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July 3, 2011
David Warsh, Proprietor

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Last Week in Jerusalem

Was economics caught unawares when the worst crisis since the Great Depression threatened three years ago?  The answer seems to be both yes and no.

There is some truth in the allegation, common at the time, that the leadership of the profession turned up flat-footed in the event. Yes, there had been some striking predictions about the trouble that lay ahead:  Raghuram Rajan, of the University of Chicago’s business school, warned of the deleterious effect of excessive innovation; Robert Shiller, of Yale University, identified the key role that sharply rising housing prices would play in the collapse. Nouriel Roubini, of New York University’s business school, kept the press gallery on its toes with a stream of dire warnings. Edward Kane, of Boston College, repeatedly cautioned against the ill effects of regulatory capture. Paul Krugman, of The New York Times and Princeton University, republished his essay on the experience of Japan in the 1990s as The Return of Depression Economics and the Crisis of 2008, just as the emergency reached a boil.

And in their best-selling book This Time Is Different, Carmen Reinhart, of the Peterson Institute for International Economics, and Kenneth Rogoff, of Harvard University, presciently depicted the broad historical pattern of financial crises in considerable detail – especially their characteristic grim aftermath.

But while  these sentinels (and others) saw trouble coming, none explained why it was so much worse than expected when it arrived. (Reinhart and Rogoff came the closest.)  So much, then, for the Cassandra Sweepstakes –  right, but for ultimately unsatisfying reasons.  Moreover, with the exception of Federal Reserve chairman Ben Bernanke, the names that newspaper readers know best did not communicate or, often, even seem to understand much about the inner workings of events when the crisis finally arrived.

That was because the very language necessaryto speak clearly about what happened has been developed comparatively recently in work along the seams of fields previously considered only separately: macroeconomics, international economics, money and finance. There had been no talk of the world of “shadow banking” when the likes of Martin Feldstein, John Taylor, Lawrence Summers, Krugman and N. Gregory Mankiw went to graduate school.  And even now there is little consensus among the Political Economic Commentariat about exactly what happened and why.

The Hot Stove League, on the other hand, those economists concerned with the reconstruction and explanation of the crisis, turned out to have a very different roster, and a much better better record of interpreting events.  That is because an appreciation of the role of financial intermediation in the economic system – both its theoretical underpinnings and a narrative account — began to be constructed in the deep recession of the early 1980s. That research tradition was stimulated by the savings and loan crisis in the United States in the late ’80s, and the Asian financial crisis in the ’90s. It has blossomed in the last few years, more or less simultaneously with the global crisis. A new generation of economists has begun to dominate the discussion of recent events – a familiar enough phenomenon, after all, in a subject in which developments sometimes move more swiftly than the frontier of research itself.

The effect has resembled a familiar contrivance of theater stagecraft, in which hurly-burly action downstage suddenly gives way to an actor – in this case, a group of actors – illuminated by a spotlight elsewhere on the stage.

Last week in Jerusalem, some of that was on display. The 22nd Jerusalem Summer School in Economic Theory, a ten-day examination of the cutting edge of some current research from the perspective of high theory was devoted to “The Global Financial Crisis.”

Among the lecturers were three eventual players in the Nobel nomination league:  John Moore, of the University of Edinburgh; John Geanakoplos, of Yale University; and Bengt Holmstrom, of the Massachusetts Institute of Technology. Among the 120 students were some of the most promising of the generation that today is just entering the profession.

The Institute for Advanced Studies at the Hebrew University invented its school format in the early 1980, in physics, in hopes of keeping Israeli science abreast of fast-moving developments. The 29th Jerusalem Winter School in Theoretical Physics will commence in December. Steven Weinberg, of the University of Texas, was its first director.

Once the physics program’s success was established, an economics school was begun, with Kenneth Arrow, of Stanford University, as director. A third school followed suit, in Life Sciences, directed by David Baltimore, then of Rockefeller University, and then a fourth meeting, Midrasha Mathematica. Ironically, only the school in Jewish Studies and Comparative History has disappointed.

Arrow directed the economics program for a remarkable eighteen years, surveying everything from evolution and learning to law and political economy. Five years ago Eric Maskin, of the Institute for Advanced Study in Princeton, replaced him. (Maskin, a Nobel laureate, announced last week that after eleven years in Princeton he would return in January to Harvard.)  And it was Maskin himself who last week introduced the session with a lecture, which he anticipated in many respects in an accessible interview last year in The Browser, describing five not-so-easy technical papers that, he said, laid that groundwork for present-day models.

The Maskin five include the 1983 paper in the Journal of Political Economy that everyone agrees was the starting point of the present-day technical discussion.  That was “Bank Runs, Deposit Insurance and Liquidity,” in which Douglas Diamond (of the University of Chicago business school) and Philip Dybvig (then of Yale and today of Washington University) first employed (then-new) game theoretic tools to depict how a calm situation in banking could turn into a fevered state.

A community of experts then went to incorporate various well-known features of the real world in the stripped-down models. Authors of landmark elaborations, according to Maskin, include Holmstrom; Jean Tirole (of the University of Toulouse and MIT); Mathias Dewatripont (of the University of Brussels); Nobohiro Kiyotaki (of Princeton); Moore; and Geanakoplos   Read Maskin’s exegesis for the flavor of the thing.

