Chapter 13

Financial Engineering and Macroeconomic Innovation

Cara M. Marshall

Queens College, City University of New York

John H. O’Connell

Financial Integration, LLC

INTRODUCTION

The credit crisis of 2007–2009 and the recessionary aftermath have sparked considerable, often heated, debate with respect to policy issues—both fiscal and monetary. The crisis led to the introduction of a number of new central bank monetary policy tools and an aggressive expansion of the monetary base in Europe and Japan. But nowhere has monetary policy been more accommodative than in the United States. While classic monetarist theory would hold that this is inflationary foolishness, the dominant concern among many economists (and some notable hedge fund managers) is for deflation, not inflation.

On another front, the recession stressed corporate cash flows, particularly in cyclically sensitive industries, leading to a sharp decline in employment. State and local governments too have been stressed as their tax bases shrank while the demands on their services simultaneously expanded. This has, once again, brought home the cyclically sensitive nature of municipal coffers. Unlike the private sector, municipalities are typically loath to shrink their work forces and reduce services until they reach a crisis stage. Not surprisingly, this has led to a general decline in the perceived quality of municipal debt and to the outright bankruptcy of some municipalities. These macroeconomic stresses on corporations ...

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