Friday, July 17, 2009


The new issue of The Economist has some tough things to say about academic economists. Does the current deep recession show that we are bozos? Do our public disagreements over optimal policy (i.e Krugman vs. Cochrane) prove that we are all ideologues who use math to dress up our priors about how the world works as we sucker New York Times readers into believing that we truly understand the world --- versus the "truth" that we are partisans using our academic clout to push the status quo in the direction we (either "liberals" or "conservatives") want to achieve?

Permit me to respond. Incentives is idea #1 in economics. Such incentives can be about $ or social incentives.

The crisis:

1. Incentives of banks to carefully screen potential borrowers in terms of their income prospects. (These guys are paid on commission and the banks were aware that they are "too big to fail" and would be bailed out by the federal government if loans go bad).

2. Incentives of Standard and Poors and rating agencies (seeking new business and aware that if they play nice and give a "AAA" rating that this generates more business). They should be randomly assigned to the companies they rank just as accountants should be randomly assigned for firm audits.

3. Incentives of the Fed --- I don't have a great model of Alan Greenspan and what he was thinking when he sharply deviated from the Taylor Rule and dropped interest rates really low. He must have believed his own hype. Rules over discretion would solve this. Keep in mind that Greenspan faced no competition. He was a monopolist and used his strange speaking style as a barrier to entry so that nobody actually understood how this "oricle" was making decisions or what he was maximizing. Capitalism works better when there is competition. His wonderful wife Andrea could have done a better job investigating his day to day decisions and reporting on NBC.

4. Expectations of rising home prices --- this is interesting but the issue here is missing markets. If you believe that Los Angeles home prices will crash, there is no asset that you can "short". In the stock market, such positions exist. The pessimists had no way to express themselves and the information was not incorporated into prices. Incomplete markets matter! As people believed that home prices would just keep rising, this led to some marginal home buyers taking the plunge who should have kept renting.

5. Owning vs. Renting --- this is a 0,1 variable. As Joe Tracy and Andy Caplin have long stated --- we need a system that convexifies this problem so that you can own 10% of your home or 30% of your home and other people will own the rest. Yes there are moral hazard problems of maintenance contracts but more sturdy durables could solve this.

6. The foreclosure crisis --- Why don't banks just seize the homes that are in foreclosure and rent them to the current owner? This would force the banks to rewrite their asset positions and they prefer to have the full loan on their books rather than admit the truth. By dragging the current owner along and hoping he will start to pay back, the bank holds an option that could be in the money if Obama's Brainy Team can stimulate us to recovery. If Banks had to honestly and in real time state the value of their assets then they would quickly start renting to these households.

Get these "micro" incentives right and we would not have had this "macro" problem. In each case , there were interest groups with a stake in the status quo and this has nailed us good.