Other experts have ordered their accounts slightly differently, depending on their angles of vision: see, for example, Robert Lucas and Nancy Stokey (both of the University of Chicago) on “Liquidity Crises” in the latest issue of The Region, a publication of the Federal Reserve Bank of Minneapolis. Their version elevates to starring positions Neil Wallace (of Pennsylvania State University), Hyun Song Shin (of Princeton), and Gary Gorton (of Yale’s School of Management).  But essentially their story is the same: people have been talking about the potential of financial crises to wreak macroeconomic havoc, at least in principle, for more than 25 years.

“The theory indeed makes the danger quite clear,” Maskin wrote in his account.  “I really don’t know why the message failed to get through to the policy makers. Perhaps the theorists deserve some blame here.”

So last week in Jerusalem, five leading theorists gave three lectures apiece describing their latest work. Students listened carefully, interrupted frequently with questions, and afterwards debated among themselves.  Moore described the interplay of “leverage stacks,” double-deck and triple-deck chains of intermediation between lenders and borrowers that are by now familiar to students of the crisis. Simon Gilchrist, third author of a celebrated paper with Bernanke and Mark Gertler (of New York University) gauging the effects of a mechanism by which small shocks might turn into big ones (dubbed the “financial accelerator” by Bernanke and Gertler), elaborated on recent extensions.  Markus Brunnermeier, of Princeton University, perhaps the master expositor of the new literature, surveyed the state of affairs. Geanakoplos explained how his experiences as a mortgage trader at Kidder Peabody in the ’90s sensitized him to the key role that collateral played in leverage cycles (“First I fired the 75 people [that he had hired into the research department of the firm].  Then they [the bosses] fired me.”) and explained how the timing of financial innovations might suffice to account for  the crisis.

Holmstrom also gave the showplace Arrow Lecture, about a long-awaited paper (joint with Gorton and Tri Vi Dang, of Columbia University), called “Ignorance Is (Almost} Bliss: An Alternative View of the Financial Crisis,” in which the often-salutary effects of opacity are explored. DeBeers bags of diamonds, large-scale automobile auctions, coarse bond ratings, securitization, clearinghouses and, of course, cash money itself – all are devices wherein value is taken for granted in good times by all, but whose worth can plummet abruptly when it becomes worthwhile to search beneath the veil.  Iilan Kremer, of Hebrew University and Stanford, spoke as well, on liquidity runs and collateral.  (Several of the talks were recorded.)

Many other participants in the debate were present only by implication, especially those preoccupied by the role played by global imbalances in the crisis:  Ricardo Caballero, of MIT; Emmanuel Farhi, of Harvard; Arvind Krishnamurthy, of Northwestern University’s business school; Pierre-Olivier Gourinchas, of the University of California at Berkeley; and Helene Rey, of London Business School. In his final lecture, Holmstrom described a paper by Nicola Gennaioli (of Pompeu Fabra Univiersity), Andrei Shleifer (of Harvard) and Robert Vishny (of the University of Chicago business school), in which a certain behavioral propensity – the unthinking neglect of unlikely but dangerous risk – played a key role in the crisis.

Between times, former chief White House economist Lawrence Summers appeared and defended the Obama administrations’s program of economic stimulus. Stanley Fischer, governor of the Bank of Israel, also spoke. Summers, a Harvard professor, last week disclosed he would be joining the Silicon Valley venture capital firm of Andreessen Horowitz as a part-time adviser. Fischer, who was among Bernanke’s teachers at MIT, steered the Israeli economy through the emergency all but unscathed.  He is probably the single most credible economist in the world.  At a certain point in its incipient real estate frenzy, for example, he ordained that banks could lend no more than 65 percent of the value of a property. “I don’t know it that was exactly the right number,” he said later, “but it seemed to work.”

The 22nd summer school climaxed with an antic lunchtime panel, organized for purposes of public relations, which instead illustrated the difficulties of sorting out the various levels of economic discourse: each participant created a frame of his own.  Robert Aumann, in high Nobel laureate-form, merrily channeled the late Milton Friedman.  Eytan Sheshinski, fresh from his triumph as author of measures to tax Israel’s newly discovered oil and gas reserves (“the Sheshinski law”) offered several technocratic prescriptions, plumping for higher bank-capital ratios and more judicious managerial incentive schemes;  Eyal Winter, co-director of the school itself, reminded listeners of certain textbook distinctions (all three are on the faculty of  Hebrew University).  Holmstrom and Geanakoplos sparred over their conflicting explanations. Pandemonious laughter threatened, whereupon Holmstrom struck a somber note.

“Economists should be a little more humble,” he said. “The true answer is that we don’t really know. Thirty years from now, the answer may be seen to have been something that we don’t know today.”  Maskin followed up: “So perhaps we have identified eight different possible mechanisms. That doesn’t mean we don’t know anything.  We know a great deal about the general picture, about the family resemblance of crises. Also we understand generally the role of regulation: leverage, price-to-value ratios, those sorts of things.”

Developments in economics are not a stage-play. There is no sudden chasm between dark and light – only afterwards are such fictions constructed. Policy is not yet clear.  And integration of theory in general equilibrium theory, macroeconomics, money and finance will take years.  New measurement systems must be devised, textbooks written, prizes given, popular language concocted. But it’s a comfort, surely, to know that such work is going on.

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