Reducing Social Welfare by Making Financial Markets More Complete: Implications for the 2008 Crisis

23 Pages Posted: 4 Dec 2019

See all articles by Lynn A. Stout

Lynn A. Stout

Cornell Law School - Jack G. Clarke Business Law Institute (deceased)

Paul H. Edelman

Vanderbilt University - Law School

Date Written: July 18, 2018

Abstract

In the two decades leading up to the 2008 financial crisis, numerous significant changes in federal law greatly reduced transactions costs in financial markets and made possible new types of trading in new types of financial instruments. The driving policy assumption behind these and similar regulatory changes was that making financial markets more complete would increase social welfare by moving financial markets closer toward Arrow-Debreu.

In this paper, we present a model that can explain why, contrary to this policy assumption, regulatory changes that made financial markets more complete in the years leading up to 2008 seemed to produce the opposite effect. Our model shows how when agents have heterogeneous expectations, making financial markets more complete can reduce social welfare by increasing aggregate risk; reducing aggregate returns; and skewing perceptions of wealth in ways that inefficiently distort aggregate consumption decisions, causing agents to over-consume in some periods so that they are forced to cut back consumption sub-optimally in subsequent periods. The intuition underlying our model is that when agents have heterogeneous expectations, making markets for financial instruments more complete amplifies the magnitude of the “winner’s curse” observed in many common-value auctions with the detrimental welfare effects we describe.

This paper remains in draft form because of the untimely death of the first author. The second author is posting it to honor her memory and to share what is some of her last work. She will be missed.

Keywords: Market Inefficiency, Aggregate Risk, Heterogeneous Expectations

JEL Classification: G14, G32, G38, K22, C65, D71

Suggested Citation

Stout, Lynn A. and Edelman, Paul H., Reducing Social Welfare by Making Financial Markets More Complete: Implications for the 2008 Crisis (July 18, 2018). Available at SSRN: https://ssrn.com/abstract=3489323 or http://dx.doi.org/10.2139/ssrn.3489323

Lynn A. Stout

Cornell Law School - Jack G. Clarke Business Law Institute (deceased)

Paul H. Edelman (Contact Author)

Vanderbilt University - Law School ( email )

131 21st Avenue South
Nashville, TN 37203-1181
United States
615-322-0990 (Phone)
615-322-6631 (Fax)

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