The first of these relates to the short-sightedness of speculators. During any asset price boom, the belief that it would go on for ever gradually gathers momentum; as a result the awareness of risk comes down, and more and more risky positions begin to be taken. Hence instead of such an asset-price boom getting truncated early, in which case the potentially-destabilizing impact of such truncation on the financial sphere would also be limited, it persists, making the financial system more and more fragile, until the end of the boom catches the entire financial system in an acute crisis.

The sub-prime crisis illustrates this point. As the real estate boom in the United States got underway, the euphoria about it began to increase. Financial firms became more and more reckless about supporting it. Credit was available to all and sundry, at one point up to the full value of the property being acquired, which itself was never carefully assessed.. To say this is not to argue that credit-giving institutions should be conservative in accommodating borrowers, but merely to underscore the fact that they are swayed by speculative considerations which make them reckless. They give credit in anticipation of rising house prices, since they expect this rise to continue. And when, for one reason or another, the rise in house prices reaches a plateau, the borrowers are caught short. To pay back their loans many of them are then forced to sell their property which brings down property prices. Finally, the time comes when the value of the assets against which the loans are given is way below the magnitude of the loans themselves. This is when the financial papers representing, directly or indirectly, claims upon real estate, are worth only a fraction of their face value, and the financial world gets into a crisis.

The second factor relates to the emergence of a vast “derivatives” market. A loan, say, for the acquisition of a piece of housing property, is typically thought of as a bilateral arrangement, between the lender and the borrower. In a modern financial sector however the risks associated with any loan are no longer borne exclusively by the lender but themselves become a marketable commodity. These risks are passed on to others through the “derivatives” market, who in turn pass them on to still others and so on. All this however does not mean that the risks themselves disappear or diminish; what it means is that there is a systematic undervaluation of risk since nobody quite knows what the risk associated with his/her portfolio of assets actually is. This piece of “financial innovation” therefore has the same effect as the first factor mentioned above, namely it leads to an underestimation of risk during any boom in asset prices, which makes such booms more prolonged and more pronounced, and the subsequent collapse in the asset prices more precipitous, and hence more calamitous for the world of finance.
The third factor has to do with government intervention. Whenever such a financial crisis, involving giants in the American financial market, looms large on the horizon, the government steps in to bail out these giants. Such government action may well be dictated by the desire to avoid a recession, but the awareness that the government will provide a bail-out also works in the direction of making financiers reckless, making them underestimate risks, and hence promoting speculative bubbles in the asset-price markets, whose bursting becomes even more debilitating than if financiers had been more cautious and less confident of a government bail-out. Economists refer to this as the “moral hazard” problem. Government intervention compounds the “moral hazard” problem.