Milton Friedman was one of the twentieth century's most distinguished economists, and one of the century's three economists (the other two being John Maynard Keynes and Friedrich Hayek) who had the greatest political influence--and he was the only American in the group. Friedman spent most of his career at the University of Chicago, so it is natural that the University should name a major new component of the University, devoted to economic research, after him. The Institute is essentially a joint venture of the University's economics department, graduate school of business, and law school. The use of his name will help the University raise the funds required for the new Institute.
The decision, announced five months ago, has generated controversy on the University campus, sharpened by the current economic crisis that is thought in some circles to have damaged Friedman's legacy (it has certainly damaged Alan Greenspan's legacy). Some 170 faculty members have signed a petition circulated by a Committee for Open Research on Economy and Society--which opposes the decision naming the new institute after Friedman--asking that a meeting of the University Senate (which consists of some University administrators and all faculty members who have been on the faculty for more than a year) be convened to discuss the decision. The stated ground of opposition is that naming the Institute after Friedman would constitute the University's endorsement of his political views and would bias the research conducted by the Institute in favor of the free-market ideology that Friedman promoted so strongly. But the opposition is also and probably primarily powered by distaste for Friedman's political and policy views and for his willingness to provide economic advice to the Chilean dictator Augusto Pinochet. Friedman's association with policies that are either liberal or politically neutral, such as the volunteer army, the earned income tax credit (the negative income tax), the legalization of the laws against marijuana and other mind-altering drugs, and even affirmative action, is overlooked.
I don't think anyone would quarrel with the idea of an institute devoted to the support of academic research on economic issues, even though many of the issues that economists examine have political implications. The name is the focus of the controversy. Friedman was an advocate of politically controversial policies with which a number of University faculty do not want the University to be associated. When buildings, classrooms, institutes, schools, etc. in universities are named after someone, it is usually a donor. Especially when an institute, which is likely to be a special-purpose organization, is named after a public figure, it is natural to associate the mission of the organization with the name of that figure: the Hoover Institution of Stanford University was named after Herbert Hoover and is indeed conservative, though it is noteworthy that the Institution's conservative reputation has not extended to Stanford University as a whole, and no more would one expect the University of Chicago to be branded as conservative merely because it contains an institute named after a conservative economist. The University of Chicago is not a conservative institution, though it is not as monolithically liberal as its peer institutions.
The purpose of naming the new institute after Friedman was presumably to encourage fund-raising; one economics professor at the University has been quoted as saying that Friedman's name would "resonate with the donors." So a further worry is that most of the donors will be conservatives who support Friedman's political views (that is to say, his conservative political views, as many of his views were not conservative), and that the new Institute will perhaps unconsciously bias hiring and promotion in favor of economists who support those views. The Institute might (again, whether consciously or unconsciously), it is feared, conceive its mission as being to promote the ideas of the "Chicago School of Economics," of which Friedman was perhaps the leading (though not the founding), and certainly the most influential, member.
But that is unlikely. Economics is a highly competitive academic field, and piety toward distinguished predecessors is not the path to academic success. It is odd that the opponents of the Friedman naming should think that economists, of all people, would subordinate career motives to loyalty to Friedman's memory or the "Chicago School" (especially young economists for whom Friedman is just a name). If the religion professor who is leading the movement against the naming is right that "Friedman's over"--that the current economic crisis has consigned Friedman, along with Greenspan, to the dustbin of economic history--he should have no fear that the new Institute will be biased in favor of Friedman's views. If a physics institute were named after Albert Einstein, would the institute's researchers reject quantum theory?
It might seem that the controversy could be easily resolved by simply changing the name of the Institute. But that would be costly to the University in several respects. First, it would doubtless offend many donors, and probably leave the Institute in worse financial shape than had it not been named after Friedman in the first place. Second, it would weaken the University administration and encourage the encroachment by faculty on administration prerogatives. There is a whiff of the 1960s in the effort by faculty (joined by a number of students) to move the University of Chicago leftward. Even if the original naming of the Institute after Friedman was a mistake, there is now too much at stake for the University administration to back down.
Not long after the death of Milton Friedman in the fall of 2006, the president of the University of Chicago, Robert Zimmer, formed a committee drawn from the Economics Department, the Graduate School of Business, and the Law School. He asked the committee, which has Lars Hansen as chair and I am a member, to prepare a proposal for a large institute that would be named the Milton Friedman Institute (MFI) in honor of Friedman's long association with the University of Chicago. The president and committee considered this far preferable to naming the institute after a rich donor, which is the common practice.The committee presented a report early in 2008 to the Council composed of some faculty members at the University of Chicago. Apparently, not much opposition to the Institute was voiced at that Council meeting.
However, in late spring of this year a letter was sent to various members of the faculty and administration opposing the MFI. It was signed by about 100 faculty members and was made available to the press. This first letter was a confused combination of hostility to the economics department, hostility to market economics, objections to a few statements in the document supporting such an institute, and personal opposition to Milton Friedman, partly because of his alleged involvement in the Pinochet dictatorial Chilean government. Over time the reasons for the opposition were more carefully articulated, and the number of faculty signing the opposition to the MFI grew to over 150. Each succeeding letter became available to the media, and many articles began to appear in magazines and newspapers.
The latest statement of opposition mainly concentrates on whether it is appropriate to name such an Institute after Milton Friedman. I will address that issue in my discussion here. These comments are mainly taken from a statement I read on October 15, 2008 to a meeting of the whole faculty called by President Zimmer to discuss several issues, but especially the MFI. I elaborate in some places because our statements were limited to three minutes.
