|Intro. Essay, eloquent and incisive and short. Quote: "Opportunity for us.... Belief that era of aggregate volatility had come to an end." What have we learned about volatility? A lot has been written on Great Moderation, name used to describe decline in business cycle volatility in United States from mid-1970s until the recent crisis. Remarkable decline in aggregate volatility. In 19th century, highly volatile; same for early 20th century; for a lesser degree in first 20 years after post-war era. Same to fairly large extent in other large developed economists. Thinking is that either because we learned the craft of monetary policy or because new technologies have changed the way that firms are able to respond to demand changes or supply opportunities. Is the argument a softening of creative destruction? Labor and capital markets are so dynamic because resources can move around more effectively. Finance is more available, resources can more easily go from declining firms or sectors without creating much unemployment or delay to those with better opportunities. Knowing that the financial sector is better able to diversify idiosyncratic risks, firms are able to be bolder and take more risks and thus be able to exploit their comparative advantages. Better allocation of resources. All true, but wouldn't call it a softening of creative destruction, as Schumpeter envisioned it, but destructive effects are not being felt as strongly in the aggregate economy. One other aspect: Wal-mart effect. One of the firms that epitomizes the effective use of information technology in inventory control and supply chain and thus able to respond to shocks much better. Probably true that monetary policy has become much wiser. Emphasis that emerged that aggregate volatility was a non-issue was nevertheless the wrong lesson to draw.
|Develop the argument for that. Nothing in social life, including the economic sphere, is independent of human agency. Variety of subtle complications arise. We are good at abstracting away from the complications. As we recognize complications that played a more important role than we thought, we go back and put them in the model. Create a web of counter-party relations. Example: I have some idiosyncratic risks and want to share them with you. Have to engage in financial trade, implicit or explicit trade: I will pay you some money if my shock is good and yours is bad, and vice versa. Write similar implicit contract with other firms or agents. Web of contracts enable diversification. Role of technology: incredible reduction of transactions costs, allowing the parties to create this web of contracts. Two pillars indispensible for this development. One is technological developments that made relatively rapid communications feasible, accounting, integrated world economy so risks could be shared across regions that are less correlated in demand and production events. Second: financial innovations. Counterparty relations that this process involved causes new risks that were not encountered before and that were not appreciated. Didn't pay enough attention to the fact that this financial system involved a lot of IOUs, and because of its web-like structure, if one set of IOUs failed, it would make the next set of IOUs essentially impossible to execute. Domino effect. What we've done well is diversified a lot of regular risks but in the process created a lot of fragility of the system to real tail events that involve a nontrivial fraction of linked parties failing. Challenge: Great Moderation. In the run-up to the recent crisis, monetary policy did not follow the same pattern that it had been doing in previous 20-25 years. John Taylor podcast, Taylor rule. Alan Greenspan took interest rates to historic lows, 2003-2004. One could argue that had he not done that, all of these problems would have been small or less dramatic. So the fact that the Great Moderation is over doesn't necessarily disprove that monetary policy had worked well over the prior period when it seemed to be working so well because Greenspan went wildly out of the range of policy. Add one thought: monetary policy by setting interest rates has ability to create movements around natural output level. Then monetary policy cannot be decoupled from our beliefs about the state of the economy. At the time people hailed Greenspan's policy, believing volatility had gone away and we could guide economy. If we'd been afraid of crisis, Greenspan would have not used monetary policy in the same way, more hesitant, worried about the run-up in housing prices. Hubris, way too much confidence in our ability to steer the economy. Would have said: "We're gonna fix this later."
|Quote: "Our second too-quickly accepted notion is that capitalist economy lives.... Mistakenly equated free markets with unregulated markets.... Greed is neither good nor bad in the abstract...." Corruption part and rent-seeking part of that. Implying that financial markets are unregulated--though some are and some aren't. Agents involved exploited either through asymmetric information or access to regulatory structure. Struck by how many people lost in the latest debacle. Didn't exploit others. How much did the people who were in central positions in the financial markets really lose? Difficult question, don't have the data; also depends on relative vs. absolute losses. Long-term Capital Management crisis (LTCM), warm-up for current bailout, same problems: LTCM had very large positions in a variety of markets; smart but risky events did not work out; Fed of NY and Federal Reserve bailed out LTCM. LTCM partners, Meriwether, lost a large fraction of their wealth. If losing relatively, punished. We think to reward the agent if things go well and punish if things go wrong. Doesn't mean reward him 10% of his rewards when things go well. Almost all major players still went home millionaires. Same for Lehman Brothers. Nugget in yesterday's newspapers: companies paid over $20 billion in non-stock bonuses. Footnote: Head of Bear Stearns, at one point worth $120 million; lost $110 million but did end up with $10 million. Could argue he should have been wiped out; many of his investors were wiped out. Have to add reputational damage. Life isn't so good. Bernie Madoff is the exception. Meriwether ousted, LTCM his brainchild; lost 90% of his wealth but then went to the next hedge fund, extremely respected in the profession. Madoff case blatantly criminal.
