Policy innovations to create more economic stablity
The current economic crisis may not be the dawning of a financial Ice Age, but it is the harshest and most tumultuous downturn since the early 1980s — and maybe much longer. According to the School’s economists, reviving Wall Street urgently requires new policy tools, and reviving Main Street requires new resources. Beyond scaffolding the nation’s near-term recovery, they say, policy innovations and resources must also serve economic growth and stability into the 21st century.
“Good policy has an opportunity to bring the recession back to familiar turf… to make the recession a manageable one,” writes Ricardo Caballero in a recent essay. Caballero is the Ford International Professor of Economics, Macroeconomics and International Finance, and Head of the School’s Department of Economics.
He argues that there is no time to waste in taking these policy steps. The unmanageable recession is hard to miss. Across America, people are experiencing plant and office shutdowns, home foreclosures, and shrinking savings as equity markets have plunged. Unemployment hovers at just under 8 percent. The greatest worry is that today’s dark economic picture may become darker yet.
Making the system more resilient
Some have questioned the very foundations of the capitalist system and the role of the government in modern economies. But that is an over-reaction, in Caballero’s view. “The system we had before the crisis is not permanently broken,” he says. “Rather, it needs to be made more resilient to aggregate shocks, especially panic-driven ones.”
Crises can be mitigated and their shock waves contained. In his November 2008 testimony to the House Committee on Oversight and Government Reform, Andrew Lo, Harris & Harris Group Professor of Finance, a member of the Associated Teaching Faculty in Economics, and director of the MIT Laboratory for Financial Engineering at the Sloan School of Management, stated, “Financial crises may be an unavoidable aspect of modern capitalism. But even if crises cannot be avoided, their disruptive effects can be reduced significantly.”
As a case in point, he cited the “shadow banking system”—a system comprised of hedge funds,
insurance companies and other financial institutions that perform many banking functions but are not subject to regulations imposed on banks. Notably, over the past 25 years (hedge funds themselves are over 50 years old), investors in the shadow system used debt, in the form of an array of credit-based derivatives, to raise capital to finance loans and thereby generate more debt. The disruptive effects of their opaque practices, combined with the mortgage crisis, drastically deepened the US recession.
That system should be regulated, Lo told the committee, but with care. Its strengths — global agility, freedom to innovate, even its secrecy — remain strengths.
Strong MIT ties on Obama's economic team
Recognizing our financial system’s strengths and its vulnerabilities; analyzing the causes of the crisis and developing and implementing policies for economic recovery are all — simultaneously — the formidable tasks President Barack Obama’s national economic advisers are now addressing.
President Obama has drafted an outstanding economic team to meet this daunting challenge, and in a reflection of the international stature of the School’s Economics Department, the team has strong MIT ties. James Poterba, Mitsui Professor of Economics and President of the Cambridge-based National Bureau of Economic Research (a nonprofit research organization that officially determines the starting and ending dates for US recessions) reviews the participants.
The Obama administration’s key economic strategists include Lawrence Summers (SB’75), head of the National Economic Council; Christina Romer (PhD’85), Chair of the Council of Economic Advisers (CEA); and Austan Goolsbee (PhD’95), a member of the CEA and chief economist for the President’s Economic Recovery Advisory Board. They join Ben Bernanke (PhD’79), who President Bush appointed Chairman of the Federal Reserve Board in 2006, and Olivier Blanchard (PhD’77), the Chief Economist of the International Monetary Fund, as key decision-makers who are influencing the policy response to the current crisis
MIT-trained economists also serve in influential policy positions in many other countries. The heads of central banks in Chile, Cyprus, Israel and Italy hold PhDs from the MIT Economics Department. The shared intellectual background of these international policy-makers may prove helpful in resolving the current crisis, as the economic downturn is global in nature and its solution may well require a unified vision.
Crisis as a laboratory for training the next generation
Meanwhile, here on the MIT campus, the School’s economics professors are hard at work training the next generation of economists, sharing their innovative research with the academic community, and providing valuable commentary about the global fiscal crisis for the national and international media and the general public.
