.gr/apo-ta-eortodania-
sta-tiropitodania-to-pikro-
chioumor-tou-diadiktiou-gia-ta-delear-ton-trapezon-ke-tin-
katarrefsi-tis-ischiris-elladasnia/>.
5 Papadogiannis, Giannis. "Πώς φθάσαμε και πώς έγινε η 3η
ανακεφαλαιοποίηση”
<http://www.kathimerini.gr/840305/article/oikonomia/epixeirhs
eis/pws-f8asame-kai-pws-egine-h-3h-anakefalaiopoihsh>
6 "U.S. Senate vote on Emergency Economic Stabilization Act
of 2008". Senate.gov. June 29, 2011.
http://openaccess.city.ac.uk/view/creators_id/ronen=2Epalan=2
E1.html
http://openaccess.city.ac.uk/view/creators_id/anastasia=2Enesve
tailova=2E1.html
http://www.senate.gov/legislative/LIS/roll_call_lists/roll_call_v
ote_cfm.cfm?congress=110&session=2&vote=00213
example, the central bank imposed a minimum level of reserves

that commercial banks should hold
from their deposits, known as reserve requirements7. Either as a
tool of monetary control or a
measure to protect banks from a serious credit default, this
policy was seen by most commercial
bankers at the time as a restrain on their high-demanded
services. Consequently, banks had to find a
way, endogenously and without violating the existing regulatory
framework, to keep the pace of
their credit supply without having to worry about the level of
deposits they hold; the solution was
the creation of an SPV (Special purpose vehicle) controlled by
the ‘mother’ bank.8
The creation of SPVs became a very popular trend within the
banking sector from the beginning of
the new millennium and reached a plateau the years before the
outbreak of the Great Recession. It
was a significant financial innovation that enabled commercial
banks to provide their services
without appearing in their balance sheets. What made this
practise even more attractive was the
easiness of starting it up and the relatively low costs of
constructing and functioning such an entity,
as capital costs were not needed9. To understand the increased

influence of SPV’s in the financial
sector, we must consider that in 2013, according to official
surveys, over 10.000 of different SPV’s
functioned in Holland10, a relatively small proportion of the
worldwide total. The vast majority of
SPV’s were registered in tax heavens, such as Bermuda, and
thus operated under the tax laws of
these countries. The latter fact added to the practise of off-
balance sheet banking increased the
inability of the regulatory authorities to supervise the actions of
credit institutions and consequently
failed to predict and take measures against the financial slump
that would soon follow.
One of the most important financial developments in the recent
years before the outbreak of the
Great Recession was the creation of new financial products,
mainly asset-backed securities.
Although the construction and exchange of these products was
designed and operated
endogenously, it is worth to mention that important decisions
made in the political field, such as the
Commodity Futures Modernization Act which was signed into
law in 2000, allowed for the rapid
expansion of the securities market11. The most prevalent type

of asset backed security was the
Collateralized Debt Obligation (C.D.O.), a bond whose
payments was subject to the earnings of a
specific collateral. Despite that the firsts CDOs were created
and distributed in 1994-5 12, what made
them especially risky for the outbreak of the 2007 crisis, was
the type of collateral used. Since the
early 2000’s most CDOs used mortgages as collaterals, many of
which mortgages were handed in the
first place to subprime borrowers. Credit rating agencies
provided a rating to each branch of CDOs
according to their risk level. It was considered generally a low
risk financial activity with a relatively
high return (Average:5-9% per year) in a period with constantly
rising house prices13; triggering thus
investors to spend more and more capital on these mortgage-
backed assets.
From 2004 to 2007 more than 1.4 Trillion dollars had been
given for the purchase of new CDOs. It
was a substantial numerical increase if we consider that in 2000
sales of CDOs reached only 60
Billion dollars14. These asset-backed securities were the perfect
instrument for banks to move credit

7 Mankiw, Nicholas Gregory, and Mark P. Taylor. Economics.
p.573
p.576
9 Nesvetailova, Anastasia. "A Crisis of the Overcrowded
Future: Shadow Banking and the Political Economy of Financial
Innovation.". p.7
10 Nesvetailova, Anastasia. "A Crisis of the Overcrowded
Future: Shadow Banking and the Political Economy of Financial
Innovation.". p.8
11 Reavis, Cate. "The Global Financial Crisis of 2008: The Role
of Greed, Fear, and Oligarchs." p.7
12 Palan, R. & Nesvetailova, A. “ Elsewhere, Ideally Nowhere:
Shadow Banking and Offshore Finance”. p.31
14Morgenson, Gretchen, and Joshua Rosner. Reckless
Endangerment: How Outsized Ambition, Greed, and Corruption
Led to
Economic Armageddon. p.283.
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risk of their balance sheets and pass it to investors or to Special
Purpose Vehicles-Entities which they
did not technically own15. More to the point, banks initially
bundle up a collection of loans and
create a package of debt from which bonds are created. The SPV
which is created by the bank buys

this collection of loans with funds raised by the issue of short-
term bonds. After this purchase, had
been completed, these loans have now been removed from the
bank’s balance sheet and thus the
latter is no longer legally responsible for them. From now on
investors of CDOs had a claim against
the SPV and not the mother bank16. Banks, and other financial
entities as insurance companies, also
created and issued CDS (Credit default swaps) through the
market, via which they could buy hedge
against the potential default risks of their loan portfolios.17
Through these processes, a very complex
financial system emerged which operated in the shadows not
only of regulators but also of investors
that couldn’t have a clear image of the product in which they
invested in; consequently, market
efficiency was impossible to prevail and the results were
obvious.
With the outbreak of the financial crisis in 2007, the global
economic order was put into question
and various heterodox views started to regain attention. From
the early 1980’s and onwards, a long
period of the preponderance of liberalism and deregulation
governed financial markets. There was a

widespread belief in the power of markets to self-correct and
operate without the need of
government intervention. It was based on the concept of the
efficient market hypothesis, a theory
suggesting that due to the efficient information available in the
marketplace, actors will behave
rationally as asset-prices will reflect real market value18. This
theory came under serious
animadversion after the Great Recession especially because of
the increasing tendency of financial
institutions, mainly hedge funds through the last 20 years, on
engaging in the practise of shadow
banking. As Lo pointed, the limited to non-existing access to
information on primary data of hedge
funds lead to the inability of economic agents to credibly
measure systemic risk in this field19.
However, the very existence and persistent growth of these
institutions depended on a high degree
confidentiality from the side of regulatory bodies and at the
same time hedge funds were a crucial
component of the American economy, inevitably leading to a
regulatory bias in favour of these giant
profit-makers20.
Based on reliable recent data, the shadow banking system

accounts for nearly one third of the
global financial system21. The term “shadow banking” was first
used by former manager director of
PIMCO, Paul McCalley in 2010, to describe the system of non-
formal bank institutions that provided
the services of real banks22. The practise of Shadow banking
has its roots back in the 1970’s with the
expansion of money market funds and through the years has
developed to a key component of
financial markets, accounting for more than 10 Trillion dollars
in 201023. The fundamental difference
of “Shadow banks” in comparison to a typical commercial bank,
was that they were subject to much
less extend on regulations and liabilities and furthermore the
former didn’t have access to deposit
15 Farhi, Maryse, and Antonio Cidra. "Crise Du Capitalisme
Financier." The Financial Crisis and the Global Shadow
Banking
System. ¶.9
p.577
Banking
System. ¶.10
p.551

20 Reavis, Cate. "The Global Financial Crisis of 2008: The
Role of Greed, Fear, and Oligarchs." p.16-17
of Greed, Fear, and Oligarchs." p.20-21
22 Bill Gross, Beware our Shadow Banking System.
<http://money.cnn.com/2007/11/27/
news/newsmakers/gross_banking.fortune/>
23 Singh, Manmohan, and James Aitken. "The (Sizable) Role of
Rehypothecation in the Shadow Banking System."
http://money.cnn.com/2007/11/27/%20news/newsmakers/gross_
banking.fortune/
banking.fortune/
insurance, the rediscount rate and the last resort credit line of
the FED24. This meant that in case of
default, as in 2007-9, these entities would not be able to secure
their assets and investors would
instantly lose their money. Except hedge funds, insurance
companies and SPV’s that dominated this
area, great attention must be given to the role of quasi-bank
public entities, mainly Freddie Mac and
Fannie Mae, which were designed for and served as liquidity-
capital providers for the US real estate
market25; a market highly overvalued and unsustainable, that
soon popped like a bubble.

