We do not yet know whether the global financial and economic crisis of 2008 will go down in history as a momentous or even uniquely catastrophic event. Unwritten history is full of events that contemporaries thought were epochal and are today long forgotten. And on the other side of the scale, there were many in the early stages of the Great Depression who belittled its import.
Although it is too soon to tell how the second half of 2008 will be featured in history books, there should be no doubt that it signifies a critical opportunity for the discipline of economics. It is an opportunity for us—and here I mean the majority of the economics profession, myself included, unfortunately—to be disabused of certain notions that we should not have accepted in the first place. It is also an opportunity for us to step back and consider which are the most important lessons we have learned from our theoretical and empirical investigations— that remain untarnished by recent events—and ask whether they can provide us with guidance in current policy debates.
This short essay first provides my views on what intellectual errors we have made and what lessons these errors offer us moving forward. My main objective, however, is not to dwell on the intellectual currents of the past but to stress that economic theory still has a lot to teach economists and policy makers as we make our way through the crisis. Several economic principles related to the most important aspect of economic performance—the long-run growth potential of nations—are still valid and hold important lessons for our intellectual and practical deliberations on policy. But, curiously, these principles have played little role in recent academic debates and have been entirely absent in policy debates. As academic economists, we should remind policy makers about these principles and the implications of current policies for the growth potential of the global economy.
The crisis is still evolving, and there remains much uncertainty about what happened in the financial markets and inside many corporations. We will know more in the years to come. Already, with what we know today, many of the roots of our current problems are apparent. But most of us did not recognize them before the crisis. Three notions impelled us to ignore these impending problems and their causes.
The first was that the era of aggregate volatility had come to an end. We believed that through astute policy or new technologies, including better methods of communication and inventory control, the business cycles had been conquered. Our belief in a more benign economy made us more optimistic about the stock market and the housing market. If we believe that any contraction must be soft and short-lived, then it becomes easier to believe that financial intermediaries, firms, and consumers should not worry about large drops in asset values.
It’s true that the data showed a robustly negative relationship between per capita income of an economy and its volatility. Also, many measures had shown a marked decline in aggregate volatility since the 1950s and certainly since the prewar era. But these empirical patterns didn’t mean that the business cycles had disappeared or that catastrophic economic events were impossible. The same economic and financial changes that made our economy more diversified and individual firms better insured also increased their interconnections. Since the only way diversification of idiosyncratic risks can happen is by sharing these risks among many companies and individuals, better diversification also creates a multitude of counterparty relationships. Such interconnections make the economic system more robust against small shocks because new financial products successfully diversify a wide range of idiosyncratic risks and reduce business failures. But they also make the economy more vulnerable to certain low-probability events, precisely because the interconnections that are an inevitable result of greater diversification create potential domino effects among financial institutions, companies, and households. In this light, perhaps we should not find it surprising that years of economic calm can be followed by tumultuous times and notable volatility.
There is another sense in which the myth of the end of the business cycle is at odds with fundamental properties of the capitalist system. As Austrian economist Joseph Schumpeter argued long ago, the workings of the market system and the innovative dynamics that constitute its essence involve a heavy dose of creative destruction, in which existing firms, procedures, and products are replaced by new ones. Much creative destruction takes place at the microlevel. But not all of it. Many companies are large, and replacement of their core businesses by new firms and new products will have aggregate implications. Moreover, many general-purpose technologies are shared by diverse companies in different lines of businesses, so their failure and potential replacement by new processes will again have aggregate ramifications. Equally important, businesses and individuals make decisions under imperfect information and potentially learn from each other and from past practices.
The large drops in asset values and the simultaneous insolvencies of many companies should alert us that aggregate volatility is part and parcel of the market system. Understanding that such volatility will be with us should redirect our attention toward models that help us interpret the various sources of volatility and delineate which components are associated with the efficient working of markets and which result from avoidable market failures. A more in-depth study of aggregate volatility also necessitates conceptual and theoretical investigations of how the increasingly interconnected nature of our economic and financial system affects the allocation of resources and the sharing of risks by companies and individuals.
