Working Paper: CEPR ID: DP8164
Authors: Geoffrey R. D. Underhill
Abstract: The inheritance of contemporary financial economics invites us to consider financial stability as integral to a liberal market setting. The crisis however demonstrated that financial markets may prove highly dysfunctional in the absence of adequate mechanisms of regulation and governance. This implies that economic theory requires an enhanced understanding of the intersection of economic rationality with the rationality of governance. This article extends the insights of institutional economics to demonstrate that the emergence of the institutions of financial governance is endogenous to the utility-maximising behaviour of competing economic agents. Utility-maximising behaviour and conflict over the terms of competition in the market generate both the formal and informal institutions and processes of governance such as regulation and dispute settlement. The model is illustrated by the case of international finance, predicting forms of policy rent seeking in a market environment: private interests embedded in public policy processes simultaneously reshaped both market and governance in line with their own perceived utility functions. The model predicts that similar policy rent seeking will dominate the reform process. Successful reform will require a conceptual understanding of this link between governance and market competition, and appropriate changes in the nature of the policy process so as to reshape markets to avoid financial instability in the future.
Keywords: transaction costs; economic institutions; endogeneity; financial governance; policy rent seeking; financial regulation
JEL Codes: A10; A12; B25; B26; B52; D02; D21; D23; D53; D71; D72
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| utility-maximizing behavior of economic agents (D11) | emergence of governance institutions (O17) |
| preferences of economic agents (D11) | market structures (D49) |
| policy rent-seeking behavior among economic agents (D72) | reshaping of market and governance (D47) |
| competition among agents (L85) | governance preferences (D72) |
| competition among agents (L85) | market structures (D49) |
| utility-maximizing behavior of economic agents (D11) | policy rent-seeking behavior (D72) |