Normalcy is Just a Few Bold Policy Steps Away

The current financial crisis was built in steps, but it took a dramatic turn for the worse during the third quarter of 2008 after the Lehman-AIG events. Since then, gloom has taken over. Economic agents of all sorts, from creditors to consumers, are frozen waiting for some sense of normalcy to be restored.  The main purpose of this article is to make the case that normalcy is much closer —just a few bold policy steps away— than is the conventional wisdom.

Knightian Uncertainty and its Implications for the TARP

Financial institutions specialize in handling risk but are not nearly as efficient in dealing with uncertainty1.  To paraphrase a recent secretary of defense, risk refers to situations where the unknowns are known, while uncertainty refers to situations where the unknowns are unknown.  This distinction is not only linguistically interesting, but also has significant implications for economic behavior and policy prescriptions. There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. Unfortunately, the very fact that investors behave in this manner, makes the dreaded scenarios all the more likely. This mechanism has played an important role in the financial crisis.

Paulson plan: ‘exemplary punishment’ could backfire

Hank Paulson’s $700bn “bailout” plan unleashed a flurry of alternative proposals, as most people recognize that time is running out. There is an urgent need for a significant intervention to break an accelerating downward spiral that is threatening the very survival of the financial core of the world economy. Most proposals, including the one just […]

Moral Hazard Misconception – Part 2

Given the dramatic recent events, I can’t help revisiting my old posting. I am even more convinced than then, that had the US Treasury sent an unequivocal signal that it was not going to tolerate speculative attacks — including punishing shortsellers along the lines of Hong Kong’s stock market intervention during the late 1990s (see:http://econ-www.mit.edu/files/180) […]

Moral Hazard Misconception

Here we go again. Two pillars of the US and world financial system, Fannie Mae and Freddie Mac, have become embroiled in the current financial turmoil. To be sure, nobody in its right mind expects these institutions to stop operating; the issue instead is whether, how and when a government intervention takes place. Treasury Secretary […]