Lessons from the current financial crisis

The adjective that economists consistently apply to the current financial crisis is "complex": the financial instruments that underlie the crisis are complex; the mechanism by which defaulting home loans triggered large scale bankruptcies is complex; how a US crisis expanded across the globe is complex. You don't have to worry about what started the current crisis because it's too complex. If anyone asks you, just mumble some choice terms: mortgage-backed security, contagion, systemic failure, liquidity crisis, credit default swap. People around you will nod in agreement and demand action (or inaction)!

Personally, I doubt anyone can wrap their mind around the totality of what is happening. The modern financial system is too sprawling and intricate. Millions of individual actors are making decisions according to some unknown psychological model based on other actors' decisions which are in turn based on imperfect information about poorly understood instruments. It's a system that does not lend itself well to explanation by simple, linear rules. Fortunately, I think there are methods we can use to shed light on the current crisis. Below, I will discuss three small, but straightforward, lessons I think we can learn from the recent market decline. My hope is that this approach will encourage others to examine what they read and hear about the financial crisis in a more critical and manageable way.

First, market depth does not imply that a financial instrument is useful or well-understood. Just because many investors trade a certain instrument does not mean that the market needs that instrument. To paraphrase Dartmouth Professor of Economics Eric Zitzewitz, many recently created financial instruments essentially involve splitting a dollar in half and trying to convince people that each half is worth 55 cents. (For instance, how much value is truly added to the market by slicing up mortgages? Is it enough to counteract the inability to renegotiate terms? Surely there is some value for hedging, but my feeling is that many people were simply trading these new instruments to make a quick dollar.) When institutions trade to make a profit without understanding how the instrument fits into and interacts with the financial system, trouble is on the horizon. The recent uncertainty in the valuation of complex instruments validates this point. No matter how many valuation models financial institutions build, it will simply not be enough to firmly establish the worth of certain instruments. The nature of a market system, especially with less-established instruments, is that a valuation model won't work unless everyone agrees it's the correct model. In good times, there's less concern over model accuracy because everyone is making money. However, in bad times, models fail, uncertainty reigns, and markets collapse. Thus, even as a whole, the market has trouble deciding which instruments are useful or even understood.

Second, we should be more worried about the former half of "too big to fail" than the latter. "Too big to fail" is shorthand for a criticism that government bailouts promote moral hazard: big companies will make more high risk/high reward decisions because they believe the government will bail them out due to their large effect on the overall financial system. This argument is not necessarily conclusive and the problem can be solved. After all, even if the government bails a company out, who would want to be involved in the management of such an enormous, insolvent enterprise? Further, the effects of moral hazard could be mitigated by strict governmental regulations concerning the amount of bailout money available to a company.

Unfortunately, government bailouts send a clear message that it is better to be a large company. They send the signal, "Hey you! Get really big market share! Serve as many people as possible, so huge numbers of individuals rely on you! Tie yourself into a lot of other big companies, so if you fail, everyone fails! Then, when times get tough, we'll save you!" Even if such an incentive is manageable by itself, it aligns with many other incentives companies have to grow. Most companies already want to increase their market share in order to increase revenue and take advantage of economies of scale. These aligning incentives push markets closer to oligopoly. Incentive for companies to tie into each other can cause a snowball effect because every large company becomes dependent on every other large company. Thus, a single failure is more likely to have a catastrophic rippling effect throughout the market. The disadvantages of such a system are too numerous to list here, but many basic features of free markets are damaged by these policies.

Third, the US continues to enjoy its status as the dominant economic power in the world and the economic benefits attached to it. Many commentators have pointed out the irony of the current global crisis: though the US was the root of the problem, when markets fell abroad, investors rushed their money straight into US Treasury bonds. Essentially, the market believes that the safest investment in the world is the US paying back its national debt. As investors put their money into treasuries, the amount of interest the US must pay on its debt decreases. Thus, as the US market declines, the government can get money more cheaply to finance bailout packages. Certainly, most other economies do not have this assistance. However, the ability of the US to sustain its economic preeminence is in question due to the myriad factors affecting its ability to repay its debt: future taxation plans, modifications to Medicare and Social Security, and shifts in worldwide manufacturing centers will all enter into the picture.

The current financial crisis is probably too complex for anyone to write decisively about its causes or total effects, but small pieces may be examined to understand correspondingly small pieces of the current economic system. Conducting similar small studies may prove to be one of the most useful tools for learning about the enormously complex entity that our financial system has become.

Many of the ideas in this article were inspired by a recent economic panel, which included Professors Samwick, Sacerdote, Zitzewitz, and Marion. The author is indebted to their discussion for sparking deeper thought on the topic.