A university names an Institute after a former professor because of 1) his contributions to the university, 2) his contributions to scholarship or science, and 3) his intellectual honesty and character. On all three grounds I believe Milton Friedman eminently deserves having this Institute bear his name.
Let me first mention I knew him for over 50 years, first as a teacher, then as colleague and close friend. I admired him enormously at all these different stages.
His main direct contribution to the University of Chicago was as an absolutely superb teacher, by far the best teacher I ever had. He opened my eyes and that of other students, including Eugene Fama, James Heckman, Robert Lucas, and Lester Telser, and George Tolley, all faculty members at the University of Chicago, to how to use economic analysis to understand the real economic world. Both in the classroom, and as a supervisor of doctoral dissertations, he was a blunt and trenchant critic of shoddy analysis, both theoretical and empirical. I along with others took a lashing from him when he thought we did some analysis badly. The effectiveness of his teaching alone could merit having an Institute in his name at our university.
Many honors have recognized his enormous contributions to economic science. Equally important is that these have endured. A simple measure of that endurance is the large number of citations to his scientific work that still appear in the top economic journals. Only one or two other economists of his generation share this distinctive measure of longer run impact of their scientific work.
He was perhaps the most intellectually honest person I have ever known. To be sure, he was an active participant in public policy debates, as are many economists with very different points of view. But in his policy papers and discussions he used the same economics as he did in his academic work. He did not try to say things to curry political favor, and never held a position in Washington, except when he had a low level job at the Treasury department as a young economist. He attacked and defended persons of various political persuasions, including some of his best friends, if he believed their opinions or writings had flaws. He publicly criticized Arthur Burns, his teacher and close friend, when Arthur was chairman of the Fed, for supporting policies that Friedman considered bad economics. That public statement put enormous strains on their friendship. He is called a conservative, but he opposed many conservative positions, such as support for the gold standard, the military draft, and the war on drugs, and advocated many others that were picked up by liberals, such as the negative income tax, and attacks on corporate welfare through government subsidies to corporations.
One of the most persistent accusations is that he advised and collaborated with the Pinochet regime. In Two Lucky People, Rose and Milton Friedman's autobiography, he discusses his dealings with that government. He also includes the relevant documents so that readers can judge a lot for themselves. He turned down two honorary degrees from Chilean universities because they were state universities under Pinochet. He made one six-day trip to Chile in 1975 at the invitation of a private bank. He gave two lectures on the "fragility of freedom". He did have a brief meeting with Pinochet and wrote a letter to Pinochet afterwards urging "shock treatment" of reduced government spending and reduced growth in the money supply in order to cure the rampant inflation then afflicting Chile. His letter contains many detailed suggestions, including a call for "generous severance allowances" for laid off government workers, and a safety net to alleviate hardship and distress among the poor.
Friedman has also been criticized for helping to train some economists who served in the Pinochet government, even though teachers cannot control what their students do. Pinochet turned to the "Chicago boys"-economists trained at the University of Chicago- only several years after the centralized control of the economy that he favored had failed completely to lift Chile out of its doldrums. What is interesting in this regard is that the Social Democratic governments that followed the fall of the Pinochet government and the reintroduction of democracy have continued the vast majority of policies introduced by these Chicago-trained economists. These policies include low tariffs and a mainly free trade policy, privatized social security, and competitive private companies and universities.
As is well known, Friedman was a strong supporter of competitive market economies, but this was not defended by ideology. He used economic analysis to argue that this was the most effective way to raise the living standards of the world's poor. I strongly agree with him, and so do the great majority of economists in different parts of the world. To be sure, one can argue against this and other policy positions he took, but that is how intellectual progress is made on crucially important economic questions.
To summarize, great teacher for 30 years at the University of Chicago, outstanding researcher, and absolute intellectual honest in everything he did. To my mind these are far more than enough for faculty, students, and alumni associated with the University of Chicago, and for others as well, to be proud to have a Milton Friedman Institute at the University of Chicago.
Will this financial crisis mark a substantial retreat from the world's movement during the past several decades toward a competitive market system? Many journalists and others have been suggesting that this crisis will lead to much more active government involvement in the economy, and even induce a return toward government ownership of many companies in the non-financial as well as the financial sector. In my opinion, what will happen to the worldwide support for competition and privatizations, freer trade, and market-based economies depend greatly on how the American and other major economies fare during the next year or longer.
The US and much of the rest of the world appear to be headed for, if not already in, a recession with falling GDP and rising unemployment. It is possible that this recession will be steep and somewhat prolonged. The extreme example of a major depression is the Great Depression of the 1930s, where real GDP declined sharply for a few years during the early 1930s, and where unemployment grew from 3 percent in 1929 to 25 percent in 1933. Unemployment was still at the remarkably high rate of 17 percent in 1939 prior to the outbreak of World War II. By contrast, American recessions since 1959 have been so mild that in no year did real GDP fall by much more than 1 percent, and yearly average unemployment rates peaked at about 10 percent. This unemployment rate was approached in both 1982 and 1983 as the Fed squeezed inflationary expectations out of the system with interest rates that sometimes exceeded 20 percent. Still, real GDP only fell a little between 1981 and 1982, and then rebounded in 1983, even though unemployment was still high in that year.
