They have to do fundamentally with well understood inefficiencies of markets. So, for example, if you and I make a transaction, say you sell me a car, we may make a good bargain for ourselves, but we don’t take into account the effect on others. If I buy a car from you it increases the use of gas, it increases pollution, it increases congestion, and so on. But we don’t count those effects. These are what are called by economists externalities, and are not counted into market calculations.
These externalities can be quite huge. In the case of financial institutions, they are particularly large. The task of a financial institution is to take risks. Now if it is a well managed financial institution, say Goldman Sachs, it will take into account risks to itself, but the crucial phrase here is to itself. It does not take into account systemic risks, risks to the whole system if Goldman Sachs takes a substantial loss. And what that means is that risks are underpriced.
There are more risks taken than should be taken in an efficiently working system that was accounting for all the implications. More, this mispricing is simply built into the market system and the liberalization of finance.
The consequences of underpricing risks are that risks become more frequent, and, when there are failures the costs are higher than taken into account. Crises become more frequent and also rise in scale as the scope and range of financial transactions increases. Of course, all this is increased still further by the fanaticism of the market fundamentalists who dismantled the regulatory apparatus and permitted the creation of exotic and opaque financial instruments.