Questions at a Conference on Financial Regulation
By Arnold Kling
Mark Thoma links to a conference at the Princeton club, taking place as I write this. I have skimmed the papers, and they raise interesting questions.
Foote, Girardi, and Willen ask whether, given expectations for ever-rising house prices, the institutional and regulatory details make any difference. If people expect house prices to rise faster than the rate of interest, then that creates in their minds a profit opportunity. One way or the other, the market will develop the financial instruments that allow people to exploit that apparent opportunity. I do not think I can endorse this view, but it is interesting.
Thomas Philippon asks how the financial sector came to be as large and profitable as it did. He argues that it is not because finance became more efficient or added more value to the economy.
Brad DeLong asks why economists could not predict and explain the economic downturn. He argues that financial panics, in which the market’s assessment of the safety of financial assets changes sharply and suddenly, are rare events that are outside the realm of typical theoretical models and statistical analysis. I am left with further questions. Which is abnormal, the faith that people had in financial assets before the crisis, or the lack of faith that people had after the crisis? And does government intervention to try to supply safe assets constitute the solution or the problem?
Robert Litan asks whether Dodd-Frank will be helpful in regulating the financial industry. He is inclined to say that it will, but he is concerned that regulation tends to be procyclical–encouraging financial innovation and growth when times are good, and then closing the barn door after the horse has left.
Other papers look interesting, also. On the whole, I think that the conference underplays the role that the government played in expanding the financial sector. My own view is that government policy did play an important role, and this affects my reaction to each of the papers.
[UPDATE: I just finished watching Ben Bernanke’s speech at the conference. It was Gorton-esque, with a huge emphasis on “panic,” “shadow banking system,” and “runs.” Bernanke points out that on any given bad day on the stock market, more paper wealth gets lost than was lost in the subprime mortgage market. This poses a puzzle as to how the mortgage market problems could have had such greater effects. Some comments I would make:
1. Isn’t it interesting that the magnitude of the bailouts was greater than the magnitude of housing market wealth lost in 2007 and 2008? And isn’t it interesting that the economic collapse was much larger still in magnitude (particularly taking into account that economic activity is a flow rather than a stock)? This pattern of relative magnitudes is evidence in favor of Scott Sumner’s view that the financial crisis was an epiphenomenon in the context of an aggregate demand shock.
Sumner is the last holdout for conventional macroeconomic analysis. DeLong wants to go back to a pre-Hicksian version of Keynes, with all its deep logical difficulties (although empirically it makes for a spellbinding just-so story). Most economists, probably including Bernanke, want to wave their hands and talk about how breakdowns in the financial sector cause economic disaster. I instead want to talk about adjustment problems when patterns of trade suddenly are exposed as unsustainable.
2. What is one to make of the fact that the private securitization markets show little sign of life? Is the current state of financial markets a continuation of an aberration (“panic”) that took place in 2008, and are you still wistful for a return to the level of intermediation in 2006? Or was there something very abnormal going on in 2006, and in hindsight we can regard 2008 as an inevitable correction? Again, the phrase “exposed as unsustainable” is the one that I think applies.]