The 2007-2009 financial crisis is also known as the subprime
mortgage crisis. Of course, this title
wasn’t given incidentally but rather underlined the role of the
US real estate market as a catalyst to
the financial slackness that occurred. The plethora of
endogenous agents believed at the time that
investing in the US house market was a quite profitable and
relatively safe financial activity26. The
housing price bubble, had started from the 1990’s and up until
the mid-2000s had a steady growth
of more than 8 percent annually. Indicative of the plasmatic
world in which this whole system was
structured, official data suggests that the average household
costed more than 4 times the money it
earned27, creating an unsustainable debt. Hyman Minsky had
described this phenomenon as “Ponzi
finance” and he insisted that this was the main reason why
capitalist societies are unstable and
doomed in repeated crisis28. More to the point, a Ponzi scheme
refers to a situation similar to the
pre-2007-9 crisis period, where people borrow money with the
belief that the market prices will
keep going high while simultaneously their current income is
not sufficient to repay neither the

interest or the principal of the loan; on the other side, banks
gave credit with the assumption that
market prices (such as in the US house market before 2007) will
keep growing with the same pace29.
Nonetheless, this wasn’t the case from the end of 2006 and an
endogenous driven belief and series
of actions based on the notion of constantly increasing house
prices led to a disastrous outcome.
The fictitious nature of a financial system based on non-
creditworthy borrowers and overvalued
assets could not have existed, at least in this extent, without the
involution of Credit Rating
Agencies. Moody’s, Standards and Pool’s and Fitch are the
three rating agencies which dominated
more than 95% of the rating agency market30 and were brought
in the spotlight when the blame
game for the financial crisis of 2007-9 had started. Historically,
the initial function of rating agencies
was to provide necessary market information to investors and
financial corporations, but through
time they extended their services in many other fields, mainly
on selling “seals of approval” in the
form of ratings (from a scale of A-D), which turned to be their
main source of revenue.31 From the

1970’s and onwards Credit rating agencies had been
transformed into the ultimate gatekeepers of
the global financial system and without their approval-rating,
agents could not sell their financial
products in the market.32 The development of rating agencies
and their engagement in the process
of constructing new financial assets by providing a rating for
which they were paid by the issuer,
Banking
System. ¶. 8
Banking
System. ¶.8
Minsky’s Economic Journey." P.260
Minsky’s Economic Journey." p.260
Structured?". p.86
Structured?". p.87
32Wolfson, Josh, and Corinne Crawford. "Lessons from the

Structured?". p.87
opened a big room for corruption and regulatory bias33. A
characteristic example of this problem,
was AAA ratings granted for products which were collateralized
on subprime mortgages, that under
normal circumstances should have been rated with a D and warn
potential investors for their risk
exposure34.
A very important development in the financial sector which
had started from the late 1980’s was
the emergence of “over the counter” (OTC)markets. In
juxtaposition to typical exchange markets
where financial products are traded openly and prices are driven
by market forces, the function of
OTC market was highly obscure35. It was estimated in 2008,
that US$ 683.7 trillion in notional values
derivatives were exchanged in this shadow market.36 The
limited regulation and supervision over
these markets increased the popularity and tendency to trade
derivatives via them. Mortgage-
backed securities, derivatives and CDS were traded uniquely in

OTC markets which offered the
perfect framework and conditions for both sellers and investors
to act as complete market makers37.
This type of market relied heavily on liquidity and an absence
of the latter, as in 2007-9, could prove
catastrophic.
In conclusion, a series of endogenous financial developments
and innovation that had its roots in
the 1980’s and reached a peak in the post-dotcom bubble era,
gave birth to a financial system highly
vulnerable and endogenously interdependent; making this
financial crisis unique in size and effect in
contrast to mainstream bubble crisis. Banks were behind this
whole process of constructing a new
financial order, where households would leave above their
means so as to continue buying their
products in the same pace. New financial products and markets,
enabled these institutions to
increase their volume of activities and function on the sly of
regulators. The outcome was an
economy paranormally overheated that was perfectly described
by S. Johnson’s quote: “there was
twice as much money looking for investment, but not twice as
many good investment”.38 Even the

stronger proponents of laissez-faire economics and the
efficiency market hypothesis, such as Alan
Greenspan, admitted that there was much space given for
financial players to endogenously profit
and manipulate the system.
Word count: 2531
Structured?". p.87
34 "Third time's the charm?". The Economist.
Banking
System. ¶..32
Banking
System. ¶.39
Banking
System. ¶.32

http://www.economist.com/blogs/freeexchange/2010/09/basel_ii
i
BIBLIOGRAPHY
1. Wolfson, Josh, and Corinne Crawford. "Lessons from the
Current Financial Crisis:
Should Credit Rating Agencies be Re-Structured?" Journal of
Business & Economics
Research, vol. 8, no. 7, 2010., pp. 85-91. Web.
2. Reavis, Cate. "The Global Financial Crisis of 2008: The Role
of Greed, Fear, and
Oligarchs." (2012). MITSloan, 16 Mar. 2012. Web.
3. Palan, R. & Nesvetailova, A. “ Elsewhere, Ideally Nowhere:
Shadow Banking and
Offshore Finance”. (2014) Politik, pp. 26-34. Web.
4. Farhi, Maryse, and Antonio Cidra. "Crise Du Capitalisme
Financier." The Financial

Crisis and the Global Shadow Banking System (2009). Web.
5. Nesvetailova, Anastasia. "A Crisis of the Overcrowded
Future: Shadow Banking and
the Political Economy of Financial Innovation." New Political
Economy 20.3 (2014).
Web.
6. McCulley, Paul. "The Shadow Banking System and Hyman
Minsky’s Economic
Journey." (2009): 257-68. Web.
7. Mankiw, Nicholas Gregory, and Mark P. Taylor. Economics.
Andover: Cengage
Learning, 2011. Print.
8. Morgenson, Gretchen, and Joshua Rosner. Reckless
Endangerment: How Outsized
Ambition, Greed, and Corruption Led to Economic
Armageddon. New York: Times,
2011. Print.
9. Singh, Manmohan, and James Aitken. "The (Sizable) Role of
Rehypothecation in the
Shadow Banking System." IMF Working Papers 10.172 (2010).
Web.
10. Από τα εορτοδάνεια στα...τυροπιτοδάνεια. Το πικρό χιούμορ

του διαδικτύου για τα
δέλεαρ των τραπεζών και την κατάρρευση της "Ισχυρής
Ελλάδας"." ΜΗΧΑΝΗ ΤΟΥ
ΧΡΟΝΟΥ. N.p., 11 May 2015. Web.
<http://www.mixanitouxronou.gr/apo-ta-
eortodania-sta-tiropitodania-to-pikro-chioumor-tou-diadiktiou-
gia-ta-delear-ton-
trapezon-ke-tin-katarrefsi-tis-ischiris-elladasnia/>.
11. Papadogiannis, Giannis. "Πώς φθάσαμε και πώς έγινε η 3η
ανακεφαλαιοποίηση” Η
ΚΑΘΗΜΕΡΙΝΗ. N.p., 28 Nov. 2015. Web.
E1.html
tailova=2E1.html
<http://www.kathimerini.gr/840305/article/oikonomia/epixeirhs
eis/pws-f8asame-
kai-pws-egine-h-3h-anakefalaiopoihsh>.
12. Bill Gross, Beware our Shadow Banking System, CNN
MONEY. Nov. 28, 2007. Web.
<http://money.cnn.com/2007/11/27/
news/newsmakers/gross_banking.fortune/>
13. "Third Time's the Charm?" The Economist. The Economist
Newspaper, 13 Sept. 2010.