As I have said in several recent blog discussions, and in my Wall Street Journal article of October 7th, I do not expect the current crisis to develop into a major depression. I do expect that most governments will place any worldwide recession that develops, even a severe one, in the context of the sizable world economic developments during the past 40 years not mainly in the US, but in Europe, Japan, China, and most other countries. Even a couple of years of declines in GDP and relatively high unemployment will not overshadow the remarkable economic achievements during these decades. These include unprecedented growth in GDP in formerly poor to very poor countries, such as Japan, South Korea, China, India, Malaysia, Chile, Spain, Portugal, and others. Growth in mainly market-oriented developing economies swept away dire poverty from hundreds of millions of families in Asia, Europe, and South America. This sustained growth also led hundreds of millions of others into middle class status, where they could afford to buy cars, well-equipped homes, television sets, cell phones, computers, and other goods that not long ago were considered well beyond the means of the typical family in all but a few countries.
Yet, even with a recession of the type I expect, there will be increased regulation of financial institutions. These could include requirements of minimum levels of capital to assets for investment banks and hedge funds, government insurance of money market funds, and greater oversight of all types of financial institutions-in prior postsI have supported versions of these changes. Although there may be other regulations and controls, I would not expect the US federal government to hold on for long to its preferred stock interest in various investment banks. I have not supported such government equity interests, and it would be a grave mistake if the govern continued to maintain such ownership. Indeed, the government's influence over Fannie Mae and Freddie Mac contributed in a significant way to the housing bust by encouraging these institutions to make many worthless sub prime loans, although clearly other important forces were also at work in the housing bust.
On the other hand, if I am wrong, and there is a prolonged and deep worldwide depression, not simply a recession, the retreat from capitalism and globalization could be severe, as happened during the Great Depression. Many countries would increase their tariffs and other trade barriers to reduce the competition to domestic production from imports. Nationalization rather than privatization will be in favor as governments take over ownership of many weak companies. Regulation of executive salaries and other wage and price controls will become much more common. Competition will be stifled as governments encourage companies to coordinate their pricing and other policies, and change laws to make it much easier for unions to organize workers. These are not attractive prospects.
Few people have sympathy for the hedge fund managers and others who made hundreds of millions, and sometimes billions, of dollars during the boom years, Still, middle class and poor families would be hurt the most by unwise government policies and attacks on the foundations of a competitive economy. Policies that frighten entrepreneurs and discourage them from accumulating private capital and investing in innovations will hurt most of us, but especially workers in various companies.
I agree with Becker that the effect of the financial crisis on capitalism will depend on the severity of the crisis. Very few people are committed in an emotional sense to a free-market ideology; if the free market seems not to be working, the population and its political representatives will cast about for an alternative. In this longish comment, I respond briefly to some of the readers‚Äô comments on my last week‚Äôs post, bring up to date my discussion of the financial crisis, and in closing return to the question whether capitalism has "failed."
1. Several comments note that there were a number of other prophets of doom besides Nouriel Roubini. Here is one: "When the downturn in house prices occurs, many homeowners will have mortgages that exceed the value of their homes, a situation that is virtually certain to send default rates soaring. This will put lenders that hold large amounts of mortgage debt at risk, and possibly jeopardize the solvency of Fannie Mae and Freddie Mac, since they guarantee much of this debt. If these mortgage giants faced collapse, a government bailout (similar to the S&L bailout), involving hundreds of billions of dollars, would be virtually inevitable." Dean Baker, "The Menace of an Unchecked Housing Bubble," The Economists' Voice, vol. 3, issue 4, article 1. Given the multitude of warnings from respectable sources, it is puzzle why the warnings did not stimulate a serious effort to evaluate the health of the financial services industry and the adequacy of regulation.
Part of the answer may lie in a perceptive comment by reader Jamison Davies. He reminds us that "Important to [Roberta] Wohlstetter's argument [about why the Japanese attack on Pearl Harbor achieved surprise] is the concept of the 'signal-to-noise' ratio, i.e. the amount of useful information being taken in compared to the information that is false, misleading, or irrelevant. It turns out that earlier concerns about inflationary spikes may have just turned out to be background 'noise'‚Ä¶as well as other economic issues, but ex ante it is extremely difficult to tell what data will be predictively useful and what is just noise." Davies adds that "the difficulty in early warning, among other things, is that if you give correct warning and act in response to that warning, the attack will likely not materialize (i.e. if the US knew Japan was about to attack Pearl Harbor our defensive preparations would prevent Japan from following through). This means that successful warnings are undercounted because the catastrophe never emerges. This tends to weaken early warning systems as they are perceived to be ineffective even though they may have averted serious problems." Davies points out that "the economic analogy is regulation. Regulations were seen as unnecessary and dismantled because there had been no crises, but policymakers failed to consider that there may have been no crises precisely because of the regulation."
Another comment quotes economist Thomas Sowell as saying: "Failure is an important part of the success of the capitalistic system.‚Äù"The commenter adds that in "the free market system, companies that are seriously mismanaged in one way or another will fail, and these failures make room for the ones that are well managed." All true, but in the current crisis many seriously mismanaged firms will be saved by the government, and many firms that are not mismanaged will fail because of the effect of the mismanagement of other firms on consumer demand and the credit market.
2. In earlier posts Becker and I have discussed whether the financial crisis is a liquidity crisis, a solvency crisis, or both. At this writing it seems that it is more a solvency crisis than a liquidity crisis. The initial bailout plan--to buy the sick assets of banks, such as their mortgage-backed securities--was premised on the assumption that the crisis was one of inadequate liquidity: uncertainty or perhaps even unreasoning fear was preventing the sale of bank assets at prices that reflected their "true" value. If this was incorrect--if the problem was not that the banks' sick assets were frozen but that the banks were undercapitalized--the plan would be unsound: either the government would pay the actual, low value of the assets, in which event the banks would have no more capital than before, or it would overpay and thus be giving the banks a gift at taxpayers‚Äô expense. The plan was quickly altered (the U.S. embarrassedly taking its cues from the prime minister of England) from a purchase of assets to a contribution of capital in which the government would receive interest-bearing preferred stock in exchange.
