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.