The main cause of the financial crisis is instability in the financial sector including the firms, institutions and markets which comprise it. To understand this instability, we have to begin with the legitimate primary purposes of the financial markets. One is to provide capital, as equity and debt, to the goods and services economy to allow it to thrive and grow. A second is to provide a stable repository for our collective savings. And a third is to responsibly provide appropriate credit to individuals. These legitimate functions have been hijacked by speculative behavior that was unchecked by regulatory structures. The consequences of this threaten to disrupt the productive efforts of millions of ordinary people who go to work every day to make stuff and provide services to one another.


In the decades leading to this crisis, the shift in our economic thinking from the long-term view on Main Street to short-term speculation and gratification on Wall Street have not only brought us to the brink of economic collapse, but have also compromised a sufficient flow of capital to important long-term initiatives—economic sustainability, renewal of infrastructure, abatement of climate change, and development of alternative energy sources—all important to a vibrant and sustainable economy.


This has happened before in history—in Rome, in Spain, Holland and England. More recently, in America, there were smaller crises before to the present one, perhaps early warnings—Black Monday, Long Term Capital Management, the dotcom bomb, and others. Now that we live in a global economy, we cannot afford the next crisis, an order of magnitude larger, in which the world's governments themselves will have to be bailed out. Rather, we can only hope that these governments are collectively up to the task this time.


There is honor and service to society in inventing and building companies and products that make life better for people, which should be justly rewarded. There is honor in architecting balanced financial regulation, to which we should dedicate careful attention. There is honor for the important financial sector when it functions as it should for the collective good, and this too should also be justly rewarded. Reasoned risk-taking by knowledgeable investors plays an important role in capital markets in providing support for initially risk innovations. But there is no honor in abusing our regulatory and financial systems for reckless speculation (i.e. gambling) that has no productive value for our collective future and that of the generations who will follow.


Nonetheless, blame will not get us out of this situation. We need to understand how and why the crisis happened and why warnings over the last years were not understood or heeded. We need to use this knowledge to stop this crisis and get the economy functioning again. In the longer term, we need to redesign and reregulate the financial system so that it performs its necessary functions without leading to periodic crises of global scale.


Two basic assumptions must guide any thinking as we undertake these tasks. First, economies, financial institutions and markets cannot function without a context of rules and laws, which regulate them. In a market, each participant tries to do the best they can for themselves. In a properly architected and regulated market this contributes to the public good. There is simply no place for an ideological discussion about regulation. Stable systems in nature such as individual organisms and ecosystems are regulated. So must ours be. The only relevant question is do the regulations work or not, where work means that stable markets allow an orderly flow of capital to and from the goods and services economy and the people who comprise it.


Second, mathematics, physics and computers already play a major and necessary role in our economic affairs. People with training in mathematical sciences play a big role on Wall Street designing and valuing complex investment instruments, and running sophisticated trading strategies. There is no going back to the era before banks and funds depended on quantitative analysis and big computer programs, and the scientifically trained people to run them. Along with economists with whom they work, other scientists and computer scientists now have a profound responsibility to see that their skills, the principles which they have found effective, and the tools they have wrought, are all used well and wisely.

2. The crisis is at least partly due to shortcomings a certain theory of economics

"Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief. … It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria."
— Testimony of Dr. Alan Greenspan, US House of Representatives Committee on Government Oversight and Reform, October 23, 2008
When economists and other scientists study a complex system they begin by asking about what assumptions have been used previously in understanding it, and how well they have done compared to data. So if we approach the crisis in this way, we have to begin by asking about the principles and assumptions that have been used to construct and justify ...
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