Endogenous Transactions Costs and Institutions in the 2007/08 Financial Crisis

This paper examines the manner by which transactions costs in financial markets, broadly defined, not only derive from the regulatory-institutional framework, but in turn affect the development of this framework. We develop a simple model of policymaking with common agency that embeds endogenous transactions costs and institutions, so that the two are allowed to influence each other over time. Our approach seeks to go beyond attributing the crisis to either complex finance or regulatory/government failures, since such explanations generate necessary but not sufficient conditions for a financial crisis. Instead, we focus on the central role of rising transactions costs. We document the increasing presence of such costs in the U.S. financial sector since 1980, along with how changes in transactions costs coevolved with regulatory and institutional innovations over the past 30 years. We argue that such transactions costs amplified an ever-greater disconnect between market prices and their economic fundamentals, and increased financial fragility to the point that the system became vulnerable to the 2007/08 financial crisis