Risks, Recessions, and Rewards

Martin Wolf, Financial Times: I’m here with Gary Becker, a Nobel laureate in economics and one of the most distinguished figures in the “Chicago School” of economics. Here we are in the middle of, or perhaps toward the end of, a huge financial crisis that started with an immense breakdown in the financial sector. Alan Greenspan, former chairman of the Federal Reserve, said he was actually quite shocked that a thing like this would happen. How would you, a representative of the Chicago School intellectually, explain and defend what has happened?

Gary S. Becker: Well, it’s hard to defend what has happened because it was a crisis, and the private sector deserves a considerable part of the blame for what happened. I think that we developed a lot of new financial instruments, many of them ideas that came out of Chicago, and they have a lot of great advantages to them. What we didn’t understand is the systemic or aggregate risk associated with these instruments. So each individual institution knew it was well diversified but didn’t really understand that if everybody else was trying to get out of these instruments at the same time, it wasn’t diversified: there was tremendous risk. That was a basic misunderstanding, and the financial theory still does not understand that problem very well: how to understand the systemic or aggregate risk of some of these newer, more exotic types of instruments that we’ve had.

Wolf: Does that implication necessarily mean that we cannot trust free markets in finance because the individual institutions, however brilliant they are, cannot simply work out the aggregate risk in the system and the system has no means of handling it?

“Factor in your worst scenario or my worst scenario about this crisis, and you still get a damn good performance out of the world economy over this period of time.”

Becker: I think we’re learning as we go along. For example, we are not going to find financial institutions holding onto these mortgage-backed securities in the future; you’re going to avoid them. They realize that the risks involved in securities are much greater than they were. These instruments were developed in the ’70s, ’80s, ’90s . . . who understood them? Greenspan and the government officials didn’t understand them; they all approved of what people were doing. Who was complaining about them? Very few people. You can cite not only Greenspan but people from both political sectors and in very different countries. We’ve learned a lot more. Do we know everything about them? No, but belief in free markets, and I’m a strong believer, doesn’t mean free markets are perfect. What it basically means is that free markets work pretty well most of the time and that governments work much worse then most markets do. Those are combined beliefs; it’s not perfection in markets, it’s a combination. Markets do well, not perfectly, and governments usually mess things up when they get too involved. And I don’t see anything out of this crisis that’s led me to change that opinion.

Wolf: Is the implication that even though you admit that the market has made really big mistakes, there actually is no regulatory solution; the best we can do is tell the public that sometimes terrible things happen and we have to live with them? Isn’t that an incredibly difficult thing to tell the wider public when they look at the collapse in demand and rising unemployment, which many people are blaming on the incompetence of the financial sector?

“These instruments were developed in the ’70s, ’80s, ’90s . . . who understood them? [Alan] Greenspan and the government officials didn’t understand them; they all approved of what people were doing. Who was complaining about them?”

Becker: Recessions occur; we’ve had them for a long time, we will continue to have them. I like to say that what’s happened in growth since 1980 or 1990 when these financial instruments came into place—and they were not the only source but a major source—we had enormous growth over that period. Factor in your worst scenario or my worst scenario about this crisis, and you still get a damn good performance out of the world economy over this period of time. It’s a risk-return trade-off; there’s some risk associated with it. If the government managed everything, maybe you’d get lower risk, but you wouldn’t get any real increase in income over time. That’s what we have to experience and what people have to understand. This was a terrible financial crisis, but it was not a terrible burden on the average person. It was a serious recession, but it was not anywhere near the Great Depression. It was not even in my judgment a depression. Yes, we have to live with that, and if you can tell me about an alternative where we can have this great growth without having an occasional recession, sure, I would buy into that. But nobody has discovered that. I think free markets are the best approach for achieving that.

Wolf: It’s better to say, we just have to live with this recession, a very deep one, every so often?

Becker: No, there are things we can do. I think people confuse two things: whether there are any steps we can take to moderate this, and whether regulators will have better insights into this than the private sector. Regulators will not have better insights into this than the private sector. What we can hope for is to instill regulations that operate fairly automatically, like higher capital requirements, so if you have the “too big to fail” problem, make the big institutions have really high capital requirements and other restrictions that kick in automatically. It doesn’t depend on the regulators having a better judgment about what situation we’re in than the market participants because they won’t have that better judgment. That’s what I hope we can achieve. Will we achieve it? Will we overregulate? A few months ago I was very much frightened by it. Now that what I call the recession is over—maybe the crisis in some sense isn’t over but the recession is over—I think we’re seeing less pressure for drastic changes in the regulations. And I think that’s a good change.