Gallegati Mauro author Greenwald Bruce C. author Columbia University. Business Richiardi Matteo G author Stiglitz Joseph E. author Columbia University. Business Columbia University. International and Public Affairs Columbia University. Economics Columbia University. Business originator text Articles 2008 English In this paper we provide a general characterization of diffusion processes, allowing us to analyze both risk-sharing and contagion effects at the same time. We illustrate the relevance of our theory with reference to the subprime mortgage crisis and more in general to the processes of securitization and interbank linkages. We show that interdependencies in real and financial assets are beneficial from a social point of view when the economic environment is favorable and detrimental when the economic environment deteriorates. In the latter case, private incentives are such that too many linkages are formed, with respect to what is socially desirable. The risk of contagion increases the volatility of the outcome and thus reduces the ability of the financial networks to provide risk-sharing. Our analysis suggests that a likely major explanation of the subprime mortgage crisis is the process of securitization itself, in addition to the absence of transparency about the characteristics of the underlying assets that the multiple layers of financial intermediation fostered, as commonly claimed. This may call for a different emphasis on the role of public intervention. While a goal to stabilize the economy in good times should be to disrupt the channels that bring contagion, that is a positive correlation in the returns, in a period of worsening economic conditions our analysis suggests regulatory intervention aimed at disconnecting the economy at crucial nodes. Moreover, we show that policy interventions should be aimed at rescuing institutions, but not their managers. Diminishing the cost of default actually increases the inefficiency due to the divergence between the social and the individual optimum. Economics Public policy 8 3 1 20 2008-09 10.2202/1524-5861.1365 1524-5861 http://hdl.handle.net/10022/AC:P:13540 NNC NNC 2012-06-18 16:10:08 -0400 2012-06-21 21:34:00 -0400 7543 eng