|Usually we rely on feedback loops of reward and punishment that induce prudent risk-taking--and prudent greed. We've now decided we can't allow the full pain to be absorbed; too messy and costly to allow these risks to unravel. All the lesson has been lost. If government hadn't bailed out Bear Stearns, etc., investors would have learned a lesson, and institutions could have responded. That feedback has been lost. That's where the regulation comes in. First: the really great success of the American economy over past 200 years and many European economies has been that they have been able to use self-interest in the right way, the way Adam Smith envisaged in the Wealth of Nations, bringing progress, economic growth, etc. Suharto, head of Indonesia, in history books as extremely corrupt dictator who filled his and his family's pockets and created economic problems in Indonesia, reduced economic growth. Aren't there people like Suharto in the United States? In the U.S. they can't do that, checked by institutional and social controls. Regulation and institutional checks are part and parcel of our lives and are important in fostering the kind of economic success we have experienced. Put that perspective into the financial sector, where great degree of sophistication is required. Almost impossible for small investors to do these things; have to put some degree of trust in these people. Don't want the government to meddle, but the examples of LTCM means it is very difficult for the market to do that. Going to take away all the earnings of companies that took part in risky earnings? Reduce their wealth but will still leave a lot of incentives for people to actually take gambles. We're not going to torture them or put them in jail. Those incentives are always going to be there. Need something that plays the same role as in the political sphere.
|Challenge. List of people prone to corruptions doesn't include governors--oversight. [Taping end of Jan. 2009, Jan. 30.] IL just voted to remove governor. Institutions includes cultural norms, political structure, important because people like Suharto can use force, so need checks and balances of Constitutional system to restrain that power. On regulatory side, central authorities try to steer, they are subject to political pressure; obsessed with creating a risk-free world. Extremely complex web of regulations; and do not well understand their interactions. A set of economic activity tends to get pushed out into non-regulated areas. As a result, our ability to constrain opportunism is impossible. Do we learn that we need to be more vigilant because markets can't do it, or do we learn the opposite: government regulation can never perfectly remove risk and maybe it would be better to let investors be more aware of how risky things are. Institutions are broad and we are not necessarily talking about regulation. Regulation comes with a lot of political costs. Issue is that the type of regulation we need though very far from being perfect is not one that is along the lines of the types we've had. Not greater regulation to insulate consumers, but the type that makes consumers aware of the risks they are facing so we can expect them to make more informed choices. Perhaps combined with safety net, ex ante fairness. Credit rating agencies: going in opposite direction. Because the relationship between credit rating agencies and the financial entities they were rating was not regulated appropriately they created the impression that everything was riskless. Subprime mortgages used to create a triple-A rated security. Led to crisis and run-up of distortions. Not more regulation perhaps but smarter regulation. Investors to have the right information.
|One more analogy: FDA (Food and Drug Administration), lots of complaints about how it functions, creates a lot of distortions, but we do need it. Would be problematic if nobody made sure that chemical compounds marketed to solve problem A are not creating other side effects that are poisoning you. Impossible to expect ordinary patient to know this. For the drug market, better to tell patients what the risks are; and certain compounds are off the charts, destroy your liver or cause unacceptable side effects. Quick reaction: Great analogy, FDA has made it much easier for some types of innovations to take place but also raised the cost of innovation. Question is not whether we need it or not, or whether it should be private or public. Private system would have its own problems just as public system has its own problems. How do you create this incredibly amorphous thing called "trust"? In the private sector, mechanisms emerge because people want them. They also emerge politically, in which case they crowd out private mechanisms. Question is: which do you like better? For credit agencies, people say they were part of the problem, but maybe people were aware that AAA didn't really mean that. The problem was that these credit agencies were forced to rate things as triple-A. Problem is extremely difficult. Every time you do a regulation, it's going to create a see-saw effect, press on one end and other end pops up. Perfect regulation is impossible, and also second-best regulation is not something you can establish in context. Big part of the credit rating agencies' disaster was related to other types of regulations--you could only hold AAA on your balance sheet in some types of organizations. Dealing with a very complex problem. Great for economists: a lot of things we can think about that can be relevant for the real world. If a private rating agency or private FDA developed and were able to build the trust, that would be great also. Would create some distortions, but that would be less than the government. Wouldn't call that an unregulated system because system like that wouldn't really emerge or persist unless the government said "I don't need to be the rater or do the rating." Not enough to go to Moody's or Standard and Poor--you need several private agencies. That's a form of regulation, and people might complain about it. Doesn't necessarily mean the government has to say you're good and you're not good. Doesn't say how these agencies would emerge.