Web.
<http://www.economist.com/blogs/freeexchange/2010/09/basel_
iii>.
banking.fortune/
1 | P a g e
How the financial markets reacted to the election of Donald
Trump, and are the
financial markets positioning themselves against uncertainty
over the president-
elect of the US?
This essay will critically investigate the pre and post periods of
Donald Trump's
election victory in the US by looking at how the financial
markets and investors
priced and reacted to the uncertainty caused by his controversial
statements
and outbursts during the election campaign. The essay is
divided into two
sections, including an analysis, from both the political and
economic

perspectives, to deeply understand why Trump sent shock waves
to some
segments of society while seen as an opportunity for the future
by others. The
first section will dive into the political sphere by briefly
touching upon some of
Trump's pledges. In the meanwhile, this essay will pick up
multiple case studies
from previous historical volatile periods. Thus, these
developments will shed
light on the question of whether financial tools, such as stocks,
shares,
derivatives, and currencies, reflect positively or negatively on
the remarkable
political or historic moments, such as election races that were
tremendously
shaping the country's as well as the world's futures. From the
general to the
specific, the case studies will only be taking the recent US
election and the
history of previously elected candidates who managed the US
into account.
Historical data from financial markets will be used explicitly
for that election

period. One example includes economic data that dropped into
markets
according to the estimated and near-official election results. For
instance, the
data appeared after Obama's trail to the Oval Office was
simultaneously
compared to the data dropped into markets after Trump's
election. This
comparison will be made to measure how investors position
themselves under
2 | P a g e
uncertain but temporary situations to minimise the momentary
risks involved.
This essay will also incorporate various references from
academic papers and
opinion leaders who wrote extensive analyses, regardless of the
election's
outcome, for newspapers to inform the public.
At the onset, it is vital to define the terms "uncertainty" and
"risk" to provide
some basic knowledge and make a clear distinction between risk
and

uncertainty in their fields. Such distinctions will help us to
understand which
term broadly captures the financial markets when it comes to
examining
volatility in financial markets. In a dictionary definition, the
Business Dictionary
describes risk as a "probability or threat of damage, injury,
liability, loss, or any
other negative occurrence that is caused by external or internal
vulnerabilities,
and that may be avoided through pre-emptive action." This
meaning becomes
clearer when we define uncertainty. In this context, the person
knows the
possible outcomes in advance. This scenario is described best
by the widely-
accepted rolling dice situation. The player knows what the odds
are for each
occasion before rolling the dice. In contrast, genuine
uncertainty occurs when
the possible outcomes cannot be known beforehand. Therefore,
in the world of
financial complexity, it is the genuine uncertainty that best fits
our measures.

The tough decisions often must be made in the complex system
of the economy
where lots of actors and financial tools interact over time. For
instance, although
every pollster indicated Hillary Clinton's victory, Donald
Trump's success can be
used as an example of risky positioning of investors caused by
the miscalculation
of the surveyors. It can be said that the centre media extensively
supported
Clinton, even at the expense of misleading the investors'
perceptions. If the
investors failed to evaluate every scenario before making an
investment, it also
meant that some of the investors lacked the required
competence, and they
heavily relied on the investment ideas coming from so-called
experts who did
3 | P a g e
not have the proper knowledge to guide investors. A research
survey in August

2008 of investment managers documents a widespread lack of
understanding
about derivatives products and risk management issues.
Moreover, the study
also reveals that 40 percent of fund managers bought investment
products that
had no structure to evaluate risk (Pengelly, 2008). The pricing
uncertainty must
depend on more reliable sources rather than just tied with
temporary events.
In my view, because of the dynamics of the financial sector,
there is always one
degree of uncertainty during the decision-making process of
investors.
However, this essay advocates the idea that in the long term, the
tools of finance
(stocks, derivatives, shares) minimize the risks and are less
likely affected by
rapid changes with the extended options available for investors.
Because the
rational investor knows that there are no more than two
variables for election
2016; therefore, at least, they had to have some idea and
roadmap that

captured all possibilities. Fragniere and Sullivan 2007, p.21,
offer this depiction
of the objective nature of standard finance academic models in
which "financial
risks can be alleviated and addressed using databases and
computer programs
tailored to the nature of your business." These options often
include
diversification strategies, which spread the portfolio into
different stocks or
alternatives and hedge the investments, which refer to coverage
of the
investment and protecting it from unexpected shocks over the
period. Thus, this
volatility does not necessarily occur because of the political
atmosphere facing
the country; it could also happen due to the variety of
backgrounds and
expectations that people have regarding their investments in the
market. At the
same time, due to technological advancements, people's ability
to access
required information via the internet is such that they are only
one click away

from making a discovery. Some scholars have argued that once
the new financial
tools came into effect in 2008, the popular perception of
investments radically
4 | P a g e
changed in parallel with the availability of financial tools that
made investing
least comfortable for them. Meanwhile, this abundant choice of
investments
adds extra complexity for examining and minimising the
uncertainty. In essence,
Leong et al. (2002, p. 9) contend that the financial
"environment is simply too
complex for the classical theories to describe adequately. In a
world that is
changing faster than we can understand, the risk seems more
difficult to
understand and control." Embedding the technology into the
financial system
inevitably leads to time saving for the investors in a way that
decreases the
required time for making efficient and healthy decisions. This

essay will address
the reasoning of investors, especially those who were caught off
guard by the
results that defied the so-called experts, pollsters, and industry
professionals
concerning the reality of Republican President-elect Donald
Trump. It can be
easily said that by electing a Donald Trump, US voters showed
a strong desire
for changing an established order. The working class that was
ruled in a country
went to the polls and rejected the rising inequality and
increased challenges that
it faced over the control of liberal elites.
There is no doubt that the US election in 2016 could be
remembered as a
milestone political event that featured the most challenging and
aggressive
presidential race in American history. Donald Trump's
extraordinary personality
and extremist approach to politics made him an exceptional
figure in the world.
Although he found an attractive place in almost every
businessperson's list, he

has relatively less experience in politics than his Democrat
opponent, Hillary
Clinton. The initial shock of investors should be understood as
an attempt to
minimise possible losses and provide themselves with a
sufficient time span to
follow the policies of President-Elect Trump and his allies as
his presidency
approaches. Furthermore, it is important to note that on the 9th
of December,
2016, the US not only changed its president but also changed its
political
5 | P a g e
ideology following Obama's leadership as a two-term Democrat.
The Democrats'
nominee Clinton who was backed by a substantial amount of
donation money
from wealthy people and was seen by far as a favourite in the
public opinion
polls. Nonetheless, Donald Trump's unforeseeable victory left
all Democrat

supporters devastated and pulverised the plans of Wall Street
experts' who
betted on a Clinton-win scenario. Thus, he won with the help of
a combination
of his unique personality and unusual approach to the current
political affairs
such as planning to re-structure a trade agreement that existed
in the world
economy for decades.
From an economic perspective, the reaction against Trump is
likely to be at least
twice as strong than the reaction of the world for previously
president-elected
nominees. Most newspapers called Trump the closest thing to
the Black Swan
event it had ever seen in history due to his commitment to no
allegiance to the
norms set by the bureaucratic elites. In the aftermath of the
2008 financial crisis,
the term "Black Swan" was popularized by Nassim Nicholas
Taleb to describe the
occurrence and influence of highly improbable events.
Moreover, the Black

Swan moments happened twice in politics in 2016, beginning
with Brexit, which
increased the fear of nationalism movements and spread it
effects into the
global world markets that already felt distressed with the
Chinese economic
cool-down. According to (Cole, 2014), "True knowledge is not
what you know
but certainty in what you do not. Volatility is simply about
putting a price on
that." In other words, investors react to the US under the
leadership of Trump
collectively due to the herd mentality that dominates human
behaviour. Thus,
on Election Day, the nervousness and uncertainty could be seen
very clearly.
Almost every stock market in the world responded in a manner
parallel with the
6 | P a g e
expectations by declining significantly. The S&P 500 and Dow
Jones were both
down by 2.5% the day after the election (Berger, 2016).

