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Archive for the ‘financial crisis’ Category

 

Ben Bernanke gave a speech in New York, transcript here, on the pre-crisis vulnerabilities in the financial sector, on the triggers for the crisis, and on the policy responses – what and why.  Clearly reasoned from economic models and closely related to the canonical (Bernanke the academic) understanding of the first part of the Great Depression.  The Federal Reserve’s actions where Bagehot’s rule in practice and are ultimately defended by saying “ . . .the responses to the failure or near failure of a number of systemically critical firms reflected the best of bad options.”

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Ben Bernanke (an ex-academic from Princeton) took on the financial press and Paul Krugman (an ex-academic from Princeton) who have been arguing that the financial crisis and great recession have exposed major failures in the academic fields of economics and finance.  I (an academic ex-Princeton) have argued that the crisis actually showed how bad the state of financial journalism. The business press is supposed to ferret out hidden off-balance sheet exposures, keep track of whether regulators are doing their jobs, and report on shady mortgage practices.  But this is hard work – it’s called investigative journalism for a reason – and it’s easier to call up people and report what they say rather than checking it or even (gasp) running some numbers.  In any case, Bernanke lays out nicely where and how economics broadly-defined missed the crisis and yet had the knowledge to understand the crisis and mitigate it.  Link here.

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A preliminary report by the FCIC on the role of the credit rating agencies in the financial crisis.  While many of you will be familiar with the story, what is still striking, at least to me, is how little Moody’s (as an example) thought about risk in aggregate.  Here is a Moody’s quote from May 2007 (from the report), a few months after the March rumblings that kicked off the crisis:

“. . . the outlook for other major drivers of mortgage losses – home price appreciation, interest rates, and refinancing opportunities for subprime borrowers facing rate /payment rests – is less favorable. As a result, Moody’s is currently projecting that cumulative losses for loans backing 2006 subprime securitizations will generally range between 6% and 8%, though particularly strong or poor performing pools may fall outside of this range. … Barring cumulative losses well in excess of current expectations, we do not expect a material number of downgrades to bonds rated A or higher.”

What is striking, at least in retrospect, is how far, far outside this range we have fallen.  Was this really such an unusual event that falling outside Moody’s forecast range was unlikely?  Only two months later, in July 2007,  S&P was downgrading AAA tranches and Moodys followed suite shortly thereafter.

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The Financial Crisis Inquiry Commission has just released a preliminary staff report entitled “Shadow Banking and the Financial Crisis.”  The underlying view of the report is that 1) the shadow banking system is like the traditional banking system – leveraging its own equity to fund long-term investments with short-term borrowing, and 2) problem that lead to the Great Recession and bailouts was a lack of a regulator/lender-of-last-resort of the types that covered the traditional banking sector.

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The coldblooded researcher in me loved the financial crisis, deep recession, and changes in government policies.  Variation in the real world allows us to learn about the real world.  But so far, I have seen little research that actually uses these events well. Thinking about how I do research, I think there are three reasons why theory is moving first.  First, the most mundane reason: in many cases, data has not become available to test things well yet. Second, theory at this point is easier because the crisis has brought to light lots of relatively-unstudied topics. Economic theory is often about constructing mathematical versions of the theories exposited by market participants. This exercise allows us to check logical arguments, expose prerequisites, and study optimal policy responses. Finally, while a big event would seem to be very informative, it is also very complicated – everything moved.  For example, one might think this is a great time to look at how a movement in house prices affects household spending. But when house prices moved, so did the stock market, the local labor market, the national and local deficits, and so forth, so that any change in household spending caused by house prices is conflated with spending movements caused by all sorts of other things.

So what have we learned? (more…)

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PBS has done an interesting and entertaining show on “rational” economic models vs. psychological models in the light of the recent crisis.  Link here. The program gets into the pool player analogy, shows experiments like auctioning a dollar (which is a great example of an experiment that people very quickly learn not to be tricked by), and ends with John Cochrane and Bob Shiller (who gets the last word).  What I see from inside finance and academia is a great surge of rational economic models on various features of the crisis.  The study of psychology and economics has been moved to the back burner. We are studying models with moral hazard, adverse selection, informational asymmetries, and lack of knowledge rather than the psychological search to understand the actions of homo economicus and to identify which actions are self-interested and which are mistakes. In some sense, this is a condemnation of the previous models as at least incomplete. In another it reflects the fact that the “rational model” is an approach rather than a testable theory (apart from the unscientific concept of welfare commonly used in economics and at the heart of the psych-econ vs. rationalist debate). A question for those outside of these research debates. . . Do you think the American public is angry because it believes that the bankers, executives, etc. acted in their own, rational self-interest or because it believes they made mistakes that anyone could have made? I would guess the former, with perhaps the exception of the mortgages written “that people could not afford” where the public blames either the borrowers or the lenders.

Nova - Mind over Money

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As financial reform finally gets moving, the debate is heating up. Here is the case of the House Financial Services Committee for how its legistlation addresses the “. . . Problems Raise By Lehman Failure.”

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