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It is obvious that the credit crisis is caused by irresponsible behavior of banks and regulators who showed little or no understanding and attention for systemic risks. Now that the financial crisis has transferred into a severe recession of the global economy, many people are becoming unemployed due to this irresponsible behavior. For instance in the Netherlands the CPB [Netherlands Bureau for Economic Policy Analysis] predicts, in its June 2009 projections, a rise in unemployment from 304 thousand persons in 2008 to 730 thousand in 2010. It is tart that in this situation most economic analysts succeed to remain employed. They keep themselves busy to inform the public about the scope and scale of the crisis, and present all kinds of policy recommendations how to solve it. However, many of these analyses and recommendations are ambivalent and contradictory.

By Frank A. G. den Butter

Therefore, other disciplines look down with great disdain to these “stupid” economists; Ewald Engelen, columnist inDe Groene Amsterdammer, calls them fallen angels. Some observers even regard the entire capitalist system and the stubbornness of economists which praise this system, as the cause of all misery.

In my opinion many of these views are based half or completely on misunderstandings. Due to bundling and selling packages of unsafe assets – the securitization – banks have become so heavily interconnected that the relatively small negative shock on the U.S. housing market has resulted in a collapse of the entire financial system. It is this falling down of the house of cards of international finance which is the actual cause of the crisis. The severity of systemic risk, which resulted in a huge amplification of the initial housing market shock, has been completely overlooked.

Because of “contagion” due to the close linkages in the financial markets, a market failure has sneaked in, where it is still not exactly clear what negative externalities have played a role (Gallegati et al . 2008; Den Butter, 2009). It has always been – and still is – the task of the government, and in this case more specifically the task of the macro-prudential regulators, to internalize such externalities. Therefore, in order to prevent such systemic crises in the future, it is necessary that there is a thorough understanding of the external effects of risk diversification and risk shifting in the financial world. This is what should keep economists busy in the years to come.

Role of trust
In order to obtain more insight on how to internalize these externalities a coherent and independent research program should be set up which goes beyond the narrow discourse coalition of the financial economists. Thereby it is especially important to grasp the mechanism that turned the financial markets from an equilibrium of mutual trust to an equilibrium of mutual distrust. The immediate task for the government is to ensure the return to the trust equilibrium, in the same way as governments have the task with the provision of public goods to solve the classical prisoners’ dilemma and to ensure that the economy moves back to an equilibrium of mutual cooperation.

The Dutch government has rightly used its position of being trustworthy when it partly or fully nationalized distressed banks. This trust in the government is extremely valuable in monetary terms, in a situation where the trust in the banks has faded. In this crisis, the Dutch government has well capitalized the trust it still had, and was very keen in keeping that trust..

Financial innovations
As mentioned before macro-prudential regulation should prevent the occurrence of market failures. In that case, financial innovations may bring about positive externalities, and not negative ones, as is now the case with securitization. In this respect, the first misconception is that innovation is always good for the economy. As an illustration we can use the example of fishermen who, due to innovation, use improved nets. Individually, they are more efficient, but collectively it means that the sea will be empty sooner. However, when there is adequate regulation – in this case strict enforcement of fishing quotas – the innovation of the improved nets will have a positive impact. The productivity increases and fish becomes less expensive.

This comparison, which is obviously only true to a certain extent, shows how innovation can strengthen negative externalities when there is no proper regulation to internalize externalities. But, with adequate regulation, positive externalities may result. The example of the fishermen and fishing quotas also reveals how difficult it can be to implement proper regulation. A group of independent experts is needed to make a credible analysis on the future development of the fish stocks.
But then political interests play such a major role in the determination of fishing quotas that the recommendations of the experts are often not followed. Eventually, the fishermen are the victims of all this.

This applies equally to banks which only follow their own interest and do not take into account the possible boomerang effects. The difference is that banks hope for a bailout so that costs of the bad behavior can be passed onto others. This prospect of a bailout should become unrewarding in the future by forcing the bank management to step down if a bailout is deemed unavoidable.

Emotions
Another misconception is that untamed emotions and irrational behavior were a major cause of the crisis. References to emotions and irrational behavior do not provide an analysis which is useful for macro regulation. Moreover, it is inconceivable that emotions play a crucial role in a world where we talk about gains or losses at a magnitude of billions dollars or euro’s. As professional poker players should not be guided by emotions and even should hide their own emotions as well as possible, the same holds for the players on the financial markets. In both cases, rapid decisions under conditions of information uncertainty should be taken, both about their own opportunities as well as the position of others. This requires a refined and experienced intuition, but no emotional or irrational behavior.

The reward structure
This brings another issue into the spotlight which is often indicated as a cause of the crisis, namely the asymmetric reward structure in the financial world in which profits are rewarded with large bonuses, but where losses are not punished (see e.g. Zalm, 2008). Of course, this is an aberration of the system, but it is rather a consequence than a cause of the systemic failure. If the external effects indeed would be perfectly internalized through adequate regulation, and the costs of excessive risk-taking are paid by the banks, the consequence would be that such asymmetric reward systems would not exist. Therefore, such asymmetric reward systems with large bonuses should mainly be seen as a symptom and indicator of the systemic error in the system. Nevertheless, if regulation does not eliminate this aberration, symptom control should take place by legal restriction on bonus systems.

Credit rating
A similar argument holds for the rating agencies which are considered accountable for the crisis. With adequate regulation, banks will not be seduced into taking excessive risks due to an overly positive risk assessment. But once again, in an imperfect world, regulators should conduct their own risk assessment.

Capitalist greed
Those who consider the crisis a prove of the bankruptcy of the capitalistic system, point out unbridled greed as causing the crisis. This too is a misconception: greed, or to put it more neutral, the pursuit of self-interest, enhances, according to mainstream economic theory, economic welfare. In the modern market economy, however, it is the task of the government to minimize undesirable greed – that is, greed that harms others. That is the main argument for government regulation, a regulation which in the case of financial markets has not properly taken place because, as mentioned before, there is no good analysis of the externalities which are at the root of the crisis.

Finally
Some see the current crisis as the bursting of a bubble, which arose because of buoyant lending and overconsumption where expenditures exceeded income year after year. The latter is particularly true for the United States. This reasoning shifts the responsibility for the crisis to almost everybody: the consumers, the government, a low interest rate policy, investors etc. The consequence of this reasoning is that no-one specific is to blame for the crisis. No, the bubble, if any, is caused by a myopic profit urge of banks and the powerlessness of macro-prudential regulation. That is where both the cause and the solution of the crisis can be found. In this perspective, the last misconception is that this crisis can be identified with the bursting of previous bubbles. If that were the case, it should been known what the best solution is, or it would even have been possible to prevent the crisis. But every bubble is different. The theory of bubbles provides only a case description, and no causal analysis. Economists may be fallen angels, but they will not make the same mistake twice.

Literature
- Butter, F.A.G. den, 2009, Falen van de financiële markten (Failure of financial markets), Bank- & Effectenbedrijf, 59, p. 14-19

- Gallegati, M., B. Greenwald, M.G. Richiardi and J.E. Stiglitz, 2008, The asymmetric effects of diffusion processes: risk sharing and Contagion, Global Economy Journal, 8, Issue 3, Article 2.

- Zalm, G., 2008, Financiële prikkels in de overheidssector en in de financiële sector (Financial incentives in the government sector and in the financial sector), Lustrum Symposium FEWEB, Vrije Universiteit, October 21, 2008.

This post is tagged economy, financial crisis