Meanwhile, the FTSE
100 plummeted by as much as 118 points, and it seems
reasonable to expect
further declines in the short term in the financial markets.
Judging when the
volatile times occur and how long they will last will be hard
from now until
January 20, which is the date that Trump takes office. In
contrast, the volatility
is strongly tied to the policies that he pledged during the
campaign. Whether or
not he will backtrack on some of his promises that caused some
raised eyebrows
initially across the world remains unclear. Most often, investors
try to price risks
appearing today by looking at the present value of the assets
and comparing
that with the overall performance over past decades so as to
conduct a valuation
for further possibilities. According to economist John Maynard
Keynes, it is not
a risk that prevents people from investing; it is uncertainty that
stops people
from investing (Cassidy, 2011). Thus, these sudden changes in

the financial
markets do not reflect the actual value of the assets. For
instance, according to
a CNN Money contributor (La Monica, 2016), the market only
rallied on 6 of the
past 21 post-election days. What this basically means is that
markets do not
respond abnormally to temporary events and correct themselves
much more
quickly than expected, usually within 2-3 days. CNN Money
also argued that the
average decline in the S&P 500 the day after Election Day
between 1932 and
2012 was 1.1%. This year, the S&P 500 rose 1.1%. Despite the
6 market rallies in
2008, which was a tumultuous year, there was a sharp decrease
in the index of
5.4%. Even in more normal times, when Obama beat Mitt
Romney in 2012, the
S&P 500 fell 2.4%. In other words, from an economic
perspective, Trump's
victory was digested far better than that of other candidates.

7 | P a g e
It is also vital to note that the US stock market is not the US
economy. The world
equity markets are comprehensively integrated and embedded
with each other
nowadays. Therefore, markets are more vulnerable and
responsive to political
changes in the world. Thus, it would not be accurate to say that
stock markets
do not respond significantly to these changes and they are
unaffected by the
political environment. The future valuation of the stock markets
is always
determined by the candidates' approach to the affairs and the
economic
conditions of the country. However, once the initial shock is
over, financial
markets become stable and much more critical and analysis-
driven. This short-
term volatility does not adequately reflect reality. In the long
run, regardless of
the political background of the president, over 10-year periods,

the earnings of
investors consistently increased. The data in Table 1 shows that
from 1926 to
2016, a dollar invested in the S&P 500 in any of the 9 decades
and 15
presidencies (from Coolidge to Obama) would have produced a
strong return.
Although historical data cannot be used to predict the future
performance of
stocks, it is quite clear that temporary shocks such as elections
and referendum
periods do not have a massive impact on long-term returns on
investment. The
individuals who see the stock market as a speculative place to
make high returns
in a short period are severely affected by these temporary
shocks.
8 | P a g e

In conclusion, trying to outguess the market is often a losing
game. This is
because, in the short term, the stock market does not reflect the
actual value of
investment tools. The aggregate expectation and knowledge of
the investors
often drive the short-term valuation of the financial
instruments. As a result, it
can be easily said that Donald Trump's election signals radical
changes in some
fields of the American economy and in the world. On the other
hand, it is still
too early to decide about the investment under Trump's
presidency. As the
master of investment, Warren Buffet, in one of his favourite
quotations, stated,
"Ignore the politics and macroeconomics when picking stocks."
From his
perspective, investors should seek the best opportunity for
which they are fully
confident in the company's long-term potential despite all fears
in the short run.
Every investor should bear in the mind that political extremism

and other
temporary issues go in an opposite direction of the stock
market. There is no
doubt that the election of the Donald Trump will have
significant opportunities
for some as well as disappointment for others. At the end of the
day, everyone
has to shape his or her future under a very challenging
atmosphere.
9 | P a g e
Appendix
Table 1

10 | P a g e
Reference List
Berger, R., 2016. How Donald Trump's Presidency Will Affect
The Stock Market. Forbes [online] 10
November 2016. Available at:
http://www.forbes.com/sites/robertberger/2016/11/10/how-
donald-
trumps-presidency-will-affect-the-stock-market/#2a7a008b58f1
(Accessed on 15 December 2016).
Cassidy, J., 2011. The Demand Doctor. The New Yorker, 10
October 2011.
[Online] Available at:
http://www.newyorker.com/magazine/2011/10/10/the-
demand-doctor (Accessed on 15 December 2016).

Fragni`ere, Emmanuel, and George Sullivan. 2007. Risk
management: Safe
guarding company assets. Boston: Thomson Learning.
La Monica, P. (2016) The 'yuge' Donald Trump market rally
continues, CNNMoney. Available at:
http://money.cnn.com/2016/11/10/investing/markets-stocks-
donald-trump-rally/index.html
(Accessed: 16 December 2016).
Leong, Clint T. C., Michael J. Seiler, and Mark Lane. 2002.
Explaining apparent stock market anomalies:
Irrational exuberance or archetypal human psychology. Journal
of Wealth Management 4:4, 8–23.
Pengelly, Mark. 2008. Survey reveals funds’ lack of derivative
expertise. Risk
21:8, 17.
donald-trumps-presidency-will-affect-the-stock-
market/#2a7a008b58f1

donald-trumps-presidency-will-affect-the-stock-
market/#2a7a008b58f1
http://www.newyorker.com/magazine/2011/10/10/the-demand-
doctor
http://www.newyorker.com/magazine/2011/10/10/the-demand-
doctor
IP2039 ADVANCED PRINCIPLES OF ECONOMICS:
FINANCIAL MARKETS AND CORPORATE SYSTEMS
2018/19
Autumn term
This module continues to analyse key concepts and approaches
to economic theory . It is a progression from Principles of
Economics 1 (markets and prices) and 2 (countries and
systems).
APE focuses on two major areas of international politics
economy: the firm/corporation and the financial market. The
modules lays out existing competing theoretical approaches and
traces the evolution of these ideas, focusing on the role of
corporation in capitalism; and on the functions of the financial
markets, money and banking in capitalism. Upon completing
the module you will be able to understand how changes in the
nature of the corporate firm are related to the functions of
finance, what are the key debates and issues surrounding the
financial system in light of the GFC, and what challenges are
posed by the structural and intuitional shifts within the
corporate and financial realm.
ASSESSMENT
In class (group) presentation (10-15 mins): 20% of module
mark
In class exam (week 11): 30% of module

mark
Written essay: 50% of mark
WEEK OUTLINE
Weeks
Tutorial,
10:00-10:50
11:00-11:50
Lecture 12:00-12:50, D220
Week 1
26
September
Introduction + Banking and the Monetary System.
(extended lecture in C318)
Presentations
sign-up
Week 2
3 October
Functions and Tools of Finance
Banking and the Monetary System: competing visions
Week 3
10 October
Post-Keynesian Approaches to Finance
Functions and Tools of Finance: competing perspectives
Week 4
17 October
The GFC: lessons for orthodoxy and heterodoxy
Post-Keynesian Approaches to finance and their limitations
Week 5
24 October
The Rise of the Corporation

The GFC: lessons for economic doctrines
Week 6
Reading week
Week 7
November
Transaction Cost Economics
Week 8
14 November
New Institutional Economics
Week 9
21 November
Legal and Sociological Theory of the Firm
NIE
Week 10
28 December
Financialised Corporate Economy: a Systemic View
Legal and Sociological Theories of the Firm
Week 11
5 December
Essay advice session
In class exam
Readings
Week 1. Introduction. Orthodoxy vs heterodoxy in economics
AN

Key Readings
Lavoie, M., 2009, Introduction to Post-Keynesian Economics,
Palgrave. Introduction.
Minsky, H., 2008 (1986), Stabilizing An Unstable Economy,
M.E. Sharpe. Chapters 5 and 6.
Week 2. Banking and the monetary system
AN
Key Readings:
Mankiw, G, 2014, Economics. Chapter 26 (The Monetary
System).
Ryan-Collins, J. et al., 2011, Where Does Money Come From?
(NEF). Chapter 1 (What Do Banks Do?)
Lavoie, M., 2009, Introduction to Post-Keynesian Economics.
Chapter 3 (e-book).
Michael McLeay, Amar Radia and Ryland Thomas, 2014,
“Money creation in the modern economy”, Bank of England.
Further
Minsky, H, 1957, “Central Banks and Money Market Changes”,
The Quarterly Journal of Economics, 71:2.
Keynes, JM, A Tract on Monetary Reform, Introduction.
Wray, R., 2010, “Alternative Approaches to Money”,
Theoretical Inquiries in Law, 11:1.
Carruthers and Ariovich, 2010, Money and Credit. A

