The recent economic crisis has once again put economics discipline morally accountable for the plight of many people around the globe. The foremost question posed here is whether the crisis was preventable in advance when appropriate policy actions had been taken. The economic crisis indeed has triggered a crisis in economics by creating a pressure for economists to search for convincing answer for this question.
The fact is that financial crises are almost always followed by severe contractions in economic activities. This reality necessitates the understanding of true connection between financial markets and the real sector of the economy. While policy-makers left no stone unturned to combat the recent crisis, the moves were just frantic lacking much knowledge on how macroeconomic policies can affect the financial market behavior. The financial system has become such a complex structure now that macroeconomic policy-making is loosing its grip on controlling activities in the financial market. Obviously, the trial and error methods were applied during the crisis because and no one knew we would pass through the crisis of this magnitude and we were prepared for it, but fortunately policy actions were able to hit right on the target that brought economies out of this mess. There is, however, an urgent need to explore more on the true relationship between macroeconomic policy-making and financial markets behavior so that we would be able to prevent similar crises from happening in the future. In light of necessity of more works to be done, the economists have now realized that we need to identify channels by which macroeconomic policy actions are transmitted directly to the financial sector so as to generate favorable outcome within the short period of time.
To be precise, the theoretical models tell us that adverse selection and moral hazard problems resulted from asymmetric information are major causes of financial crisis, and the framework should be developed in such a way that the policy actions should have direct impact on controlling these asymmetric information problems. For this, one of the possible channels could be balance sheet channel. Since an important source of asymmetric information problem is declining net worth effect on the balance sheet of firms and financial institutions and what policy-makers can do is they develop policy measures such that their actions are immediately reflected to the firms’ balance sheet. In fact, the decision of injecting capital to increase net worth of troubled banks was one of the most effective measures taken by central banks to combat the recent crisis. It’s time to look for more such direct measures to be prepared for the prevention of futures crises.
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Petrica Molnar:
ReplyDeleteI do agree with this blog in that we should find means of attacking balance sheets to increase proper investing and decrease moral hazard and adverse selection. I do however disagree in the tactics used to bailout the banks. You see I believe deposit insurance, and banking insurance provided by the government increases moral hazard. The banks know that they can engage in risky behavior because all losses will be insured. This increase in moral hazard is not good. We need to find ways to stimulate the economy and attack balance sheets, without just simply giving money away to increase net worth. Strategy was effective in a desperate time, however we should be looking for preventive measures, inflation is bound to catch up with us eventually.
Let’s consider your posted position that macroeconomic policy needs a more direct and proactive mechanism to assist in the avoidance or identification of possible crisis causing conditions, and your statement that, “the framework should be developed in such a way that the policy actions should have direct impact on controlling these asymmetric information problems”
ReplyDeleteI agree that the balance sheet is a very good place to consider making the desired affects of policy more immediate. Let’s look at the balance. On the left side there are assets; on the right there are liabilities and equity; equity = assets minus liabilities, (the varied and different definitions of capital, depending on what subset of equity is being used is something that needs to be modified).
The goal has always been to provide confidence that there is enough capital to withstand the impact of market and economic turmoil – in particular, its impact on the toxic assets that litter banks’ balance sheets. Look at two of the alternative approaches that have been recommended and used. One is to add more equity to the right side by issuing new stock (preferred or common). (This would add cash to the left side to keep them in balance.) The other is to reduce the uncertainty of the left (asset) side by helping banks sell toxic assets; even when the banks had to sell them for a little less cash than their current balance sheet value was, the effect of reducing vulnerability has been realized and since cash does not lose value (at least not in an accounting sense). Alternatively the thought was the same effect could be achieved by insuring the value of the assets while leaving them on bank balance sheets, because then the risk transfers to the insurer, unless the insurer becomes insolvent.
So this is how things went in September of 2008 Paulson’s Plan was to focus on the left side; the idea was to buy toxic assets off of bank balance sheets. Then in October of 2008 the Treasury did an about-face and switched to the right side, recapitalizing banks by buying preferred stock from them (TARP). In November and January, Treasury and the Fed did combined bailouts of Citigroup and Bank of America, in which they both provided fresh capital and guaranteed certain assets against falls in value. In February and March of 2009, Treasury shifted all the way over to the left (asset) side with the PPIP, which was hailed (by its supporters, at least) as a way to cleanse bank balance sheets – something that had not been accomplished by TARP. Its supporters were wrong, more work needs to be done.
Renell Anderson
The problem with the financial sector is that they got too carried away and too comfortable with risky lending practices. Yes, it made them some money in the short term, but after the crisis they were forced to ask the government for bailout. I do agree that better accounting rules and better overall oversight needs to be in place to help the government take appropriate actions in the future, and for the financial system to quickly realize its own errors and attempt to remedy them from within. While many people disagree with the government bailouts, they were probably necessary. No one has seen a crisis such as this since the Great Depression, and the government had genuine and legitimate fears that it can get a lot worse. Many banks and financial institutions were bailed out of fear of larger economic collapse. Were such measures necessary? Only time will tell. Among other things, Ben Bernanke and the Federal Reserve Bank increased the money supply by over twofold, which in all likeliness was the one crucial move that stopped this recession from turning into a depression.
