Judging from preliminary details, the U.S. Treasury’s plan to rescue the financial system is a lot savvier about the relationship between financial markets and the macroeconomy than are the usual-suspects critics from both left and right who are already pouncing on the plan.
Unlike the critics, Treasury has absorbed the key lesson from the last 30 years of academic finance research: Asset price movements mainly reflect changes in investors’ collective attitude toward risk.
The financial meltdown that shifted into high gear last September has flushed into public view many surprising facts. One of the strangest is the existence, in the economics profession, of a bizarre religious cult. This cult adheres to the dogma that the “price of risk” is the Holy of Holies that can properly be set only by the immaculate invisible hand of the financial marketplace; and cult members seem to believe, to paraphrase President Lincoln from a rather different context, that “If the Market wills that the economic crisis continue until every dollar of economic activity created by the taking of risk shall be repaid by another dollar destroyed by a newfound fear of risk, so it still must be said that the judgments of the Market are true and righteous altogether.”
Pondering the role of the central bank in a modern economy, one cannot help but be reminded of the apocryphal story of the western explorer who encounters an eastern mystic teaching his disciples that the world rests on the back of a giant turtle. When the explorer challenges him, “and what does the turtle stand on?” the mystic, having anticipated the question, replies with a smug smile: “It’s turtles all the way down!”
A consensus seems to have emerged in the United States that fresh thinking is needed for a targeted stimulus package that will address effectively the many connected problems the economy faces. One piece of the problem is that there has been a near-halt in construction, as it has become clear that too many homes have been built on speculation that house prices could only rise and never fall. Moreover, there has been a large decline in borrowing to finance the construction of homes and commercial buildings, as both households and businesses (even financially sound ones) have hunkered down to weather the storm.
One of the all-time-great pieces of samizdat literature in economics is a paper written by John Campbell of Harvard and Robert Shiller of Yale for a private briefing of Chairman Alan Greenspan and the other members of the Federal Reserve Board, exactly twelve years ago (in November of 1996).1 Campbell and Shiller’s question was whether the stock market had entered a bubble phase; the persuasiveness of their answer can be judged by the fact that Chairman Greenspan gave his famous speech about “irrational exuberance” less than a month later.
In the past decade or so, an economist asked to tell a horror story over toasted marshmallows at a cookout would not have conjured up empty McMansions haunted by subprime ghosts (though in retrospect that would have been a pretty good tale). Instead, among friends if the mood was right, we might say to each […]
Economists of all stripes remain puzzled about how Treasury Secretary Henry Paulson’s Troubled Asset Relief Plan is supposed to fix the American financial system. What is not in dispute is that the crisis has been triggered by a collapse in confidence about how much of their debt subprime borrowers will repay. (This affects financial stability […]
Journalists probably have a secret rule of thumb that says you lose half your readers every time the phrase ‘accounting rule’ appears in an article. For the half of you who are still with me, let me try to inoculate you against this natural human inclination by pointing out that this week may be the […]
Discussions of how to deal with the ongoing financial mess have been confusing (and, often, confused) because the problem actually has two quite distinct aspects, which keep getting mixed up with each other. So let me try to distinguish (following my colleague Olivier Jeanne, speaking at the Johns Hopkins University’s Center for Financial Economics panel […]