A disturbing note is Secretary of the Treasury Paulson's plea to the banks who have received the capital contribution to lend it out rather than hoard it. What is disturbing is that since banks are in the business of lending and do not receive a return on money that they hoard, they don't need prodding to make loans unless the risks are too great. The risks remain too great unless the capital infusion ($250 billion split among nine banks) is large enough to make the banks adequately capitalized. With the recession/depression spreading and deepening, the risks of lending are growing and so the banks need a bigger capital cushion than when the economy was booming. It will not be prudent for them to lend unless either they have that cushion or the government guarantees the repayment of the loans they make.
3. The severity of the recession/depression precipitated by the financial crisis cannot yet be gauged accurately. One reader amusingly cites the prediction of "Scholars of Astrology" that the economy will recover in seven months. If so, the crisis will not provoke a serious rethinking of the nation's commitment to a market economy. But if the recovery takes substantially longer--if, as seems possible, we are in the midst of the most serious depression since the Great Contraction of 1929 to 1933 (and why has the word "depression" become unmentionable? Why does everyone except me prefer the anodyne euphemism "recession?)--then that commitment will come under fire. Should it?
There are three basic types of economy (with many intermediate possibilities, of course): a pure free-market economy; a regulated market economy; and socialism. In the first, all economic ordering is left to private action: money is private, contracts are enforced not by legal means but by concern with reputation and threats of retaliation, caveat emptor prevails, and the role of government is limited to providing internal and external security against violence. In such a world there are, for example, no restaurant inspectors, and if you get ill eating in a restaurant you have no legal recourse; but restaurants might form voluntary associations that would conduct inspections, and careful consumers would patronize only the members of reputable such associations.
Very few economists support so lean a system of government. Virtually all support a regulated market system in which, for example, victims of food poisoning have tort remedies but systems of restaurant inspection are also instituted, to back up those remedies in recognition that most incidents of food poisoning are not serious enough to warrant the expense of bringing a lawsuit and that many restaurants operate on a shoestring budget and could not pay a substantial tort judgment. An alternative to inspectors might be requiring anyone entering the restaurant business to post a substantial bond and allowing the successful plaintiff in a tort suit against a restaurant to recover his attorneys‚Äô fees. But these are simply alternative methods of regulation rather than a recursion to a pure free-market economy.
Given the history of economic failure under socialism, we should exhaust the possibilities for adopting more effective regulations of the financial-services industry before jettisoning our regulated market system in favor of a socialist one. That is so obvious as not to require argument. What is less obvious is why so many people think that the financial crisis is proof that a market economy does not work and thus we need fundamental change rather than merely incremental regulatory reform.
The answer lies in what conservative economists used to call the "Nirvana fallacy." This is the idea that any failure of the economy to attain optimality is a "market failure" that warrants government intervention. Conservative economists pointed out that the proper comparison is never between the operations of the actual market and an unattainable theoretical perfection, but between market-directed and government-directed or -regulated allocations of resources in particular economic settings. Market failures are ubiquitous, as the current crisis demonstrates. The crisis is not primarily a result of government actions. The quasi-governmental status of Fannie Mae and Freddie Mac and the pressures exerted on them by Congress to facilitate home ownership by insuring risky mortgages were contributing factors to the crisis, but the basic causes were misassessment by the industry of the risks associated with extremely high levels of borrowing, misunderstanding of risk by home buyers encouraged by real estate brokers, mortgage brokers, and banks, conflicts of interest by rating agencies, corporate compensation policies that truncated downside but not upside risk, and the private costs of disinvesting in an industry undergoing a bubble (the housing industry) before the bubble bursts, since until that moment the profits from riding with the bubble will be increasing. An additional factor was government inaction, but the failure of government to intervene in a market that is failing obviously presupposes rather than illustrates market failure. In contrast, gratuitous government intervention when there is no market failure is a genuine example of government failure.
So a confluence of market failures has created an economic crisis, and the challenge is to develop regulatory responses that reduce the cost (net of the direct and indirect costs of the regulations themselves) of such failures. Complacency on the part of some economists and politicians about the efficiency of the market system, and specifically an exaggerated belief in the robustness of financial markets, have created the impression that the current crisis is a crisis of capitalism rather than just another demonstration of the radical imperfection of human institutions--including the market.
When Becker and I blogged on the financial crisis last Sunday, the bailout had just been announced. The reaction of the stock markets and of senior government officials here and abroad suggests that the premise of the bailout--that the financial crisis is a liquidity crisis that can be resolved by the government's buying the assets of troubled banks at prices equal to the value the assets would have if there were a market for them (that is, if there were adequate liquidity to enable transactions)--was mistaken. The crisis appears to be one of solvency rather than (or perhaps along with) one of liquidity; banks, along with insurers of bonds and other securities, are undercapitalized and so, as I suggested last week, require a capital infusion rather than just a purchase of frozen assets.
All of which merely underscores the enormous cloud of uncertainty that has enveloped the crisis and left economists struggling to understand the causes, magnitude, future course, and cures of what is shaping up as the biggest economic bust since the Great Depression of 1929 to 1933. Last week's stock market crash may also reflect doubts about the government's competence to deal effectively with the crisis. There is a sense that its reluctance to take an equity stake in the banks reflects a doctrinaire hostility to public ownership.
