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Economic Brief

December 2014, No. 14-12

Understanding Market Failure in the 2007-08 Crisis

Borys Grochulski and Wendy Morrison

Did market failures cause the 2007-08 financial crisis? While economists have made substantial progress exploring this question, the answer remains unclear. The answer is important because financial regulation that does not address a specific market failure risks causing new inefficiencies and unintended consequences in the financial system and broader economy. To demonstrate how economic theory can be used to identify market failures and guide policy, this Economic Brief discusses a common market failure called a "pecuniary externality" and demonstrates the pitfalls of applying regulations in situations where the precise sources of market failures are not well-understood.

Additional Resources

Diamond, Douglas W., and Philip H. Dybvig, "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, June 1983, vol. 91, no. 3, pp. 401-419.

Ennis, Huberto M., and Todd Keister, "On the Fundamental Reasons for Bank Fragility," Federal Reserve Bank of Richmond Economic Quarterly, First Quarter 2010, vol. 96, no. 1, pp. 33-58.

Farhi, Emmanuel, Mikhail Golosov, and Aleh Tsyvinski, "A Theory of Liquidity and Regulation of Financial Intermediation," Review of Economic Studies, July 2009, vol. 76, no. 3, pp. 973-992. (A working paper version is available online.)

Grochulski, Borys, "Pecuniary Externalities, Segregated Exchanges, and Market Liquidity in a Diamond-Dybvig Economy with Retrade," Federal Reserve Bank of Richmond Economic Quarterly, Fourth Quarter 2013, vol. 99, no. 4, pp. 305-340.

Haltom, Renee, and Jeffrey M. Lacker, "Should the Fed Have a Financial Stability Mandate? Lessons from the Fed's First 100 Years," Federal Reserve Bank of Richmond 2013 Annual Report, pp. 4-25.

Kilenthong, Weerachart T., and Robert M. Townsend, "Information-Constrained Optima with Retrading: An Externality and Its Market-Based Solution," Journal of Economic Theory, May 2011, vol. 146, no. 3, pp. 1042-1077.

Lacker, Jeffrey M., "Economics After the Crisis: Models, Markets, and Implications for Policy," Speech at the Center for Advanced Study in Economic Efficiency, Arizona State University, Tempe, Ariz., February 21, 2014.

Lacker, Jeffrey M., "Committing to Financial Stability," Speech at the George Washington University Center for Law, Economics and Finance, Washington, D.C., November 5, 2014.

Santos, João, "Evidence from the Bond Market on Banks' 'Too-Big-to-Fail' Subsidy," Federal Reserve Bank of New York Economic Policy Review, December 2014, vol. 20, no. 2.

"Too Big to Fail," Federal Reserve Bank of Richmond Our Perspective Series.

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