Economic Theory & The Financial Crisis

Interviewee Background (Via The Browser)

Nobel Prize winning economist Eric Maskin is the Albert O Hirschman Professor of Social Science at the Institute of Advanced Study in Princeton. Along with Leonid Hurwicz and Roger Myerson, he was awarded the Nobel Memorial Prize in economics in 2007 for his contribution to mechanism design theory. Maskin says that economic theory actually did a very good job of anticipating the financial crisis. He argues that policymakers  had better start paying attention if they want to prevent, or at least mitigate, future crises.

Excerpts (Via The Browser)

Q: Your first choice is a classic article on banks and bank runs from 1983 by Diamond and Dybvig. Like most economic theory, it is probably too technical for non-economists, so do you want to start by explaining what it says? And, also, why you chose it, given that, with the exception of Northern Rock, this crisis hasn’t been particularly characterized by bank runs?

A: Diamond and Dybvig lay out their vision of the role of banks and the notion of liquidity. Even though the current financial crisis isn’t mainly about old-fashioned bank runs, it certainly is about banks and also about liquidity. Liquidity is the thing that enables a consumer to cover her immediate spending needs when her wealth is tied up in a long-term project, or that allows a producer to finance a project today even though it won’t pay off until tomorrow.

And providing liquidity is where banks come in. Banks, according to Diamond and Dybvig, are in the business of transforming illiquid assets – assets that pay off in the future – into liquid assets, so that people can undertake the spending and productive projects they want now. Banks accomplish this by pooling the risks of many individual people. It may be difficult to predict whether an individual person will choose action A rather than B, but it is relatively easy to predict what proportion of a large group of people will choose action A. This is the same principle that insurance companies rely on.

So, let’s say it’s Thursday and there’s a large population of people. Each person has some wealth but doesn’t know when she will need to spend it – that is, whether her spending needs will occur on Friday or on Saturday. There is also a productive project. Each dollar invested in this project on Thursday yields $1.50 of output on Saturday. If a person doesn’t have to spend until Saturday, then she can benefit handsomely from the project. On Thursday she can invest her wealth in it, and on Saturday end up with 50 per cent more than she started with. But what if, instead, her spending needs turn out to occur on Friday? In that case, she has to take her money out of the project then, losing the 50 per cent return she would have received had she been able to wait until Saturday.

So, here’s what a bank does. Lots of people deposit their wealth in the bank on Thursday and it then invests these deposits in the productive project. Even though the bank doesn’t know for sure whether any given person will want to withdraw her money on Friday, it knows accurately what proportion of people will do that. So it can, in effect, give those people insurance. Rather than just giving them their deposits back – which is what these people would get if they were on their own without a bank – it can pay them interest, in exchange for reducing the interest rate for the Saturday withdrawers below 50 per cent. In other words, the Saturday people subsidize the Friday people (in the same way that, with health insurance, people who remain healthy are subsidizing those who get sick). And the bank makes this possible.

Q: There’s been lots of criticism, for example from Paul Krugman, that the economics profession did not foresee the crisis. But from the way you’re talking, it seems there are existing models that predict that these crises will happen, and it’s a question of how you respond.

A: I don’t accept the criticism that economic theory failed to provide a framework for understanding this crisis. Indeed, the papers we’re discussing today show pretty clearly why the crisis occurred and what we can do about it. The sort of economics that deserves attack is Alan Greenspan’s idealized world, in which financial markets work perfectly well on their own and don’t require government action. There are, of course, still economists – probably fewer than before – who believe in that world. But it is an extreme position and not one likely to be held by those who understand the papers we’re talking about.

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19. October 2009 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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