But here is the biggest mystery of all: why was the crisis not foreseen? An article on the front page of the business section of yesterday's New York Times attributes that blindness to "insanity," more precisely to a psychological inability to give proper weight to past events, so that if there is prosperity currently it is assumed that it will last forever. This explanation is implausible--often people fail to adjust to change because they expect the future to repeat the past--and unhelpful, especially when one remembers that the academic specialty of Federal Reserve Board chairman Bernanke is the Great Depression.
We can get more help in answering the question of unpreparedness, or neglect of warning signs, from the literature on surprise attacks, notably Roberta Wohlstetter's great book Pearl Harbor: Warning and Decision (1962). As she explains, there were many warnings in 1941 that Japan was going to attack Western possessions in Southeast Asia, such as the Dutch East Indies (now Indonesia); and an attack on the U.S. fleet in Hawaii, known to be within range of Japan‚Äôs large carrier fleet, would be a logical measure for protecting the eastern flank of a Japanese attack on the Dutch East Indies, Burma, or Malaya. Among the factors that caused the warnings to be disregarded are factors that may also have been decisive in the neglect of the advance warnings of the financial crisis now upon us: priors (preconceptions), the cost and difficulty of taking effective defensive measures against an uncertain danger, and the absence of a mechanism for aggregating and analyzing warning information from many sources. Most informed observers in 1941 thought that Japan would not attack the United States because it was too weak to have a reasonable chance of prevailing; they did not understand Japanese culture, which placed a higher value on honor than on national survival. Securing all possible targets of Japanese aggression against attack would have been immensely costly and a big diversion from our preparations for war against Germany, deemed inevitable. And there was no Central Intelligence Agency or other institution for aggregating and analyzing attack warnings.
Much the same is true of the warning signs of the current financial crisis. Reputable business leaders and economists had been warning for years that our financial institutions were excessively leveraged. In mid-August of this year the New York Times Magazine published an article foolishly entitled "Dr. Doom" about a perfectly reputable academic economist, a professor at New York University named Nouriel Roubini, who for years had been predicting with uncanny accuracy what has happened. In September of 2006--two years ago--he had "announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. These developments, he went on, could cripple or destroy hedge funds, investment banks and other major financial institutions like Fannie Mae and Freddie Mac." By August of this year, when the Times article was published, Roubini's predictions had come true, yet he continued to be ignored. Until mid-September, the magnitude of the crisis was greatly underestimated by government, the business community, and the economics profession, including specialists in financial economics. Bernanke had repeatedly stated that it was unlikely that the mortgage defaults that accelerated after the housing bubble burst in mid-2006 would spill over to the financial system or the broader, nonfinancial economy. In May of 2007, for example, he said: "Importantly, we see no serious broader spillover to banks or thrift institutions from the problems in the subprime market." It has been more than two years since the housing bubble burst. One might have thought that that was enough time to enable the experts to discover that our financial system was in serious trouble.
Why were the warnings ignored rather than investigated? First, preconceptions played a role. Many economists and political leaders are heavily invested in a free market ideology which teaches that markets are robust and self-regulating. The experience with deregulation, privatization, and the many economic success stories that followed the collapse of communism supported belief in the free market. The belief was reinforced, in the case of the financial system, by advances in financial economics, and relatedly by the development of new financial instruments that were believed to have increased the resilience of the financial system to shocks. Borrowing and then lending the borrowed funds is inherently risky, because you have fixed liabilities but (unless you invest in risk-free assets such as short-term Treasury Bills) risky assets. But it was believed that the risks of borrowing had been reduced and therefore that leverage (the ratio of borrowing to capital) could be increased without increasing risk. Bayesian decision theory teaches that when evidence bearing on a decision is weak, prior beliefs will influence the decision maker's ultimate decision.
Second, doing something to reduce the risks warned against would have been costly. Had banks been required to increase their reserves, this would have reduced the amount they could lend, and interest rates would have risen, which would have accelerated the bursting of the housing bubble--and then Congress or the Administration would have been blamed for the fall in home values and the increase in defaults and foreclosures. In addition, it is very difficult to receive praise, and indeed to avoid criticism, for preventing a bad thing from happening unless the probability of the bad thing is known. For if something unlikely to happen doesn't happen (as by definition will usually be the outcome), no one is impressed; but people are impressed by the costs of preventing that thing that probably wouldn't have happened anyway. This is why Cassandras--prophets of doom--are so disliked. It usually is infeasible as a practical matter to respond to their warnings--but if the prophesied disaster hits, those who could have taken but did not take preventive action in response to the warnings are blamed for the disaster even if their forbearance was the right decision on the basis of what they knew.
The deeper problem is that it is difficult and indeed often impossible to do responsible cost-benefit analysis of measures to prevent a contingency from materializing if the probability of that happening is unknown. The cost of a disaster has to be discounted (multiplied) by the probability that it will occur in order to decide how much money should be devoted to reducing that probability. No one knew the probability of a financial crisis such as we are experiencing. Even Roubini did not (as far as I know) attempt to quantify that probability.
Which brings me to the last and most important reason for the neglect of the warning signs, because it suggests the possibility of responding in timely fashion to future risks of financial disaster. That is the absence of a machinery (other than the market itself) for aggregating and analyzing information bearing on large-scale economic risk. Little bits of knowledge about the shakiness of the U.S. and global financial systems were widely dispersed among the staffs of banks and other financial institutions and of regulatory bodies, and among academic economists, financial consultants, accountants, actuaries, rating agencies, and business journalists. But there was no financial counterpart to the CIA to aggregate and analyze the information--to assemble a meaningful mosaic from the scattered pieces. Much of the relevant information was proprietary, and even regulatory agencies lacked access to it. Companies do not like to broadcast bad news, and speculators planning to sell a company's stock short do not announce their intentions, as that would drive the stock price down, prematurely from their standpoint.
