Lessons from the Crisis for Teaching Macro

The NY Times “Room for Debate” recently had a forum on “Rethinking How We Teach Economics”, with contributions by Blinder, Taleb and Skidelsky, among others. In my contribution, I focused on the importance of asymmetric information and self-reinforcing feedback loops:

In the typical introductory textbook, wages and prices adjust so that labor is fully employed and goods are sold at the right price. A more sophisticated treatment shows up in more advanced texts, but even in some graduate texts, there is an emphasis on the self-correcting aspects of the modern macroeconomy. Recessions are eventually overcome as prices adjust to the right levels, even in the absence of government policy.

…[E]ven when unconstrained, price movements are often insufficient to clear markets, as pointed out by George Akerlof, A. Michael Spence and Joseph Stiglitz in work that garnered them the Nobel Prize. This outcome is particularly likely in markets where both sides of an economic transaction have differing sets of information, like in the credit market. During the financial crisis of 2008, the asymmetry of information regarding each institution’s financial situation was so pronounced that lending fell precipitously as trust dissipated. These informational problems were only exacerbated as lending fell further. Eventually, no interest rate could induce lending and price failed to clear the credit market. Restoring the functioning of the credit markets required mitigating those information asymmetries, essentially by way of short-term government guarantees.

…The crisis highlighted the existence of these self-reinforcing feedback loops, and we ignore them at our peril.

Jeffry Frieden and I expand upon this theme in our book Lost Decades (p.89).

As prices dropped, the feedback loop that had fed the bubble took hold in reverse, with a vengeance. Homeowners with mortgages worth more—sometimes much more—than their homes had good reasons simply to give up and turn the house over to the bank. As foreclosures mounted and creditors tried to unload the houses they had been stuck with, prices were forced down further. Even many of those who wanted to try to keep up payments were done in by the financial innovations that had previously made their mortgages attractive. When home prices were rising, it was easy to refinance at attractive rates; as they fell, it became impossible to refinance. …

This post originally appeared at Econbrowser and is posted with permission.