Monday, September 28, 2009

Scare Tactics and the Financial Crisis

The Stiglitz-Prescott view:

Here is Nobel prize-winner Joseph Stiglitz quoted by Free Exchange:

We’ve really extended the safety net beyond to big to fail, and my view is that there’s been no convincing argument that any of this was ever needed. It was based on the notion of fear — that if you didn’t do it, the whole financial set of markets would fail. Economics would have suggested that if you did a debt to equity conversion, converting long-term debt into equity, the financial institution would be well capitalized, there would be no reason to panic, and there would be more confidence in the market. But those who saw an opportunity to use scare tactics to get what they wanted did use those scare tactics, and it worked.

Here is Nobel prize-winner Ed Prescott quoted by Brad DeLong:

[P]eople got scared.... The press scared people. People running for office scared people. Bernanke scared people; Paulson scared people.... [P]eople began not to know what was going to happen. Then they stopped investing--by investing, I mean getting a new car or fixing up your house. And that led to the economy--it was depressed a bit that fourth quarter of last year...[With] benign neglect the economy would have come roaring back quite quickly...

Free Exchange says that Joseph Stiglitz's views are "insane" and Brad DeLong says that Prescott "does not live in the consensus reality with the rest of us." I am not sure why they are so confident.

I'm not sure why they are either.


thinking said...

I agree that these views are crazy, even if expressed by Nobel Laureates.

We let the banks fail in 1929 and we really did get a great depression.

Remember what happened when Lehman Bros was allowed to fail? That is widely viewed as the biggest mistake made during the handling of the whole crisis.

Thank goodness we didn't experiment with this idea of doing nothing.

I respect alot about what Stiglitz has written, including this from his Vanity Fair article this year, when diagnosing the causes of the financial crisis:

"The truth is most of the individual mistakes boil down to just one: a belief that markets are self-adjusting and that the role of government should be minimal. Looking back at that belief during hearings this fall on Capitol Hill, Alan Greenspan said out loud, “I have found a flaw.' Congressman Henry Waxman pushed him, responding, 'In other words, you found that your view of the world, your ideology, was not right; it was not working.' 'Absolutely, precisely,' Greenspan said. The embrace by America—and much of the rest of the world—of this flawed economic philosophy made it inevitable that we would eventually arrive at the place we are today."

thinking said...

If one is going to go only by what Nobel Laureates write or say (a dubious proposition at that), then one has to admit that Nobel Laureate Paul Krugman, among others, disagrees with this view.

Also, re Prescott (whose interview was back on Mar 30), as DeLong points out, Prescott rather strangely stated his belief that after 1984 the Federal Reserve stopped trying to stabilize the economy.

Apparently, Prescott also stated:
"I think the financial crisis has been greatly overstated as a problem... [it] has had virtually no consequences for the real economy..."

I'm sure Prescott is a brilliant man in his own right, but that doesn't mean he cannot be spectacularly wrong. He wouldn't be the first Nobel winner to say some crazy stuff.

I also don't know that it's accurate to state this as the "Stiglitz-Prescott" view. They were not interviewed together or even in the same month, nor have they been collaborating on this.

Stiglitz and Prescott, indeed, are probably at odds on most issues of public policy. For instance, while Prescott seems to be generally for a lesser govt role, Stiglitz is for a greater govt role. In fact, the context of the Stiglitz quote is to argue for more regulatory reform.

thinking said...

Finally, as one more addendum: let's not forget that Stiglitz earlier this year said this:

"Nationalization is the only answer. These banks are effectively bankrupt."

I'm not sure how that squares with his current statement.