Our second too-quickly-accepted notion was that the capitalist economy lives in an institutionless vacuum, where markets miraculously monitor opportunistic behavior. Forgetting the institutional foundations of markets, we mistakenly equated free markets with unregulated markets. We understood that even unfettered competitive markets are based on a set of laws and institutions that secure property rights, ensure enforcement of contracts, and regulate firm behavior and product and service quality. But we became increasingly removed from the role of institutions and regulations supporting market transactions in our conceptualization of markets. Institutions have received more attention over the past fifteen years or so than before, but the thinking was that we had to study the role of institutions to understand why poor nations were poor, not to probe the nature of the institutions that ensured continued prosperity in the advanced nations and how they should change in the face of evolving economic relations.
In our obliviousness to the importance of market-supporting institutions, we were in sync with policy makers. They were lured by ideological notions derived from Ayn Rand’s novels rather than economic theory. And we let their policies and rhetoric set the agenda for our thinking about the world and—even worse—our policy advice. In hindsight, we should not be surprised that unregulated profit-seeking individuals have taken risks from which they benefit and others lose.
But we now know better. Few among us will argue today that market monitoring is sufficient against opportunistic behavior. Many inside and outside academia may view this as a failure of economic theory. I strongly disagree. On the contrary, the recognition that markets live on foundations laid by institutions—that free markets are not the same as unregulated markets— enriches both theory and practice. We must now start building a theory of market transactions that is more in tune with their institutional and regulatory foundations. We must also turn to the theory of regulation—of both firms and financial institutions—with renewed vigor and hopefully additional insights gained from current experience.
The third notion that has also been destroyed by recent events is less obvious. It is also one that I strongly believed in. Our logic and models suggested that, even if we could not trust individuals, particularly when information was imperfect and regulation lackluster, we could trust the long-lived large firms—the Enrons, the Bear Stearns, the Merrill Lynchs, and the Lehman Brothers of this world—to monitor themselves and their own because they had accumulated sufficient “reputation capital.” Our faith in long-lived large organizations was shaken but still standing after the accounting scandals in Enron and other giants of the early 2000s. It may now have suffered the death blow.
Our trust in the self-monitoring capabilities of organizations ignored two critical difficulties. The first is that, even within firms, monitoring must be done by individuals: the chief executives, the managers, the accountants. And in the same way as we should not have blindly trusted the incentives of stockbrokers willing to take astronomical risks for which they were not the residual claimants, we should not have put our faith in individuals monitoring others simply because they were part of larger organizations. The second difficulty is even more troubling for our way of thinking about the world: reputational monitoring requires that failure should be punished severely. But the scarcity of specific capital and know-how means that such punishments are often not credible. The intellectual argument for the financial bailout during the fall of 2008 has been that the organizations that are clearly responsible for the problems we are dealing with today should nonetheless be saved and propped up because they are the only ones that have the “specific capital’’ to get us out of our current predicament. This is not an invalid argument. Neither is it unique to the current situation. Whenever the incentives are there to compromise integrity, to sacrifice quality, and to take unnecessary risks, most companies will do so. And because the resulting vacuum of specific skills, capital, and knowledge that their punishment will create makes such a course of action too costly for society, all kinds of punishments lose their effectiveness and credibility.
The lessons for our thinking from this chain of reasoning are twofold. First, we need to rethink the role of the reputations of firms in market transactions, taking the general equilibrium—the scarcity value of their skills and expertise when reputations of several of them fail simultaneously—into account. Second, we need to revisit the key questions of the economics of organization so that a firm’s reputation should be derived from the behavior—and interactions—of directors, managers, and employees, rather than from the hypothetical value of the firm.
When we look at the academic tally, we can always blame ourselves for missing important economic insights and not being more farsighted than policy makers. We can even blame ourselves for being complicit in the intellectual atmosphere leading up to the current disaster. But on the bright side, the crisis has increased the vitality of economics and highlighted several relevant and exciting questions. These range from the ability of the market system to deal with risks, interconnections, and the disruptions brought about by the process of creative destruction to issues of a better framework for regulation and the relationship between underlying institutions and the functioning of markets and organizations. It should be much less likely in the decade to come for bright young economists to worry about finding new and relevant questions to work on.