What happened to the global economy and what we can do about it
Day: October 22, 2008
I’ve added a new section to the Financial Crisis for Beginners page trying to answer the question of where all that money we used to have has gone to, using an economy of just three people.
If there are other topics you’d like explained simply, please let me know.
There is a paper by three economists at the Federal Reserve Bank of Minneapolis that is getting a lot of attention on the Internet today. (How often can you write that sentence?) V.V. Chari, Lawrence Christiano, and Patrick J. Kehoe set out to debunk four myths about the financial crisis:
In short, they are saying that despite all the hand-wringing about banks not lending to consumers and businesses, it just ain’t true, and even if it were, most lending isn’t done by banks anyway. The implication, to simplify somewhat, is that we are in a media storm of hype that may itself have negative effects.
While I would love to believe this, I don’t think they make the case conclusively. A few quibbles (for this to be understandable, you may have to look at the original paper):
Yesterday was the last day for settlement of credit default swaps linked to Lehman debt. One of the fears raised in the dark days of September was that the failure of a bank like Lehman would create hundreds of billions of dollars of liabilities for companies that had sold insurance on Lehman debt, and that market participants had no way of knowing who was good for that money, because many sellers were hedged and might be counting on payment from another seller, who might be counting on …
Well, the financial system is still standing. While we won’t know who lost money until the next quarterly earnings are announced, no one defaulted on the CDS. In part, this was due to the fact that as Lehman bonds fell in value, sellers of CDS had to post collateral to buyers, so a lot of the losses had already been recognized. (I believe AIG was an exception to this, because they had a AAA bond rating and hence did not have to post collateral until they were downgraded.) Perhaps things would have been worse without the many liquidity-increasing steps the Fed took over the last month; if you have to raise cash in a hurry, it is far easier to get it from the Fed now than it was in the past. In any case, it appears we have one less thing to worry about, at least for now.
The Economist is hosting a debate on financial system regulation between no less than two Nobel Laureates, Myron Scholes and Joseph Stiglitz. (Be sure to read the opening statements before the rebuttals, or it may not make sense.) The debate is less over specifics than over the general question of how much regulation there should be. They may be lying low right now, but there will surely be legions of executives and economists arguing that we actually need less regulation in order to foster financial innovation.
The Economist recruited Scholes to defend this view, but unfortunately he puts on a rather tepid defense. I read his arguments three times and I think they boil down to this: Crises stem from too much leverage, and therefore bank capital requirements should be increased. (He also says, however, that “Determining the amount of leverage to be used by financial institutions is a business decision.”) If banks need additional capital in a crisis, it should be provided by the government and priced accurately. In his rebuttal he also proposes a new accounting framework, potentially implemented by a regulator, that provides a more accurate assessment of the risk faced by a financial institution. So, as far as I can tell, it boils down to: (a) higher capital requirements; (b) government capital in times of crisis; and (c) better accounting. For the rest, we can count on existing laws against things like fraud. Unfortunately, the only evidence he provides for the thesis that “more regulation is bad” is that economic growth was lower from the 1930s to the 1970s, which he calls an era of regulation, than since the 1970s, an era of deregulation. (Like everything in history, economic growth levels are overdetermined, meaning that you can find a dozen different explanations of any given historical phenomenon.)
Stiglitz doesn’t do such a great job proving the “more regulation is good” thesis, either; his evidence is that countries with “strong regulatory frameworks” are less likely to have financial crises. But Stiglitz gets at the basic question: is unbridled financial innovation good or bad? Does it really lower the cost of capital enough to compensate for the costs of crises like the current ones? Which innovations are good and which are bad? Can we get the good ones without the bad ones?
Continue reading “Nobel Laureates Debate Financial System Regulation”
I spent most of the last two days teaching some special sessions on the global crisis at MIT and doing final preparations for a couple of courses that will start next week.
Three relevant points strike me from interacting with students, faculty and other members of the MIT community, which – as you might guess – is a very international set of people.
First, everyone now understands this is a truly global crisis. The ramifications are already apparent in places that, even a month ago, you would have thought quite distant from the US financial sector, such as small business in India or Australian real estate (the link is of course credit). There is very little that can, in some sense, shock any more: Chinese growth could stall, credit may tighten further, European medium-term prospects are already being be called into question, and so on.
Second, very few people yet see the complete picture. We all have some pieces clear in our minds, but it’s only when we talk – particularly in a free-wheeling classroom discussion – that we begin to see how it all fits together. It’s only when you engage with someone from Iceland, or a person with money in a UK bank, or a student whose income is in a depreciating currency, that you really begin to realize the scale and interconnectedness of the problem.
Third, I’m struck and encouraged by the calmness that follows a really open discussion. People are worried, but talking about the problems helps them get perspective and start thinking about strategies. How exactly are they going to cope, what should they do differently, and where will they see the impact on this or that business?
All of this makes me think that we can usefully contribute to each other’s understanding by talking (and arguing) through more dimensions of the crisis and its impact. In that spirit, we will open up our classroom over the next two months, to bring your views and questions to MIT and vice versa. We’re still working on the exact details of how best to do this (and we’re very open to suggestions), but as much as possible it will be through this website. Tell me if it helps.
The Baseline Scenario 