In any event, no effort to determine the probability of financial disaster was made and no contingency plans for dealing with such an event were drawn up. The failure to foresee and prevent the 9/11 terrorist attacks led to efforts to improve national-security intelligence; the failure to foresee and prevent the current financial crisis should lead to efforts to improve financial intelligence.
Of all the puzzles about the failure to foresee the financial crisis, the biggest is the failure of foresight of professors of finance and of macroeconomics, with a few exceptions such as Roubini. Some of the media commentary has attributed this to economics professors' being overly reliant on abstract mathematical models of the economy. In fact professors of finance, who are found mainly in business schools rather than in economics departments, tend to be deeply involved in the real world of financial markets. They are not armchair theoreticians. They are involved in the financial markets as consultants, investors, and sometimes money managers. Their students typically have worked in business for several years before starting business school, and they therefore bring with them to the business school up-to-date knowledge of business practices. So why weren‚Äôt there more Roubinis? I do not know. And why, if not more Roubinis, not more financial economists who took the warning signs sufficiently seriously to investigate the soundness of the financial system? I do not know that either.
I will first make a couple of comments on the present situation. It is not yet obvious that the recent steps taken by the Fed and the Treasury have been "failures". One cannot make that determination when the $700 billion plan has not yet been tried, and the Treasury seems to be changing its mind about the approach to use. I agree with the argument in the recent article in the Wall Street Journal by Paul Volker, the distinguished former head of the Fed, that the Fed and Treasury have enough tools to end the financial panic, and to get investment by banks started again.
To be sure, a recession is looming, but is this the biggest economic bust since the Great Depression? It is the biggest financial crisis since the 1930s, but the economic bust of the Great Depression meant a 25 percent unemployment rate for much of a decade, and sharp and sustained falls in GDP. While I expect unemployment to increase significantly from its present 6.1 percent level, and GDP to fall for a while, maybe sharply, there is little chance the downturn will approach anywhere near the 1930s levels. Perhaps it will be the most severe recession since then, although even that remains to be seen.
Consider what happened in Japan during the 1990s when it had a widely discussed major financial crisis that lasted for a decade. Unlike the Great Depression, Japan's real GDP did not fall much but was mainly stagnant: the real value of its GDP was 430 billion yen in 1990, 462 billion yen in 1995, and 482 billion yen in 2000. Nothing in this stagnating Japanese experience approached the economic devastation of the 1930s. I believe we have learned how to avoid such a huge economic disaster, although a decade of world stagnation would be quite bad.
To come to this week's blog topic, I also have a somewhat different take than Posner on why warning signals were ignored. The period since the early 1980s until the crisis erupted involved both rapid economic growth for most of the world, and unprecedented stability in this growth. Inflation rates were low and fluctuations in real output, as measured by the size and duration of recessions, were modest compared to the past. Economists and central bankers like Greenspan believed that we had learned how to keep inflation low, and also had the capacity to smooth out fluctuations in output and employment. The main Central Bank technique was inflation targeting, and a more general set of rules, called Taylor rules, that targeted a combination of the inflation rate and deviations of real output growth from its long term trend rate. These policies did work well for about 25 years, which created considerable confidence that they could handle future economic difficulties as well.
The second relevant development has been advances in financial instruments, such as derivatives, securitization, credit-backed swaps, and other even more esoteric instruments. These instruments seemed to work quite well in managing, spreading and even reducing the risk of the assets held by banks and other institutions. However, in the process they encouraged greater risk-taking ventures, as reflected by the large increase in the leverage-that is, in the ratio of assets to capital- of banks and financial institutions like Fannie Mae and Freddie Mac. What has been insufficiently understood is that the growing use of these instruments, and the growing leverage of financial institutions, created considerable aggregate risk for the system as a whole that could not be diversified away.
This combination of growing central bank confidence in its ability to iron out various wrinkles in economic performance, and the belief that the new financial instruments would help manage and reduce risk, blinded the vast majority of economists (I include myself), bankers, and government regulators to the vulnerability of the whole system. This vulnerability was especially important for aggregate shocks akin to a classical run on banks. When institutions are highly leveraged, they have great difficulty coping with a massive loss of confidence in the system.
While Roubini and others who warned about weaknesses in the mortgage market and other parts of the financial system deserve credit for their foresight, experts predicted numerous disasters during the past several decades that never happened. For example, after the huge one-day stock market collapse in October 1987, Business Week and other magazines and newspapers warned that a Great Depression might soon be coming. I argued against that view in a column I published in Business Week the same week as the market crash (reprinted in The Economics of Life by Guity N. Becker and myself). These dire forecasts turned out to be completely wrong. Similar highly negative but wrong economic forecasts were made during the internet bubble, after the Asian financial crisis of 1997-98 (on this see my post of September 21st), the aftermath of the 9/11 attack, and after other periods of economic distress. In an atmosphere where the world economy showed great capacity to withstand difficult shocks, it is not at all surprising that some forecasts of disaster that turned out to be more correct were ignored.
In addition, one should not minimize the great economic achievements of the past 25 years in the form of rapid growth in world GDP, low world inflation, and low unemployment in most countries. Perhaps these achievements will be overshadowed by a deep world recession, but that remains to be seen. If the impact of this financial crisis on the real economy is not both very severe and very prolonged, and time will answer that question, the combination of the past 21/2 decades of remarkable achievement, and the economic turbulence that followed, may still look good when placed in full historical perspective.