Since the onset of this financial crisis, the department’s advanced doctoral courses in macroeconomics have shifted their focus and delved deeply into issues of liquidity and credit crises. Students are learning about the small set of existing theories that can account for financial crises like the current one, and beginning to develop their own explanations for recent phenomena.
Diving into the wreck
Bengt Holmstrom, Paul A. Samuelson Professor of Economics and a specialist in contract theory and corporate finance—believes that economic crises—even crises as deep as the current one—have led to innovations. However, he doubts that the US recovery will be enduring unless the roots of our current crisis are identified and thoroughly understood.
“Think of the current situation as a sick person and the government as a doctor. The bailout is akin to treating one symptom—his fever. That makes him feel better. But I’m skeptical that this is enough. I want to find out what’s causing the fever,” he said.
Caballero, an expert in financial markets and speculative bubbles, describes the crisis of 2007–2009 as, in fact, two recessions—with the second recession overlaying and overshadowing the first one. The initial recession of 2007 was a more or less a standard credit crunch, he says, a real estate-driven recession resulting from a decline in housing prices and the natural stresses inherent in the sub-prime mortgage market.
“People seem to forget that the much-maligned sub-prime shock, in itself, was very small. The real problem was how it froze the entire securitization industry,” Caballero said.
He also noted that mortgage bundling—the practice of turning mortgages from bank loans into securities traded on the stock market—began as an innovative response to the needs of cash-rich emerging markets (such as China) that were seeking more secure investments for their money than those they could find
Holmstrom shares this view: “As foreign capital came in, Wall Street acted as it is supposed to act. It served as an intermediary—creating savings instruments for the abundant foreign money that was seeking (ironically) for a safe haven in the US and for the politicians who dreamed of a way to expand home ownership to low-income US families. The presence of Freddy Mac and Fannie Mae implied that the government would fund the debt if something went wrong.”
But the viability of sub-prime lending and securitized mortgages depended on broad-based and ongoing increases in housing prices. The mortgage-backed securities that were created by bundling these loans were particularly vulnerable to sustained decreased in house prices. Once those prices began to decline, the rate of defaults increased, and banks wrote down hundreds of billions of dollars in bad loans.
In Caballero’s analysis, even the real estate-driven recession could have been managed—if not for the US Treasury Department’s decision to not bail out Lehman Brothers, the global financial services firm that filed for bankruptcy protection in September 2008. The Treasury’s decision to permit Lehman’s failure ignited the second recession, beginning with a run among financial institutions that resembled the infamous bank runs of the 1930s, but on a vast scale, enmeshing regulated banks and unregulated shadow institutions alike.
“The failure to support Lehman introduced enormous uncertainty,” Caballero said. “Economic agents panicked. It’s as if they knew a tsunami might take place, but not where it might come from.”
Media coverage of failing firms and layoffs contributed to mounting uncertainty and fear. By the end of 2008, holiday shoppers were staying home. Investors and banks were hoarding funds. To judge by unemployment and market figures in early 2009, this storm could be long and hard, unless the policy responses are right on the mark. Understanding history may be the best way to avoid repeating it.
Both Fed chairman Bernanke and CEA Chair Romer are scholars of the Great Depression, and their training will be valuable under the current conditions. At the same time, Poterba and Robert Solow, MIT Institute Professor of Economics and Nobel laureate, emphasize that 2009 is not 1933, and that the US economy was far weaker in the early 1930s than it is now, with unemployment reaching 25 percent.
Job One: minding the store
The controversial $800 billion stimulus plan, now known as the “Recovery and Reinvestment Package,” contains many good elements. As a stand-alone policy response, it is unlikely to fully resolve the current crisis, but it is an important step.
“The bailout money is necessary,” says Solow, “though it gripes me that it all goes to the agents of this crisis. The first $350 billion, dispersed to large banks, seemed to vanish. Now Congress is going to insist that some of the second half be used directly to stem foreclosure losses. And there’s some justice in that.”
