Creating Financial Harmony: Lessons for China

The current turmoil in global financial markets, which began with the U.S. subprime crisis in 2007, has shed a bad light on market lib-eralism. But it was the socialization of risk—not private free mar-kets—that precipitated the crisis. Government sponsored enterprises (GSEs), not private enterprises, politicized investment decisions and overextended credit to high-risk households by buying up and guaranteeing subprime and Alt-A mortgages.1 Financial innovation and the information revolution allowed greater specialization and diversification of risk, but government backing of GSE debt created a moral hazard problem and, together with loose monetary policy and flawed regulations, led to excessive risk taking and overinvestment in housing. When housing prices began to decline in 2007, defaults spread and banks failed. Toxic assets rapidly mounted and the housing crisis morphed into a gener-al credit crisis. The central issue this article addresses is how to structure institu-tions and incentives to promote financial harmony. The notion that the subprime/credit crisis stemmed from “market failure ” diverts attention from “government failure. ” To remedy that diversion, this article examines the sources of the present financial crisis and find