The Federal government of the United States has seldom taken an equity interest in private companies, although this has been proposed sometimes, especially as a way to get higher returns on social security assets. However, the new financial bailout bill provides not only for the government to buy assets from banks, but that it also take an equity stake in the banks being helped. The purpose is to protect the government from paying too much for the many difficult to value assets that are acquired. The thinking is that if they overpay for some assets, they can make that back through a rise in the value of the stock or other equity interest that they would have.
However, the main purpose of the buyout is to increase the liquidity of the banking system and thereby reduce the banking system‚Äôs retreat from riskier investments. Yet the government's actions regarding an equity interest seem to be based on a fear that it will be outsmarted in the prices it pays for assets that are very difficult to value because they have no market. Whether the government will lose after the fact is not clear since it can afford to hold the assets to maturity. Moreover, taking an equity interest is also unnecessary in order to protect taxpayers from overpaying. Modern auction theory offers various ways to induce sellers (or buyers) of assets and other objects to "tell the truth"; that is, to bid their best estimate of an asset's worth. In using auction to buy bank assets it would be helpful if the government did not automatically take all assets offered by banks, so that banks have to compete against each other. Competition can also be increased by spreading the auctions out over time (I am indebted to my colleague Phil Reny for useful comments on optimal auction design). To be sure, the seller's estimates of the worth of their assets may turn out to be wrong, so the government would bear some risk. However, with an optimal auction mechanism design, the government need not fear grossly overpaying ex ante for the assets they acquire.
Even if the government were to lose money on this buyout, it is a bad precedent for it to take an equity interest in private companies. Inevitably, this leads to government involvement in business decisions and corporate governance. Experience shows that political rather than economic criteria tend to dominate in the pressures exerted by government shareholders on corporate decisions. This is already reflected in the bailout bill since it limits compensation for executives, including "golden parachutes" for executives of the companies helped. One can hardly have a high opinion of the executives who led such venerable institutions as Merrill Lynch and Lehman Brothers, and many other banks, into investment portfolios with such poor capacity to withstand a financial disturbance. Still, many of these executives have lost most of their very considerable fortunes since they usually owned or had options on many shares of their companies, and these shares have plummeted in price. It is appropriate that top executives suffer major losses when their companies collapse.
There is no good reason, however, for the government to interfere and impose limits on salaries and severance pay. Controls over wages and salaries have never worked well, and only encourage myriad ways to get around them, including generous housing allowances, vacation homes, easy access to private planes, large pensions, and other fringe benefits. There develops a war between the government's closing of loopholes, and the ingenuity of accountants and lawyers in finding new ones.
Governmental ownership of shares, with or without voting rights, opens up possibilities for much greater mischief than controlling executive salaries. For example, a bank or other company may want to reduce its employment in order to regain greater profitability. The government owners of these shares will be under pressure from congressman and senators who represent districts where employment would be affected to try to rescind or modify these cuts. Even without government ownership, congressmen protest corporate efforts to shift various activities overseas because labor and other resources are cheaper there. Such objections will be magnified when governments have direct equity stakes.
There are many illustrations of the bad influence on corporate governance exerted by the governments of France, Italy, Russia, and many other countries that own shares in private companies. One current appalling example is the situation of Alitalia Airlines, where the government owns almost half the stock. This has been a very inefficiently run airline that is hostage among others to powerful unions. Strikes have been common, flights frequently takeoff and arrive quite late, and baggage losses are high- experienced travelers try hard to avoid using Alitalia. Since Alitalia's command of routes into and out of Italy has market value, stronger European Airlines, such as Air France and Lufthansa, have wanted to take this airline over. However, the Italian government has resisted these efforts and continues to finance the sizeable monthly deficits of the airline. It fears the power of the unions who realize that many airline jobs at Alitalia will be lost if a more efficient airline takes charge.
This and other examples of harmful government interference in the running of companies where they have an equity interest provides a very good lesson for the United States. Avoid taking any equity interest in private companies when buying assets of banks under the bailout bill, or when investing other government revenues.
I want to comment on Becker's post, of course, but I will also take the opportunity to respond to one of the themes in the very interesting comments that readers of our blog made on my post of last week.
I agree completely with Becker that the government should not in general have an ownership interest in private companies. The "in general" qualification is intended in part to approve of allowing the government to acquire such an interest temporarily, as part of the current bailout (for reasons I explain below); and in part to leave open the question whether the Social Security Administration should be permitted to invest some of its funds in the stock market; if the investment were spread over the entire market, so that SSA had only a very small stake in any given firm, the influence of government on firm management would be small. I would worry, however, that it would grow and turn out to be an entering wedge for socialism, but that is a story for another day.
I also agree that caps on the salaries of the executives of banks that participate in the bailout are dumb. Not only are such caps bound to be evaded, but if they were not evaded they would have the curious effect of subsidizing mediocrity. Capping the salaries of the executives in one industry will drive out (and deter from entering) some of the ablest executives, creating a space that will be filled by mediocrities. The allocation of talent across industries will be distorted and the recovery of the financial sector retarded.
Where I differ from Becker is with respect to the question whether the government should demand common stock in the banks it buys assets from. I think it should (as it is authorized to do by the bailout law just enacted).
The reason goes to the heart of the justification for the bailout. The banks are holding assets of dubious value. This makes them reluctant to lend money, because as I explained in my last post what banks do is borrow (for example, from depositors) and then lend the borrowed money, and they need a capital cushion against the possibility that the people they lend to will default. The smaller the cushion, the more conservative a bank‚Äôs lending policy must be.
