Editor's Note: Professor Franklin Allen came to the World Bank on October 27 to give an FPD Chief Economist Talk on the topic of Reforming Global Finance: What is the G20 Missing? Please see the FPD Chief Economist Talk page  to download a copy of his presentation and watch a video of his Talk.
The recent financial crisis clearly had more than one cause. My view is that the most important one was a bubble in real estate prices, not only in the US but also in a number of other countries such as Spain and Ireland. It was the bursting of this bubble that has led to so many problems in the world economy. A significant part of this is a direct effect on the real economy rather than an effect transmitted through the financial system. For example, Spain had one of the best regulated banking systems and its banks did much better than in other countries. Yet with a doubling of its unemployment rate to 20 percent, its real economy has been devastated. In contrast countries like Germany that did not have a real estate bubble but had much larger drops in GDP have not suffered nearly as much. Germany's unemployment rate is now lower than at the start of the crisis.
This view naturally raises the question of what caused the bubble. Again, many factors are at work here, but I would stress two: (1) Loose monetary policy and, (2) Global imbalances. Low interest rates helped fuel a bubble in the US. Unlike stock markets, real estate markets are not efficient. Returns are positively serially correlated. This means that if returns are currently positive they are likely to keep being positive for a while, and this makes buying attractive. During the recent bubble, we saw speculators in real estate markets flipping properties in as little as 3 months without bothering to attempt to earn a rent over this period. This is why real estate bubbles--once started--continue for a while. Loose monetary policy combined with global imbalances, and in particular the large accumulation of reserves by Asian central banks, so that credit was easily available in countries like the US, Spain, and Ireland. These two factors were the main culprits behind the bubble.
Having said this, the financial system clearly had significant problems, and regulation did not do its job of preventing a systemic crisis. It has been the interaction of the failures in the financial system and the collapsing of the bubble that has caused problems in many countries.
Much of the G20 agenda focuses on reform of banking regulation. However, much of this reform is not based on a coherent theoretical framework. In particular, there is not a clear view on what the main market failures are that the regulation is correcting. Perhaps more importantly there are many reforms missing from the G20 agenda. Preventing future bubbles is one of them. Some others are reform of central banks to allow checks and balances, elimination of global imbalances, policies to ensure liquidity is provided efficiently, overcoming limits to arbitrage and mispricing, separation of commercial banks and risky activities, a role for public banks and sovereign default risk.