I joined nearly 10000 other economists at the annual meetings for the American Economic Association in San Francisco January 3rd through the 5th.  Of course there were plenty of lively discussions and academic presentations on causes of the 2008 financial crisis. 

Despite 10000 participants, the conference was not a big economic stimulus for the Bay Area economy (Economists are too cheap – low spending on entertainment and bad tippers).  Surprisingly, however, consensus among many experts was found for both the cause of this crisis and the needed policy actions. 

The 2008 crisis is primarily attributable to what economist call an adverse selection problem.  Adverse selection is the tendency for credit and insurance products to be purchased by only those who have greater than average need.  This leads to market failures because it raises costs to providers of credit and insurance.  The people and businesses that want to borrow the most are the most risky. 

Economists obviously agree that banks and other lenders did a poor job these past few years screening out those borrowers most likely to default on their loans.  So many institutions had so much to lend and did not care to whom it was lent.

When the risk of adverse selection is higher than normal, lenders will generally raise the amount of required collateral. This did not happen as lenders looked only to increasing home values as better and better collateral. 

Thus, most recommendations as to how we can avoid another calamity like that which we are now in center on better collateral for all types lending.  Homeowners will need more than just their house and businesses will need more assets.

Find consensus on the reason for the crisis, and rarely short of ideas or opinions, economists at the meetings provided many recommendations for fiscal, monetary, and regulatory policy.

Fiscal Policy

Not unlike politicians, in regards to fiscal policy there was the most disagreement. Alan Blinder argued that the short-term incentives of financial industry managers got us into this mess and that that fiscal policy should focus instead on the long-term.  The recession is not likely to be over soon, but spending on infrastructure (e.g., roads, bridges, and communication networks) will help boost the economy in the coming years.

Robert Hall of Stanford University discussed how infrastructure spending would be slow to work and tax rebates just increase saving. Therefore he argued for a sales-tax holiday.

Monetary Policy

On the contrary, monetary policy responses to the crisis generated substantial agreement.
Barry Eichengreen from the University of California at Berkeley spoke on the need for a better way of removing the troubled loans from bank balance sheets.  Anil Kashyap of the University of Chicago agreed, and went farther to say that bad banks should be more quickly shut down or nationalized. 

San Francisco Fed president Janet Yellen spoke on how effecting the Fed’s actions have been – showing that spreads, the difference between government bond rates and other market rates, have significantly narrowed since the start of the crisis.

 Fredrick Mishkin, former Fed governor agreed.  However, he noted how important it will be for the Fed to quickly undo all that has been done so far as soon as economic activity picks up again, or otherwise the U.S. economy will face dramatic inflation problems.

A strong dissenter is Stanford Professor John Taylor.  Dr. Taylor strongly criticized the Fed and Treasury for worsening the situation with ad hoc responses.  He further argued that the fed has favored certain markets and firms, thereby conducting an industrial policy using currency printing presses.

Regulation

Information and transparency was the theme with regards to regulation.  Robert Shiller of Yale University said much of what is being discussed is just short-term thinking. More thought should be given to what will really help the economy in the long-run, such as better financial education and more information markets.

Consistent with the latter recommendation, Gary Gorton also of Yale presented work showing how the crisis is one of liquidity. He studies the short-term bond markets and found very poor information links between mortgages and the cash markets banks use to finance them.  If markets were more transparent, the risk of adverse selection would be better known and better managed.
Economists always leave the room with a discussion of where do we go from here.  Suggestions for further research focused on study of not just the economy, but very specific aspects of the financial markets.

Markus Brunnermeier of Princeton pointed out that economists need a better measure of “too big to fail”.  Research going forward will focus on the level of risk that bank failures really have for the overall economy. 

Pietro Veronesi and Luigi Zingales, both from the University of Chicago, showed research calculating the costs and benefits of the U.S. Treasury’s current intervention in the banking system.  It is estimated that the $125 Billion direct investments in U.S. banks created $109 billion of value at a taxpayers’ cost of $112 -135 billions.  Clearly, we need better measures of how letting the banks fail would have hurt the economy as was expected.

We may not have resolved all the World’s problems, but the 10000 economists in San Francisco found many points of agreement, and even more things we need to study further.

-   Peter Crabb

Dr. Crabb hosts a blog for the Idaho Statesman which may may be found at http://www.idahostatesman.com/crabb/

Filed under: Uncategorized