Arnold Kling  

Mankiw, Rogoff, and Merton

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Where are the Macro Theorists?... Two Quick Takes...

Harvard put together a faculty roundtable on the financial crisis. Thanks to Alex Tabarrok for the pointer.

I skipped over much of it to listen to the three last panelists. Greg Mankiw (starts about minute 44) said that chapter 26 of his textbook explains the importance of the financial sector. It's one thing to say it's important (as Rogoff says, the auto and the steel industries are also important), but quite another to come up with a macroeconomic model of the Wall Street/Main Street linkage that would help me out.

Ken Rogoff (starts about minute 57) says that the financial sector needs to shrink. He's been writing that, and I've incorporated his views into my criticism of the Paulson plan.

Please listen to Ken, who is a respected policymaker as well as a leading academic. He calls the financial sector bloated, and he draws out the same implications that I do. In particular, rather than being a trigger for a new depression, the shrinkage of the financial sector is part of a necessary adjustment. But hear how he tells it.

Ken also describes our international position as precarious. He will drive Don Boudreaux crazy, because he sees this in terms of currency values and "our" trade deficit. But I think that the point that our government may suddenly find itself facing higher borrowing costs is certainly worthy of emphasis.

Merton (right after Rogoff, but you don't want to skip Rogoff) is one of those speakers whose mind produces so many thoughts that all you get to hear are excerpts. One point he makes is that there has been a large real loss of wealth in housing, amounting to trillions of dollars.

This made me think along these lines: when trouble hits, everyone looks out for themselves, and your goal is to be the first person to jump ship. If Merton is right, a lot of people are going to be hurting, relative to their plans, over the coming years, and a lot of them may turn to government for help. The financial sector will have gotten the jump on everyone else, and there won't be much money left in the Treasury when individuals start to realize they are suffering. The banks mark their mortgage assets to market right away. Individuals don't revalue their houses and revise their retirement planning. (Granted, this means that when house prices were rising they didn't become as optimistic as they would had they mentally marked to market.) In a few years, as people retire, they won't have nearly as much home equity to borrow against as people had a few years ago, and we don't know how that might play out.

The other point that Merton made was that top executives and regulators do not understand the technical characteristics of today's financial instruments. Once again, this is vindication for a view that I have been pushing. I worry that there is a disconnect between the geeks and the suits in valuing these mortgage securities. The geeks think that their low values are realistic. The suits think that the securities are undervalued. Paulson is a suit. I'm a geek.


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COMMENTS (9 to date)
Matt writes:

The financial sector is important up to a point of aggregation where risk is more or less spread across all sectors of the economy. That is, the average saver can efficiently invest across the yield curve with surplus funds.

Once we get close to that point, any more financial sector costs a extra high transaction costs for each additional increment of risk reduction. Ken is right, we have moved beyond an efficient financial sector.

Hi Arnold,

FYI, I quoted you for a contribution to the Boulder Daily Camera (Colorado, circulation ~ 30k print), and it was published in today's edition:

A bailout allows government to do even more harm. As former Freddie Mac senior economist Arnold Kling explains at EconLog, the "bailout is going to lead to the same two-way influence peddling. ... An orgy of lobbying is bound to ensue. ... it creates a tight interlocking between Big Finance and Big Government [and the] the consequent destruction of liberty and economic dynamism."

TC writes:

I don't agree with this column, but here is Bruce Bartlett supporting the bailout. Here's an excerpt.

There are, of course, policies in place today that didn't exist in 1929 that make another Great Depression unlikely. (The most important is federal deposit insurance for the vast bulk of deposits.) But there is still a great danger that, if the financial sector becomes overloaded with assets falling in value, it could lead to a long period of economic stagnation, such as that suffered by Japan in the 1990s.

One reason for this is that Federal Reserve policy becomes impotent when the financial system simply can't distribute changes in the money supply throughout the economy.

We're seeing evidence of this already, as interest rates on Treasury securities fall to very low levels. When this happens, we have what economists call a "liquidity trap" - and it means that the Fed is incapable of stopping a deflation once it gets started.

Bottom line: We're closer to the precipice than Congress or most of the public understands. Our entire economic system really is at stake - and those treating the bailout plan as just another government spending program are seriously wrong.

Mercutio.Mont writes:

Would suggest that people mark to market on the way up, but are slow to do so on the way down.

Maybe it was different in DC, but in CA the optimism at the height of the bubble was palpable. Now that things are down, all you ever see/hear is, "Things suck over in X neighborhood, but my neighborhood is just fine."

People will be shocked.

dWj writes:

The financial sector is an export sector for the United States. How will this affect the trade deficit?

chug writes:
top executives and regulators do not understand the technical characteristics of today's financial instruments.

In journalism, putting this anywhere other than at the beginning of the article - but especially at the end - is called "burying the lede."

SheetWise writes:

I thought that Warren and Merton did a great job of defining and characterizing the issues. Rogoff has the correct tone -- and I'd elect him to lead the debate.

Mankiw stumps me. I've been reading him for a couple of years, but I'd never seen him before. He never says much that's original, provocative, or profound. Now I see that none of these faults are redeemed by his personality or presence.

mobile writes:

Rogoff points out that the financial sector accounts for 4% of GDP and 30% of US corporate profits. Wouldn't this usually mean that the financial sector should be expanding?

nicholas shackel writes:

Did anyone notice the bootlegger and baptist moment in the question period, when the guy from a bank who was also a regulator (!) testified in support of Warren's claim that more regulation is essential?

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