Sociological Approach. Chapters 3 and 4.
Bell, S. 2001, “The role of the state and the hierarchy
of money”, CJE, 25:2.
Davidson, P.; Weintraub, S. (1973). "Money as Cause
and Effect". The Economic
Journal. 83 (332): 1117–1132.
Week 3. Functions and tools of finance
AN
Key texts
Mankiw, G., Economics Ch.25 (The basic tools of finance).
Kent Baker and J, Nofsinger, eds. 2010 Behavioral
Finance. Investors, Corporations, and Markets. Part 1.
(Foundation and Key Concepts). E-book online.
Further
Bernstein, P., 2005. Capital Ideas, the Improbable Origins of
Modern Wall Street. Ch. 1 (Are stock process predictable?).
Toporowski, J., 1993, The Economics of Financial Markets and
the 1987 Crash, Chapter 2 (How Capital Markets work).
Shiller, R., 2012, Finance and the Good Society, Chapter 25 and
26.
Kurztman, J. 1994, The Death of Money, Ch.
Shiller, R., Irrational Exuberance, Part 4.

Week 4. Post-Keynesian approaches to finance
AN
Key Readings
Minsky, H., 1986. Stabilising An Unstable Economy, Chapter 6.
Mehrling, P. 2000, “Modern Money: Fiat or Credit?”,
Journal of Post Keynesian
Economics, 22:3. pp. 397-406
Lavoie, M. 2010, Introduction to Post-Keynesian Economics.
Chapter 3. “A Macroeconomic Monetary Circuit” – ebook
online.
Further
Marc Lavoie, 1984, “ The Endogenous Flow of Credit and the
Post Keynesian Theory of Money”, Journal of Economic Issues,
Vol. 18, No. 3 (Sep., 1984), pp. 771-797
Minsky, H., 1975, JM Keynes, Chapter 3. Fundamental
Perspectives.
Ryan-Collins, J., Where Does Money Come From? Chapter 3.
Davidson, P. 1972, “Money and the Real World”, The Economic
Journal, Vol. 82, No. 325 (Mar., 1972), pp. 101-115.
Clower, R. 1999, “Post-Keynes Monetary and Financial
Theory”, Journal of Post-Keynesian Economics, 21:3.
Kregel, J. 1998, “Aspects of a Post Keynesian Theory of
Finance”, Journal of Post
Keynesian Economics, 21:1.
Mehrling, P. 2000, “Minsky and modern finance”, Journal
of Portfolio

Management, 26:2.
Cottrell, A, 1992, Post Keynesian Monetary Economics:
A Critical Survey
Week 5. The GFC: lessons for orthodoxy and heterodoxy
AS
Key Texts
Acharya V. et al. ,2009, “A Bird’s-Eye View. The Fc of 2007-
09: Causes and Remedies”, in V. Acharrya and M. Richardson,
eds., Restoring Financial Stability. How to Repair a Broken
System, NY: Wiley and Sons.
Wray, R. 2009, “The rise and fall of money manager capitalism:
a Minskian approach
Camb. J. Econ. (2009) 33 (4).
Palley, T. 2010, “The Limits of Minsky’s Financial Instability
Hypothesis as an Explanation of the Crisis”, Monthly
Reviewhttp://monthlyreview.org/2010/04/01/the-limits-of-
minskys-financial-instability- hypothesis-as-an-explanation-of-
the-crisis/
Further
Leijonhufvud, A. 2009, “Out of the corridor: Keynes and the
crisis”, CJE, 33:4.
Ch. Whalen, 2016 Money Manager Capitalism: Still Here, but
Not Quite as Expected, Journal of Economic Issues Volume
36, 2002 - Issue 2
Milberg, William (12/01/2013). "Implications of the recent
financial crisis for firm innovation". Journal of post Keynesian
economics (0160-3477), 36 (2), p. 207.

Charles J. Whalen, 1993, “Saving Capitalism by Making It
Good: The Monetary Economics of John R. Commons”, Journal
of Economic Issues, Vol. 27, No. 4 (Dec., 1993), pp. 1155-1179
Lawrence, G. (07/01/2015). "Defending financialization".
Dialogues in Human Geography (2043-8206), 5 (2), p. 201.
Week 6. Reading Week.
Week 7. The Rise of the Corporation
RP
Key Reading:
Philips, Richard, 2012, The firm, the corporation and
contemporary Capitalism in Ronen Palan, ed. GPE:
Contemporary Theories. London: Routledge.
Alfred D. Chandler, 1990, the Enduring Logic of Industrial
Success, Harvard Business Review.John H. Dunning, 2000, The
eclectic paradigm as an envelope for economic and business
theories of MNE activity, International Business Review, 9:2
Further Readings:
Richard R. John, 1997, Elaborations, Revisions, Dissents:
Alfred D. Chandler, Jr.'s, The Visible Hand after Twenty Years,
Business History Review, 71:2
Chandler, Alfred. D. 1977. The Visible Hand: The Managerial
Revolution in American Business, Cambridge, Mass.: The
Belknap Press of Harvard University Press
Chandler, A.D. Jr.,1990, Scale and scope. Cambridge, MA:
Belknap Press.
Clegg, 1987, Multinational Corporations and World

Competition.
Robin Ed. The History of the Company: The Development of the
Business Corporation 1700-1914.
Week 8 Transaction Cost Economics
RP
Ronald Coase, 1937, The Nature of the Firm. Economica, 16:4
Steven Tadelis and Oliver E. Williamson, 2012, Transaction
Cost Economics.
http://papers.ssrn.com/sol3/Papers.cfm?abstract_id=2020176
Further:Stewart Schwab, 1989, Review: Coase Defends Coase:
Why Lawyers Listen and Economists Do Not, Michigan Law
Review, 87:6
Hart, O, 1995, Firms, Contracts, and Financial Structure.
Oxford University Press.Sumantra Ghosha and Peter Moran,
1996, Bad for Practice: A Critique of the Transaction Cost
Theory, Academy of Management Review, 21:1
Week 9. New Institutional Economics
RPOliver E. Williamson, 2000, The New Institutional
Economics: Taking Stock, Looking Ahead, Journal of
economics Literature, 38:3
Douglass North, 1990, Institutions, institutional Change and
economic Performance, Cambridge, Cambridge University
PressFurther
Mary Douglas, 1996, How Institutions Think. New York:
Syracuse University PressOliver E. Williamson, 1981, The
Economics of Organization: The Transaction Cost Approach,
American Journal of Sociology, 87:3
Oliver E. Williamson, 1975, Markets and Hierarchies. London,

Routledge.
Week 10. Legal and Sociological Theory of the Firm
RPKey Texts Neil Fligstein, 1996, Markets as Politics: A
Political-Cultural Approach to Market Institutions, American
Sociological Review, 61:4
Robé, J.-P. (2002). Enterprise and the Constitution of the World
Economy. International Corporate Law, 2, 45-64.
Further
Neil Fligstein, 1993, The Transformation of Corporate Control,
Cambridge: Harvard University Press
Ronen Palan, 2015, Futurity, Pro-Cyclicality and Financial
Crises, New Political Economy 20:3
Foss, N. J., & Klein, P. G. (2013). Organizational Governance.
In R. Wittek, & T. A. Snijders, The Handbook of Rational
Choice Soical Research.
Lamoreaux, N. R. (2004). Partnerships, Corporations, and the
Limits on Contractual Freedom in U.S. History: An Essay in
Economics, Law and Culture. In K. Lipartito, & D. B. Sicilia
(Eds.), Constructing Corporate America: History, Politics,
Culture (pp. 32-54). Oxford: Oxford University Press.
Week 11. Conclusion: a systemic view of the financialized
corporate economy
Required
Nesvetailova, A. 2010, “Money and Finance in a globalised
economy”, in R. Palan, ed., GPE: Contemporary Theories.
Sawyer, Malcolm (12/01/2013). "What Is Financialization?".
International journal of political economy (0891-1916), 42 (4),
p. 5.