ReplyDeleteMichael Kinsley
I agree with Petricia and the blog. The problem isn't that we can't fix the financial problems, it's that we can't prevent them from happening. Oozing billions of dollars into the economy in the short will indeed get us out of this slump but what happens in the long run with this problem turns into another? Taking a look at the books is definitely a good way to start, but given these problems and the past economic problems, we need to come up with a way to prevent a financial crisis such as this from happening again. Infusing the economy with money instead of jobs will not help. Allowing so many American jobs to be sent across seas when we have so many Americans ready and willing to work will not help keeo money flowing in the economy. Backing Banks that aren't backing the people will surely lead to our demise. This financial crisis should surely give us a wake-up call so that we can prevent to something of this magnitude from happening again as opposed to reacting to situation which will only cause more problems in the long run.
ReplyDeleteI agree that additional economic policies are needed for 2010 and beyond. Unfortunately we find ourselves, as a society, in a position of reacting rather than responding to the economic problem at hand. This situation disappoints me. I would have expected, with the number of economists in this great country as well as internationally, revolutionary, out of the box thinking would have been occurring conducting research, generating models and hypotheses that would have minimized or deterred the recent economic melt down. I realize that some of these findings would potentially need to be incorporated into regulations and policies by politicians and the Feds; however, having economists as part of these organizations should make this an attainable task. I am concerned that perhaps we got too comfortable or blinded by greed, didn’t see the disaster coming, and missed an excellent opportunity to take this nation to the next economic level and continue the strong cutting edge performance that is characteristic of this nation.
ReplyDeleteThere has been some conversation about incorporating behavioral economics. I hope higher institutions of learning are seeking ways to incorporate this field of study into their economic curriculum so that those who are leaving these institutions as graduates are armed with the needed tools to function as 21st century economists. Either way changes truly need to occur as the American people’s tolerance for financial bailouts to firms functioning with asymmetric information or principal-agent problems are wearing thin.
Avadella White
During the economic crisis, the government was faced with multiple challenges. Government had to support the failing financial institutions, stimulate the reducing economy and reduce unemployment rate.
ReplyDeleteInjecting capital into the banks and financial institutions by the central bank, boosted financial markets confidence in the banking system.
Temporary increase of standard insurance amount by FDIC, also boosted the consumers’ confidence in the banks and stopped huge withdrawals. FDIC increased standard insurance amount to $250,000 per depositor (is in effect through December 31, 2013).
Future regulations, which will ensure banks and financial institutions execute stress tests (simulate worst case scenarios) at a periodic basis could help resolve the moral hazard issue. The results from the stress tests might stop the banks to stop taking higher risks or be prepared to face any new crisis.
Future regulations, by mandating the release of stress test (simulate worst case scenarios) results executed by the banks and financial institutions at a periodic basis could help resolve the asymmetric information issue. This would power the investors to make the decision of encouraging or discouraging the banks with high risk profile.
*****ANTARA MAJUMDER*****
The recent global financial crisis was indeed caused by severe lapses in bank regulation and lack of supervisory oversight. The FASB was recognized by the SEC and was established for making sure firms and financial institutions are following generally accepted accounting principles when reporting financial statements. However, mark-to-market accounting allowed institutions to report risky assets or liabilities at current market price (fair value) instead of purchase price. So, the value of the assets were priced based on current market conditions. At the time, expectations on housing were so optimistic that assets on financial institutions were extremely overvalued. Financial intermediaries became highly levered and started to report huge losses as the mortgage securities began to default.
ReplyDeleteRegulators need to promote transparency within the primary and secondary markets so investors can asses the risk on marketable securities. Also, financial institutions must raise their capital requirements to cover risky investments with restrictions placed on their Leverage ratios. Credit rating agencies must be regulated by the SEC and not just a function of a profit seeking entity. Finally, hedge funds should not be exempt from government regulations and should have restrictions imposed on derivatives trading.
Brian Frisch
I do agree with the post that the blame for financial crisis is put on economists. It should be noted that during the sub-prime lending fiasco. That the government did not adhere to economic policy when they realized that the sub-prime lending could be a profitable venture and decided to give the banks a safety net to help encourage lending to would be homeowners who rated as a risk for a mortgage. This was a clear deviation from economic policy. Included in this the net created by the government to help increase sub-prime lending it creates a win situation if the venture were to profit with the public paying the loss through taxes should it be unsuccessful ; which it wasn’t. The focus should be pointed on the most prominent cause of crisis which is typically the initiating of financial liberalization. Its inception allows less restriction and fosters financial development but has its flaws for the same reason as it has to be monitored periodically to prevent excessive risk. In that sense I do agree as well that the majority of monitoring should be done at the banks as they are the one of the major intermediaries through which the channeling of funds from savers and loans to others .
ReplyDeleteI agree strongly with the blog posting in that making each firms' actions immediately reflected to that firms’ balance sheets is one of the main economic policies that needs to be adopted in order to prevent economic downturns such as the most recent one. It is positively true that the decision to inject capital to increase net worth of troubled banks was one of the most effective measures taken by central banks to combat the recent crisis because lack of capital to back up assets was the primary cause of the housing market collapse and the ensuing financial crisis. Economists are being blamed, economic theories are being reconsidered, and new ways to blend macroeconomic policy directly into the inner workings of the markets is being discussed. And while I agree with the Professor that it’s time to look for more such direct measures to be prepared for the prevention of futures crises, it is the most necessary to hold firms accountable for their actions and investments, to make sure assets are backed up by true capital, and for policy makers to implement measures that reflect true information that the public needs to be aware of. Risky behavior by firms must be constricted in some manner, government bailouts are simply a means to deflect the danger of risky behavior and further promote it. However, government must play a new, more important role in the private economy, which is certainly not a very popular opinion, but rather than play a post-crisis role, it must be a pre-crisis role in which policy is enacted to demonstrate firms cannot take such risks as to jeopardize the integrity of the complex economy.
ReplyDelete-Javier Janbieh