|So far, cause of the crisis and what we might put in place to prevent such a thing in the future. That in economics is "normative"--what would we like the world be like down the road and what can we do to get there. The "positive" side of economics is what is going to be, not would we like it to be like. Political Coase theorem: There are market forces within politics that can lead to efficiency, or is it really the case that these market forces are not sufficiently active. [taping January 30, 2009]. Yesterday in the paper, four things: 1. The Fed is considering altering the terms of mortgages they are holding, allowing the homeowners to pay less in principal; 2. the House has passed out of a committee the possibility to allow judges to go on a case-by-case basis and lower the principal for homeowners; 3. the Senate is considering paying people to trade in their cars so long as the used car is then destroyed--reminiscent of the 1930s, idea being to somehow create demand for cars--even better if you could only own a car for a week; 4. Senate or House is voting in rider on new spending package that all the infrastructure such as steel have to bought from American firms. Tendency in economics to treat political action the same as individual action, as if there is an "us" or a "we," but it's an emergent phenomenon without many feedback loops. Efficiency in government. When there are a few parties that create externalities for each other we can rely on a Coase Theorem so that they are going to work out their differences. Sometimes been used in concept of politics as well. Serious limits in political sphere. They work in the economic sphere based on precise institutional structure that regulates relationships. Saxophone example. Can actually enter into a contract. If it's explicit we need the courts, if it's implicit we need social norms. Same is not true in politics. The person in power at the moment has the right and power to enforce the contract and say what kinds of payments and actions are okay and which will be prevented. Asymmetry exists because political power is non-divisible object. Political deals harder than private economic deals. Theoretical theme. Coase Theorem type of approach will have much less bite in political than in private transactions. In real world issues, this is only one aspect. One other important element is that coordination is a very difficult thing in political transactions. Only from time to time that large number of people will focus on one specific dimension. It may be that everybody knows they will be better off with free trade, but if at a point in time there is a salient issue of protectionism, significant group of vocal people who will benefit from that, doesn't help that others know they will be better off without protectionism. The vocal minority can manage to solve their collective action problem and might get their way. Final issue: a lot of uncertainty for the public and amongst economists about what constitutes good policy. Krugman. Roberts or Becker as counterpart. Can't really expect the population, voters to agree about everything if they can't agree. Future of political economy in the United States? A lot of dangers. Public wants action, uncertain about the right action. Some cheap and wrong solutions. Protectionism, rallying cry, our jobs are going to be saved, terrible policy, wrong kind of policy as adopted in the 1930s. Important political economy risk is that we can over-regulate. Limited amount of regulation we need, smart regulation. Don't want to limit entry. Don't want in the name of jobs create entry barriers that would prevent new and efficient firms from entering. All possible because there are many different ideas that are playing out right now. Other political economy risk: Why backlash against capitalism and free markets? People could say to go to the other extreme. In essay: there is a difference between free markets and unregulated markets. Real dangers, but looking forward: how afraid that they would materialize? At the end of the day, the Obama team at least has good economists on it in terms of IQ and knowledge: Larry Summers, Austen Goolsbee, Christy Romer. Not as if we have delegated economic policy to a bunch of lawyers who know nothing about economics. Disagreement. Anybody who says they know the answer is being a little optimistic.
|Hubris about stability, being humble in the face of uncertainty. Being smart isn't enough, have to be wise; even being smart and wise aren't enough. Ben Bernanke looked like greatest person alive we could have at the Fed but he is struggling; and buffeted by political situation. Is the Obama team really going to have a say? Growth may very well be the victim of this political system. Not just whether we have good economists but how does the political system interact with them. Bernanke-Paulson plan, parts difficult to justify, pushed into by political concerns; can use all your brilliant economics but at the end of the day a lot of political decisions. Economic growth: overwhelmingly important issue. Severe recession that costs us 3-4 percentage points of GDP is nothing compared to the loss we would incur by sacrificing economic growth. A 1% decline economic growth in the next 20 years would accumulate to 40-50 percent of loss of GDP in 40-50 years. Sacrificing consumption today is not only sacrificing consumption of relatively wealthy people but also unemployment and real poverty, but at the end of the day, want economic growth guarantees stability. New ideas, allocation of productive resources, essence creative destruction. Real danger would be to take actions that in the name of saving 1% of GDP this year we sacrifice 1% growth rate of GDP for extended period of time, which for 30 years would be about 35% lower GDP. That would be a very large price to pay in exchange for trying to smooth a business cycle recession. Prevent a Great Depression, but as soon as we create the insurance policies to prevent that, focus should turn to policies that are not just important for current conditions but do the right thing for the economic growth potential of the economy.