Bolton and Schatfstein, Corporate finance, the theory of the
firm and organisation” J of Economic perspectives, 12:4
(autumn 1998).
Davis, Gerald F. (01/01/2015). "Financialization of the
Economy". Annual review of sociology (0360-0572), 41 (1), p.
203.
Further
Kent Baker and J, Nofsinger, eds. 2010 Behavioral Finance.
Investors, Corporations, and Markets. Part 4. (Behavourial
Corporate Finance). E-book online.
Lazonick, William (12/22/2010). "Innovative business models
and varieties of capitalism: financialization of the U. S.
Corporation". Business history review (0007-6805), 84 (4), p.
675.
David A. Zalewski & Charles J. Whalen, 2010,
“Financialization and Income Inequality: A Post Keynesian
Institutionalist Analysis”, Journal of economic issues, 44:3.
Prasch, R. 2014, “The Rise of Money Manager Capitalism and
Its Implications for Economic Theory and Policy”, Journal of
Economic Issues, 48:2.

IP2039 Essay Questions
1. What are the problems with the conventional view of banks
as intermediaries between savers and borrowers? Discuss
focusing on a country of your choice.
1. Focusing on a single country case study, analyse who really
creates ‘money’ in the economy.
1. Can tools of finance price uncertainty? Answer focusing on
either:
a) the behaviour of the financial markets post-Brexit vote;
b) the reaction of the financial markets to the election of Donald
Trump.
1. Are bubbles always driven by irrationality? Answer with
reference to one of the following:
a) The dotcom bubble of 2000-01; b) the 1970s developing
economies lending boom; c) house price bubble of your choice.
1. What are the endogenous developments in the financial
system that have led to the 2007-09 financial crisis?
1. What are the limitations of Post-Keynesian analyses of the
nature of the 2007-09 crisis?
1. What are the limitations of behavioural economic analyses of
the 2007-09 crisis?
1. What does Minsky’s notion of Ponzi finance suggest about

the sources of financial fragility today? Answer focusing on one
of the following: a) the collapse of Parmalat in 2003; b) the
collapse of Enron in 2001; c) the Russian default of 1998.
1. Critically analyse Chandler’s theory of the M-Corporation
with regard to a transnational corporation of your choice. Is the
theory relevant today?
1. How relevant is the theory of transaction cost economics
today? Answer with regard to a case study of a firm of your
choice.
1. Identifying an area of activity or a sector that can be
understood as a club good, critically discuss the relevance of
club good theory.
1. Identifying a relevant resource, critically analyse the
relevance of the CPR theory.
1. In what sense can we think of the firm as a political actor?
Discuss focusing on a bank or a corporation of your choice.
IP2039 ADVANCED PRINCIPLES OF ECONOMICS
Are bubbles always driven by irrationality? Examining the main
theories behind the
housing market crash of 2007.

1
CITY UNIVERSITY OF LONDON
BSc International Political Economy
Module: IP2039 Advanced Principles of Economics Essay
Are bubbles always driven by irrationality?
Examining the main theories behind the housing
market crash of 2007.
theories behind the
2
The turn of the twenty-first century stunned the world by

bursting one of the largest economic
bubbles that have ever been formed. The crisis seemed to erupt
out of nowhere, with most
economic minds being left perplexed as to what was happening.
Theoreticians and policy
makers around the globe had failed to predict the massive
financial crisis that unleashed in
2007 and continued in the following years. The housing bubble
disrupted the orthodox model
that was mainly based on the idea of rationality and on the
underlying principle of self-
stabilising market forces. This research paper sets out to
explore the concept of rationality in
regards to economic bubbles, while also looking into the main
constituents of the housing
market crash. This essay will also attempt to outline the
fundamental notions of mainstream
and heterodox economics, and make use of systemic cycles to
provide a further insight into the
idea of finance capitalism.
Economic bubbles are phenomena that can easily demonstrate
how feeble the human mind is.
These happenings occur when investors increase the demand for
an asset to such an extent that

they cause a soar in the asset’s price beyond any rational
reflection of its intrinsic value (Abreu
and Brunnermeier, 2003). Identical to soap bubbles children
like to play with when they are
little, economic bubbles eventually burst, and when they do,
they dissipate all the invested
capital into the wind.
These bubbles have been experienced in numerous cases
throughout history, starting from the
Dutch Tulip fever in the sixteen hundred and continuing with
the South Sea and Mississippi
mania dominating the following century, to more recent cases of
speculation with the dot.com
bubble and the subprime mortgage phenomenon (Garber, 2000).
Episodes of mass hysteria
have taken place periodically, but every time they are close to
re-occurring, experts seem to
theories behind the

3
erase the past from their memories and think it will be different
this time around (Blanchard,
1979).
The nineteen-eighties represented a turning point in the global
financial system as globalisation
and deregulation ensued (Turner, 2008). The end of nineteen
century witnessed various crisis,
from runs on banks to currency attacks and oil price shocks
(Kindleberger, 1978). This period
also saw the ascension to power of several advocates of
deregulation in the United States that
ultimately contributed to the various crises of the twenty-first
century (Inside the Fed, 2011).
A basic assumption of theorists is that bubbles are inherently
irrational (Godelier, 1973). These
bubbles seem to constitute in a deviation of prices from their
real intrinsic values, a notion that
enters into direct contradiction with standard economic theory
(Avery and Zemsky, 1996).
While bubbles are seen as irrational beasts that disrupt the
economy, few attempt to understand
how they actually work. The Dutch Tulipmania was just one of

the examples that showed us
how important it actually is to decipher the enigma and look
behind the notion of irrationality
(Garber, 2000). During the housing market crash, animal spirits
were roaming at large through
all levels of the economy. The general public relied on the
constant assurances put forward by
politicians, financiers, policymakers and various pundits that
appeared to know what they were
doing. People were continuously told that the economy had
entered a new era of prosperity,
where real-estate prices would rise indefinitely and where the
American Dream is only one
loan away (Avery and Zemsky, 1996). Evidently, such an era
never existed, and the dream
promptly turned into a nightmare. The housing market crash ran
away not only with many
people’s homes but also with all their entire life savings, their
self-respect and most
dangerously, their trust in the system – the trust that is regarded
as the main constituent of
modern society.

theories behind the
4
After the collapse of the dot.com bubble in the early twenty-
first century, the Federal Reserve
took the unnatural decision to suppress interest rates at one per
cent for an extended period of
time (Davies, 2010). The same years witnessed a global savings
glut, as developing nations
across the world had accumulated vast financial reserves
through commodity production and
were looking to invest their savings (Turner, 2008). This era
coined as The Great Moderation
concurred with the housing boom in the United States economy
(Bernanke, n.d.). This period
of low volatility and high returns for a variety of asset classes
led to investors from the opposite
side of the planet willing to capitalise the US economy.
To this day, economists still widely disagree when attributing
blame for the unusually low-

interest rates. On one hand, some consider the Federal Reserves
decision to maintain short-
term rates low as one of the main triggers of excessive lending
and borrowing. Defenders of
the Federal Reserve shift the liability to the savings glut that
emerged in East and flooded
western economies by buying reliable treasury bonds and
pulling down interest rates (Chance,
2012). Due to decreased interest rates, investors, banks and
hedge funds pursued riskier assets
that could offer higher returns.
In the years preceding the crisis, irrationally exuberant
financiers thought they had found the
ideal way to eliminate risk when in actual fact they had only
lost track of it (Shiller, 2008).
Before the turn of the century, house loans in the United States
were becoming increasingly
popular, they were a way of self-fulfilling the American Dream.
Nonetheless, when the 2000s
arrived, the housing market had already reached saturation of
credit-worthy borrowers, thus
lenders started offering mortgages to subprime people with
inferior credit histories that had
little chances of ever paying them back (Shiller, 2008). These

