Reducing Social Welfare by Making Financial Markets More Complete: Implications for the 2008 Crisis
23 Pages Posted: 4 Dec 2019
Date Written: July 18, 2018
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: Suggested Citation