Chapter 12. Learning from the crisis

References [ CPB | General | Scientific ]     Summary

Authors

Casper van Ewijk & Coen Teulings
Contact: Coen Teulings

In this chapter

The crisis is a crisis in the banking sector, not a crisis of the economic system in general.

The banking crisis is not a moral crisis, but ultimately the result of inadequate regulation.

Times of crisis, in particular, reduce the disciplinary effect of the reputation mechanism.

It is a misconception to think that shareholders' focus is short-term profit.

After years of steady economic development economic institutions were poorly prepared for a rare but major shock (a 'black swan').

International financial integration is important because it allows better diversification of risk, which leads to faster growth and higher living standards.

References

CPB

Wim Suyker and Henri de Groot , 2007, China and the Dutch economy: Stylised facts and prospects, CPB Document 127, Den Haag.

On how China's growth affected the Dutch economy. Argues that cheaper Chinese products are saving Dutch consumers an average of EUR 300 a year.

General

Nassim Nicholas Taleb, 2008, The Black Swan, The Impact Of The Highly Improbable, Penguin Books Ltd.

Brilliant book on how unique events determine world history and how people constantly tend to forget the existence of 'black swans'.

Coen Teulings, 2007, Moraliteit en marktwerking, een verstandshuwelijk?, Annalen van het Thijmgenootschap, jaargang 95, aflevering 3.

This article is an accessible discussion of the interaction between markets and morality, or between ethics and economics. Emotion is a way to bind us to our promises and good intentions, and thus contributes to the functioning of our society.

Scientific

Daron Acemoglu, January 2009, The Crisis of 2008: Structural lessons for and from economics, MIT.

A noteworthy thesis on the crisis and how to survive it, with wise lessons in humility for economists.

Robert H. Frank, 1988, Passions within Reason, Norton Company.

An analysis on the origin of our moral awareness and emotions, and their strategic role in the economic process. The author is both an economist and a psychologist.

John Kenneth Galbraith, 1954, The Great Crash. Mariner Books.

A classic work on the crisis of the 1930s. On how speculation in 1929 led to the Wall Street crash and what lessons we can draw from it.

Maurice Obstfeld, 1994, Risk Diversification, and Growth, American Economic Review 84, pp 1310-1329.

The author demonstrates that financial integration has a hugely positive effect on global economic growth and welfare.

Robert J. Barro, 2006, Rare Disasters and Asset Markets in the Twentieth Century, Quarterly Journal of Economics 121, pp. 823-866.

Economist Robert Barro discusses rare, yet far-reaching setbacks such as calamities and disasters. These range from wars to major economic crises like the Great Depression of the thirties. In statistical terminology, it concerns events from the tail end of the probability distribution. These must not be forgotten, warns Barro. It is a well known fact that stock market yields have fat tails; extreme results are more common than the standard regular distribution predicts. Barro argues that these catastrophes should also be taken into account when thinking about expected returns.

Robert Axelrod, 1997, The complexity of Cooperation: Agent-based models of competition and collaboration, Princeton University Press.

A wonderful book and highly readable, which analyses why people work with each other. The background is the game of a repeated prisoner's dilemma, for which Axelrod invented the "tit-for-tat" strategy. Especially noteworthy is his description of the cooperation between the hostile parties in the trenches in northern France during World War I.

Kenneth Binmore, 1994, Game Theory and the Social Contract, vol.1 en 2, MIT.

This book is serious scientific fare. It is about the meaning of norms and beliefs in repeated games of prisoner's dilemma. The book also gives a nice overview of the significance of evolutionary models for the possibility of cooperation in a repeated prisoner's dilemma.

Summary

This final chapter draws some lessons from the credit crisis. To start with, it argues that the crisis concerns the banking sector, and not the functioning of the system in general. Furthermore, the crisis is an economic crisis and not a moral one. More accurately, economists and policymakers seem to have put too much trust in the reputation mechanism in preventing opportunistic behaviour. Economic theory provides several reasons why this mechanism may fail in the banking sector and during crises, in particular. This calls for adequate regulation and a stronger position of the government vis-à-vis the shareholders in case of bank failures.

This is not to say that shareholders have contributed to the onset of the crisis. On the contrary, it is a misperception that shareholders' interests are short-term in nature and therefore at variance with the long-term thrust of the firm. One has to be suspicious therefore of proposals to limit the influence of shareholders. Similarly, international financial integration is not to blame for the crisis. Shocks to the economic system are inevitable, diversification of such shocks on a worldwide scale is a prerequisite to growth in the long run. Tentative simulations by Maurice Obstfeld indicate that international financial integration can increase average growth from 1.7 to 2 percent per year, corresponding to a welfare gain of 30 percent. A final lesson is that our institutions should be better geared towards risks and in particular towards rare - and therefore easily forgotten - catastrophic events like the Great Recession.

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