risky mortgages were then passed
theories behind the
5
on to financial innovators at large banks that were responsible
for packaging them into safe
securities.
The mortgage-backed securities were ultimately used to create
collateralised-debt-obligations,
which were then cut into tranches based on their degrees of
default. Investors were tricked into
buying the safer tranches as these were awarded triple-A ratings
by specialised biased agencies.
Pooling unrelated loans into one security was thought to
disperse the risks associated with
default, as banks insisted that property markets in various
American cities would increase and
decrease independently of each other. Financiers and large
banks seemed to have found the

perfect solution at the time, for oversea investors that were
looking for higher returns in a world
dominated by low-interest rates. This assumption proved to be
wrong when the United States
began to experience a national house-price decline.
Nonetheless, in spite of the research done by financial
historians and economists who had
studied the spectacle of bubbles beforehand, the vast majority
of people at that time refused to
see the bubble for what it actually was. Each and every active
player in all industries, from
bankers to economists and policy-makers were as
unknowledgeable as the homebuyers
themselves.
The market bubble that was created in the early 2000s can also
be analysed through two
theoretical frameworks, orthodox and heterodox. Orthodox
economists follow the neoclassical
view that regards disruptions as mere exceptions to the rule and
not as inherent flaws within
the system (Lavoie, 2011). In contrast, heterodox theorists
validate Hyman Minsky’s vision of
the modern financial world. The analysis of the latter can be

considered superior as it expands
on the work of John M. Keynes and regards the causes of
economic crisis as endogenous to the
system (Minsky, 1986).
theories behind the
6
Rational choice is seen as a basic principle in orthodox
economics (Lavoie, 2011). This idea
sees individuals as logical beings, always acting in their own
self-interest as a way of
maximising their own utility. For orthodox economists, the
average of these rational individual
decisions is thought to aggregate into what is referred to as a
society. They are firm believers
that markets are the optimum way of organising society, as
these are regarded to be stable
constructs that can always self-regulate and return to their
natural state of equilibrium (Lavoie,

2011). In their view, the global financial crisis has been the
outcome of various factors that
inhibited the self-equilibrating mechanism, such as irrational
behaviour, state interference and
information asymmetries (Allen and Gale, 2007). In this view,
the financial bubble was an
irrational anomaly and not an inherent flaw of capitalism.
Mainstream theoreticians see rationality as the logical pursuit of
chosen goals, and anything
that falls outside of this orthodoxy is simply discarded as being
irrational The idea is mainly
based on the assumption that financial agents hold the fullest
information available at all times
and are not subjected to irrational behaviour or distractions
brought by unconventional
preferences (Lavoie, 2011). Nonetheless, the financial crisis has
proven that this view is flawed
and that market players are not always in complete knowledge
of future trends.
Mainstream economists are also well versed in using statistical
and mathematical models to
price factors such as risk and uncertainty. According to Eugene
Fama, at any point in time, the

Efficient-Market Hypothesis can rightly price a security by
closely estimating its intrinsic value
(Fama and Miller, 1972). Creating a price for risk is a highly
dangerous activity and the globe
has witnessed this with the financial crisis when eminent
financiers and economists relied on
David X. Li’s formula to quantify collateralised-debt
obligations (Jones, 2009). David X. Li
was deemed as the world’s most influential actuary at the time,
a remark that was swiftly taken
theories behind the
7
back in the aftermath of the crisis by the same Financial Times
(Jones, 2009). Once again,
mainstream economists disregarded what they could not
understand and only priced the little
slice they considered knowing, being conceited enough to
regard their model as fully rational

and perfectly informed.
Another major concept of this school of thought sees no way
around regulating inflation and
the supply of money. Orthodox economists deem the trade-off
between inflation and
unemployment rates as necessary conditions of capitalism; the
idea being mainly based on the
Phillips Curve model (Phillips, 1958). An instance that
contradicted this assumption took place
during the mid-nineties when many mainstream practitioners
could not explain the
phenomenon taking place around the world, that witnessed both
a period of low inflation and
an unprecedently low level of unemployment (Fuhrer, 2009).
This new age of capitalism, the
period of The Great Moderation, where prosperity was thought
to be spreading around the
world and crisis were nowhere in sight did not last long, as the
speculative bubbles started to
burst, first with the dot.com bubble and once more with the
house market crash (Ofek and
Richardson, 2003).
The financial crash of the twenty-first century has demonstrated
once more the inherent

imperfections of orthodox economics and its neoliberal
economic policies. According to
Hyman Minsky (1986), the orthodox strand of economic thought
can easily demonstrate that
markets will always lead to a coherent or optimal result only
once they disembbed their model
from the very fabric of society. Orthodox economists are able to
justify and defend many of
their ideas in theory, but they often fail to implement them in
the real world due to the irrational
exceptions to their perfectly rational framework. The
established economic theory thus
abstracts its mathematical quantifications out of time and
historical space, transforming the
theories behind the
8
model into a static concept. This model disregards information
asymmetries and does not deal

with elements such as time, money, uncertainty, financing of
ownership of capital assets or
investment (Minsky, 1982).
The main heterodox position that brings a critique to these
concepts is the Post-Keynesian
strand. In the nucleus of Post-Keynesian economics lies the idea
that money is fabricated
endogenously by the private banking apparatus (Smith,
Suchanek and Williams, 1988). One
can also find at the base the concept of effective demand and
uncertainty, the idea that
quantitative easing and increases in budgetary deficits do not
link directly to inflation, and that
financial markets are prone to periodic booms and busts
(Dymski, 2009). In addition to the
Post-Keynesian thinking, behavioural finance theorists also
assign the blame for these bubbles
to cognitive biases, where market players are subjected to herd
behaviour and groupthink
(Baker and Nofsinger, 2010). For behaviourists, emotional
prejudices appear to be at the core
of financial bubbles.
Encompassed in Arrighi’s The Long Twentieth Century (1994)

lives the idea that systemic
cycles of capital accumulation have constantly re-occurred all
throughout history. Arrighi
(1994) evaluates modern times by contrasting them with the
longue durée - the economic,
cultural and social history of capitalism across centuries
(Braudel, 1984). By virtue of his work,
Arrighi (1994) provides an insight into how societies and their
institutions have reshaped
themselves across time, and how contemporary events are a
constant re-occurrence of past
dynamics. The 2007 financial crisis can be regarded as a sign of
autumn for the capitalist cycle,
as capitalism has reached the stage of financial expansion,
where, according to Arrighi,
theories behind the
9
"[Every] capitalist development of this order seems, by reaching

the stage of
financial expansion, to have in some sense announced its
maturity: it [is] a sign of
autumn" (Braudel, 1984, p. 246; emphasis added).
The signs of autumn are indicative of the culmination to an S-
cycle, at the end of which inter-
state conflicts and major crisis ensue (Mensch, 1979, p. 73).
The world has witnessed a mini
episode of such a systemic shift with the emergence of the
crisis, that caused a massive
disruption to the global economic system. The financial
phenomenon of 2007 was just one of
the symptoms to the dawn of contemporary capitalism, that has
lately disembedded itself from
the bottom layers of material life and has ventured to the top
layers of the anti-market (Braudel,
1982).
The causes hiding behind economic bubbles have been debated
plenty of times before, and the
notion of irrationality is still widely regarded as the main
contributor (Blanchard and Watson,
1982). Markets were normally considered to be efficient
mechanisms where economic agents

act rationally at all times. However, the infamous mania of tulip
bulbs was just one of the
earliest demonstrations of the mayhem irrationality can cause.
Nonetheless, as it happened with the housing bubble of the
twenty-first century, mainstream
experts dismissed concerns regarding the irrationality of
overpriced assets by invoking a new
economic era where old valuation rules no longer apply due to
reduced volatility of the market,
greater stability and improved policy making (Bernanke, n.d.).
The past few decades have seen the blame for the global
financial crisis being passed around
from one sector to another, from Greenspan to Bush, from
corporations to the state, from banks
to institutions. Ultimately, the crisis has been the outcome of an
ever-increasing leveraging
ratio across all sectors, that were overly confident in asset
prices rising indefinitely. This
theories behind the