If the government in executing the bailout buys the bank's bad assets at prices equal to their true, low value, the bailout will have no effect (with a qualification, concerning liquidity, noted below). A bank will be exchanging an asset worth say $1 million for $1 million; its capital will be no greater, and so neither will its willingness to lend be any greater. The bailout will work only if the government overpays. Suppose it pays $2 million for an asset worth only $1 million. Then it has added $1 million to the bank's capital. That capital is owned by the bank's shareholders. The government's purchase of the asset will therefore have enriched the shareholders.
Moral-hazard issues to one side, why should the taxpayer be enriching shareholders? The alternative is for the government to say to the bank in my example: we will pay $2 million for your lousy asset but in exchange we want you to issue us $900,000 worth of stock. (Not $1 million worth of stock, for then the bank might have no incentive to make the sale--or might, as the capital infusion could help it to stave off bankruptcy.)
I anticipate the following objections: (1) The banks will not participate. But why not? They would not only be making money on the deal; as I just mentioned, by strengthening their capital base they would also be reducing the likelihood of bankruptcy. (2) Government should not have an ownership interest in private companies. I agree, but this would be a temporary interest; the government would sell its interest as soon as it could find a private purchaser. (That was what happened in Sweden after it bailed out its banks from a crash similar to ours in thr 1990s. See Joellen Perry, "Swedish Solution: A Bank-Crisis Plan That Worked," Wall St. J., Apr. 7, 2008, p. A2.) (3) The taxpayer can recoup completely without the government's taking an ownership interest because the problem is not that the "bad" assets are so bad, as that they are illiquid; the bailout will restore liquidity without adding to bank capital.
The third point is the most important, and let me pause on it. The idea behind it is that the value of the "bad" assets that the banks hold is unnaturally depressed by the panic that has seized the financial industry. The bailout will dispel the panic and so restore the "bad" assets to their true, "good" value. The government will need only to hold the assets until their maturity and it will be able to sell them then at a price equal to or even higher than the "excess" price that it will have paid for them during the bailout.
The objection to this analysis is that if the situation is as depicted, there should be more private buying of bad bank assets than we are observing. Buffett should be investing not only in Goldman Sachs but also in hundreds of other financial institutions. There is plenty of global capital and why isn't more of it going to the purchase of bank assets whose true value is greater than their current market value? The bailout makes most sense if hundreds or even thousands of banks (there are more than 8,000 banks in the United States) really are broke or nearly broke, so that credit will dry up unless there is a massive infusion of capital into the banking industry. The fact that the required infusion is coming from the U.S. government suggests that the global capital markets are not confident that they could recoup investments in buying bank assets.
But this objection is not conclusive. It is possible that the banks' problem is not, or at least not only, undercapitalization because of the decline in the value of their assets, but lack of liquidity, which is different. Suppose you have a very valuable asset but all of a sudden the government decrees that money is no longer legal tender--that all transactions henceforth must be in bamboo shoots. Now, though your asset was valuable before the decree and will again be valuable when the decree is lifted, at the moment there is no market for it. If you do not know when the decree will be lifted, you will be very reluctant to make loans, because you will not know whether, if a loan goes sour, you can sell or borrow against your assets in order to cushion the loss and avoid bankruptcy.
If that is the problem, the bailout may restore liquidity and thereby enable banks to sell or borrow against assets on the basis of their true value, and eventually the government will recoup the cost of the bailout, because it will own those assets and can sell them, when markets return to normal, for at least what it paid for them. But probably the banks' problem is a combination of undercapitalization and illiquidity. Their assets include assets whose value is tied to mortgages, and the value of mortgages has declined because of increased risk of default as a result of the bursting of the housing bubble. Insofar as the bailout helps banks to overcome undercapitalization as well as illiquidity, it will be enriching the banks' owners--unless it demands common stock in partial compensation for its buying the banks' questionable assets for more than they are worth.
The theme in the readers' comments to which I would like to respond, and it is also a theme in the Wall Street Journal's editorial comments on the financial crisis, is that government policy, rather than the free market, is responsible for the crisis--government policy in the form of encouragements spurred in part by Congress to home ownership through the government-chartered though private Fannie Mae and Freddie Mac home-mortgage companies, low interest rates imposed by the Federal Reserve Board, and lax supervision by the Securities and Exchange Commission and other regulators. I wish it were true. And what is true is that the government, including Congress, the Federal Reserve Board, and the SEC, were complicit in contributing to or creating some of the preconditions for the crisis--cheap credit and lax regulation. But there is a difference between creating and merely exacerbating a crisis. Moreover, it is a paradox to exonerate the market on the ground that the government did not do enough to regulate it!
I believe that the basic causes of the crisis were six factors internal to the market system. The first was abundant and therefore cheap global capital--the result of private economic activity--and, consequently, low interest rates, which encouraged borrowing. The second factor was a housing bubble caused in part by those low interest rates and in part by aggressive marketing of mortgages. The third was new financial instruments that businessmen believed reduced borrowing risks and so increased optimal leverage. The fourth was the difficulty of "selling" a conservative business strategy to shareholders in a bubble environment. Borrowing more and more at low interest rates while home or other asset values are rising enables financial institutions to make higher profits, and a firm that refuses to jump on the bandwagon will as a result experience lower profits and will have difficulty convincing shareholders that they really are better off because the higher profits of the competing firms are unsustainable.
The fifth factor was sheer uncertainty--was it a bubble? If so, when would it end? Would the new financial instruments assure a safe landing if it was a bubble and it burst? And the sixth factor was that the downside risk to highly leveraged financial institutions was truncated by generous severance provisions for their executives, authorized by boards of directors that were not effective monitors of executive decisions.
Cycles of boom and bust are intrinsic to capitalism. Government can make them more serious, and sometimes less serious, but if you take away government you will still have periodic economic crises.