In HolmstrÖm’s analysis, government policy must stabilize housing. “Mass foreclosures are not good; vacant houses deteriorate, lose value and invite other problems. One idea has been for the government to hire house sitters—perhaps even the original owners. This presents a huge moral hazard, but it’s an idea.” Housing activists in Miami are already sheltering the homeless in foreclosed properties, but a national policy is urgently needed.
As this issue goes to press [May 2009] the Treasury is developing a plan to renegotiate mortgages for homeowners, through banks it has taken over. Congress has begun debating other macro-solutions for the sodden US housing market, including federal mortgage subsidies. The US Treasury Department is considering inviting private financiers to invest in failing banks.
Ideas for recovery
Caballero proposes a macro-remedy the administration could use at once to avert a worsening crisis. Policy mistakes of 2008, he says, mainly exacerbated uncertainty and panic. Since investors withdraw when they get that impending-tsunami feeling, what’s needed now is the financial equivalent of flood insurance. In addition to serving as the financial system’s last-resort lender, the government should also provide access to paid macroeconomic insurance to firms so neither they nor their shareholders must absorb “extreme, panic-driven aggregate shocks,” as they are currently doing.
The government must become the “explicit insurer for generalized panic-risk,” Caballero says. “The essence of a solid recovery should build from this explicit and systemic insurance provision.”
Paradoxically, this solution offers the best deal for the taxpayer, as each new bout of uncertainty causes massive wealth destruction, which far exceeds any implicit transfer to Wall Street that measures to provide macro-insurance may entail. “It is very important to try to remove as much as possible of the extremely myopic political constraints that are getting in the way of solving this crisis,” Caballero says.
Andrew Lo offered the House Committee another way to reduce the vulnerability of the overall financial system to shocks by the shadow system. He urged the administration to require—immediately—that hedge funds worth more than $1 billion provide regulatory authorities such as the Federal Reserve or the Securities and Exchange Commission (SEC) with information on their assets, liabilities, and investors.
He also proposed that an independent agency, modeled on the National Transportation Safety Board, be established to investigate and monitor systemic risk. The new agency would treat the collapse of financial institutions as the NTSB treats plane crashes, reporting to the government and the public on their causes and advising precautionary measures.
Solow focused on mitigating the recession’s impact on workers themselves. It takes only three years out of the work force for skills to depreciate, he said, so prolonged unemployment concerns him. Since businesses produce first and hire second, a “shovel-ready jobs” program appeals to Solow as a reasonable, just, and swift intervention.
The intersection of Wall and Main
Americans of all walks of life have been affected by recent economic events, and the current recession will continue to cast its shadow on forthcoming years. Addressing Main Street and Wall Street, President Obama has repeatedly cautioned patience over impetuousness, and moderation over exuberance.
The late Charles Kindelberger, the MIT economistwhose seminal 1978 monograph “Manias, Panics and Crashes” remains a classic reference on financial crises, might have been speaking directly to President Obama’s economic team when he wrote that the government’s role as the lender of last resort is “fraught with ambiguity and dilemma. Intervention,” he reminds us, “is an art, not a science.”
The Obama administration’s economic advisers are now practicing that art. Meanwhile, the next generation of economic crisis doctors—the group that will be called upon to navigate future financial crises—are observing their predecessors closely from the vantage points of the School’s economics classrooms and carrels in E52.
The current economic crisis is an all-too-real educational experience for the School’s economics students. Responding to the crisis, both graduate and undergraduate economics students are working closely with distinguished faculty members like Caballero, HolmstrÖm, Lo, and Poterba. Together, they are building new models to better understand the sources of severe economic shocks, and designing policy instruments to contain and help avoid such crises in the future. ∎
Editor/Art Director: Emily Hiestand, Office of the Dean
Writer: Sarah Wright, a journalist and teacher who has written and edited for The Boston Globe, MIT News, Technology Review, Vogue, and other national publications. Sarah is a contributing writer for Soundings Magazine.