10
financial disaster resulted from the conventional view that
markets do not deviate a great
distance from their equilibrium point and that the experts
presiding over them are rational
individuals with full access to all information available and an
inherent ability to correctly price
risk and uncertainty.
In respect to bubbles, the essential fault in the system is people
assuming that this time it will
be different - a mass delusion of a new era taking shape that can
escape all natural laws of
economics. Such an era ends once there is no more capital
available to drown the market in. At
that point, someone notices that the emperor has no clothes, and
everything comes down
collapsing. Contemporary economists have not yet found a way
to outrun economic bubbles;
all they can do at the moment is just to take a seat and wait for
the next one to emerge.

theories behind the
11
REFERENCES
Abreu, D. and Brunnermeier, M. (2003). Bubbles and Crashes.
Econometrica, 71(1), pp.173-
204.
Allen, F. and Gale, D. (2007). Understanding financial crises.
1st ed. Oxford: Oxford
University Press.
Arrighi, G. (1994). The long twentieth century. 1st ed. London:
Verso.

Avery, C. and Zemsky, P. (1996). Multi-dimensional
uncertainty and herd behavior in financial
markets. 1st ed. Fontainebleau, France: INSEAD.
Baker, H. and Nofsinger, J. (2010). Behavioral finance. 1st ed.
Hoboken, N.J.: Wiley.
Bernanke, B. (n.d.). The Federal Reserve and the financial
crisis. 1st ed.
Blanchard, O. (1979). Speculative bubbles, crashes and rational
expectations. Economics
Letters, 3(4), pp.387-389.
Blanchard, O. and Watson, M. (1982). Bubbles, rational
expectations and financial markets.
1st ed. Cambridge, Mass.: National Bureau of Economic
Research.
Braudel, F. (1982) Civilization and Capitalism II: The Wheels
of Commerce. New York:
Harper and Row.
Braudel, F. (1984) Civilization and Capitalism III: The
Perspective of the World. New York:
Harper and Row.
Chance, G. (2012). China and the Credit Crisis. 1st ed.
Chichester: Wiley.
Davies, H. (2010). The financial crisis. 1st ed. Cambridge, UK:

Polity Press.
theories behind the
12
Dymski, G. (2009). Why the subprime crisis is different: a
Minskyian approach. Cambridge
Journal of Economics, 34(2), pp.239-255.
Fama, E. and Miller, M. (1972). The theory of finance. 1st ed.
New York: Holt, Rinehart and
Winston.
Fuhrer, J. (2009). Understanding inflation and the implications
for monetary policy. 1st ed.
Cambridge, MA: MIT Press.
Garber, P. (2000). Famous first bubbles. 1st ed. Cambridge,
Mass.: MIT Press.
Godelier, M. (1973). Rationality and irrationality in economics.
1st ed. New York: Monthly
Review Press.

Inside the Fed: monetary policy and its management, Martin
through Greenspan to Bernanke.
(2011). Choice Reviews Online, 49(01), pp.49-0389-49-0389.
Jones, S. (2009). The formula that felled Wall St. [online]
financialtimes.com. Available at:
https://www.ft.com/content/912d85e8-2d75-11de-9eba-
00144feabdc0 [Accessed 8 Jan. 2017].
Kindleberger, C. (1978). Manias, panics, and crashes. 1st ed.
New York: Basic Books.
Lavoie, M. (2011). The Global Financial Crisis: Methodological
Reflections from a Heterodox
Perspective. Studies in Political Economy, 88(1), pp.35-57.
Mensch, G. (1979). Stalemate in technology. 1st ed. Cambridge,
Mass.: Ballinger Pub. Co.
Minsky, H. (1982). Can "it" happen again?. 1st ed. Armonk,
N.Y.: M.E. Sharpe.
Minsky, H. (1986). Stabilizing an unstable economy. 1st ed.
New Haven: Yale University
Press.

theories behind the
13
Ofek, E. and Richardson, M. (2003). DotCom Mania: The Rise
and Fall of Internet Stock
Prices. The Journal of Finance, 58(3), pp.1113-1137.
Phillips, A. (1958). The Relation between Unemployment and
the Rate of Change of Money
Wage Rates in the United Kingdom, 1861-1957. Economica,
25(100), p.283.
Shiller, R. (2008). The subprime solution. 1st ed. Princeton,
N.J.: Princeton University Press.
Smith, V., Suchanek, G. and Williams, A. (1988). Bubbles,
Crashes, and Endogenous
Expectations in Experimental Spot Asset Markets.
Econometrica, 56(5), p.1119.
Turner, G. (2008). The credit crunch. 1st ed. London: Pluto
Press.

ADVANCED PRINCIPLES OF ECONOMICS
Financial Markets and Corporate Systems
1
What is the module about?
Competing perspectives on financial and economic matters
Developing critical skills in economic pluralism
Applying theoretical perspectives to real-life problems and
testing their limitations

2
Orthodoxy vs heterodoxy
Orthodox (mainstream) economics – a theory of rational choice,
which assumes that individuals make decisions that will
maximize their own utility, and uses statistics and mathematical
models to demonstrate theories and evaluate various economic
developments.
Heterodox economics – approaches to economic theory that are
alternative to mainstream.
3
Key principles of orthodox economics
Key principles of orthodox (mainstream) economics:
Scarcity
Methodological individualism
Trade-offs and rationality (people think at the margins)

Markets are a good way to organise the economy
Governments can sometimes improve market outcomes
Prices rise when there is too much money printed
Inflation / unemployment trade-off
4
“Established economic theory, especially the highly
mathematical theory … developed after WWII, can demonstrate
that an abstractly defined exchange mechanism will lead to a
coherent, if not an optimum, result” (Minsky 2008 [1986]: 4).
Yet these models abstract from corporate boardrooms, Wall
Street and the City, and the messy political process.

5
In the real world
A rise in demand may not lead to increase in prices;
An increase in real wage does not lead to decline in profits
Decline in saving rate does not lead to increase in investment
Flexible price systems does not bring equilibrium
Budget deficits may not lead to inflation
A ‘corporation’ is not the ‘firm’
6
Mainstream models do not deal with:
Time
Money (finance)
Uncertainty
The ownership of capital assets
Investment

7
Key principles of heterodox economics
Economic systems are not natural systems
An economic is a social organisation created either through
legislation or by an evolutional process of invention and
innovation.
Money and finance are not neutral
Institutions are key to the shape and the dynamics of an
economic system
Scarcity is socially and politically constructed
8
Week outline
Introduction.
Banking and the Monetary System.
Functions and Tools of Finance
Post-Keynesian Approaches to Finance
The GFC: lessons for orthodoxy and heterodoxy
New Institutional Economics

Legal and Sociological Theory of the Firm
Financialised Corporate Economy: a Systemic View
Essay advice session
9
WeeksLecture 10:00-10:50, C318Tutorial, 11:00-11:50
C 300
Week 1
2
September Introduction + Banking and the Monetary System.
(extended lecture in C318)Presentations
sign-up
Week 2
9 October Functions and Tools of Finance Banking and the
Monetary System: competing visions Week 3
16 October Post-Keynesian Approaches to Finance Functions
and Tools of Finance: competing perspectives Week 4
23 October The GFC: lessons for orthodoxy and heterodoxy
Post-Keynesian Approaches to finance and their limitations
Week 5
30 October The Rise of the Corporation The GFC: lessons for
economic doctrines Week 6 Reading week Week 7
13 November Transaction Cost Economics The Rise of the
Corporation Week 8

20 November New Institutional Economics Transaction Cost
Economics Week 9
27 November Legal and Sociological Theory of the Firm
NIE Week 10
4 DecemberFinancialised Corporate Economy: a Systemic View
Legal and Sociological Theories of the FirmWeek 11
11 December Essay advice session In class exam
10

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