Justin Fox: What We’ve Learned from the Financial Crisis: Noted
Justin Fox: What We’ve Learned from the Financial Crisis:
The basic idea that had governed economic thinking for decades was that markets work.... In the summer of 2007, though, the markets for some mortgage securities stopped functioning.... Trust evaporated, and not until governments jumped in, late in 2008, to guarantee that major banks would not fail did the financial markets settle down and begin fitfully to function again. That intervention seems to have prevented a second Great Depression--although the inhabitants of a few unfortunate countries such as Greece and Spain might beg to differ. But the economic downturn was definitely worse than any other since the Great Depression.... And what has been the impact on economic thinking?... To me, three shifts in thinking stand out: (1) Macroeconomists are realizing that it was a mistake to pay so little attention to finance. (2) Financial economists are beginning to wrestle with some of the broader consequences of what they’ve learned over the years about market misbehavior. (3) Economists’ extremely influential grip on a key component of the economic world--the corporation--may be loosening. These trends are within and on the fringes of elite academia... but... for the past half century... economic ideas born at the University of Chicago, MIT, Harvard, and the like really have tended to trickle down and change the world....
In its most extreme form, this “new classical” macroeconomics taught that any government attempts to stabilize the economy were pointless. Before long “new Keynesians” were factoring in frictions, such as the tendency of prices and wages to be “sticky” and resist adjustment to changed economic conditions. But their “dynamic stochastic general equilibrium” models were also populated by rational individuals making forward-looking decisions; they forecast relatively gentle fluctuations and generally pointed toward only modestly activist policies.... As Lucas put it in his 2003 presidential address to the American Economic Association, the “problem of depression-prevention has been solved.”
This claim was odd in that the proximate cause of the Great Depression—a breakdown of the financial system in the United States and elsewhere—hadn’t really been part of the discussion.... Then the global financial crisis struck.... Mainstream macroeconomic theorists came under heavy fire for having spent decades on work of almost no relevance to the current predicament. Happily, those theorists weren’t the only economists around. As Ricardo Caballero, of MIT, put it in a 2010 article, scholars on the “periphery” of macroeconomics were already “chasing many of the issues that played a central role during the current crisis, including liquidity evaporation, collateral shortages, bubbles, crises, panics, fire sales, risk-shifting, contagion, and the like.” This periphery wasn’t even all that peripheral: Ben Bernanke, at the center of the crisis-fighting campaign as chairman of the Federal Reserve, had long studied how bank failures spread economic havoc....
Once the moment of panic had passed, however, unanimity quickly unraveled. In early 2009 there were essentially two working theories about what to do next. One, harking back to Keynes, was that these tempestuous times called for bold measures.... The other theory was that with a financial meltdown averted, things were more or less back to normal. Inflation would soon again be a threat that demanded vigilance from central bankers. Big government deficits would lead to crises of investor confidence. Unemployment insurance and other aid programs would do more macroeconomic harm (by discouraging work) than good. The old rules would still apply. The events of the past five years have delivered a pretty dramatic refutation of the second theory....
A few finance scholars, most persistently Thomas Philippon, of New York University, have also been looking into whether there’s a point at which the financial sector is simply too big and too rich—when it stops fueling economic growth and starts weighing on it. Others are beginning to consider whether some limits on financial innovation might not actually leave markets healthier. New kinds of securities sometimes “owe their very existence to neglected risks,” Nicola Gennaioli, of Universitat Pompeu Fabra; Andrei Shleifer, of Harvard; and Robert Vishny, of the University of Chicago, concluded in one 2012 paper. Such “false substitutes...lead to financial instability and could reduce welfare, even without the effects of excessive leverage.”...
The most dramatic empirical finding in corporate governance in the aftermath of the financial crisis is that the banks and investment banks that got into the most trouble in 2008 were generally the ones with the most shareholder-friendly executive pay and governance arrangements. As noted, equity accounted for only a tiny part of many financial institutions’ balance sheets, meaning that shareholders had far less at stake than creditors did. They were less owners than thrill-seekers along for the ride—sharing in the gains if a bank’s risk taking succeeded, but on the hook for only a tiny portion of losses if it failed...
