RSF Review

A professor of finance at MIT, Andrew W. Lo is an editor of the RSF volume Rethinking the Financial Crisis. The volume addresses important questions about the complex workings of American finance and shows how the study of economics needs to change to deepen our understanding of the financial sector.

Q: In a recent paper, in which you review more than 20 books on the financial crisis, you wrote, "there is still significant disagreement as to what the underlying causes of the crisis were, and even less agreement as to what to do about it." What is it about the financial crisis that has prevented economists from offering a definitive account of its origins?

More Research on the Financial Crisis
• Conference: Rethinking Finance
• Interview with Alan Blinder
• Paper: Reading About the Financial Crisis: A 21-Book Review

A: There are at least three challenges in understanding something as complex as the recent financial crisis: the breadth of knowledge needed to span the various parts of the financial system, the data, and the motivation. The crisis involved regulatory issues, financial innovation, real estate markets, accounting rules, investment and commercial banking, and monetary policy. No single individual has all the necessary expertise to span all these issues, which means that the individuals with the domain-specific knowledge must collaborate to piece together this incredibly intricate jigsaw puzzle. But even if we had the collective expertise, we would still need to gather significant amounts of data to test the various hypotheses proposed by the experts. Finally, while some of this forensic analysis is being done by economists such as those in Rethinking the Financial Crisis, much greater resources are needed to conduct a larger and more systematic analysis, and those resources aren't forthcoming because there isn't a consensus that we need to get to the bottom of these issues. For example, the Dodd-Frank Act was passed more than half a year prior to the final report of the Financial Crisis Inquiry Commission, and that report wasn't even able to come to a common conclusion (the bipartisan commission came to three mutually contradictory conclusions!).

Q: Many people believe that the financial crisis revealed major shortcomings in the discipline of economics, and one of the goals of your book is to consider what economic theory tells us about the links between finance and the rest of the economy. Do you feel that economists understand enough about the nature of financial instability or liquidity crises?

A: I think that the financial crisis was an important wake-up call to all economists that we need to change the way we approach our discipline. While economics has made great strides in modeling liquidity risk, financial contagion, and market bubbles and crashes, we haven't done a very good job of integrating these models into broader macroeconomic policy tools. That's the focus of a lot of recent activity in macro and financial economics and the hope is that we'll be able to do better in the near future.

RSF Visiting Scholar Jo Carol Phelan co-published a paper with Jeffrey W. Lucas in the December issue of the Social Psychology Quarterly. Here is the abstract:

This article explicates and distinguishes the processes that produce status orders and those that produce stigmatization. It describes an experimental study in which participants were assigned interaction partners before completing a task where they had opportunities to be influenced by the partners and opportunities to socially reject the partners. Results show clear influence effects of educational attainment and mental illness but no effects for physical disability. Social distance effects are present for mental illness and physical disability but not for educational attainment. Results additionally show that stigmatizing attributes combine with task ability in affecting influence and also suggest that task ability may reduce social rejection. These results indicate that stigmatizing attributes combine with status markers in a way similar to previously studied status attributes. The findings extend traditions of research on status and stigma while also having potentially important implications for strategies to reduce inequalities based on mental illness.

In an essay on the Newtown killings, visiting scholar Edward Mulvey argues that it is extremely difficult for mental health professionals to predict when patients with mental disorders may turn to violence. "There are a large number of withdrawn, socially awkward young men in our society; some have mental disorders and some don't," Mulvey writes. "We simply cannot predict which ones will go on a shooting rampage. It's like looking for a needle in a haystack; you will probably only know where it is when it pricks your finger."

Mulvey, a professor of psychiatry at the University of Pittsburgh, argues that policymakers and families should instead focus on providing support and treatment to those with a mental illness:

We will only know what is happening in a troubled person's mind by talking to them regularly before they are desperate. The idea of identifying, ostracizing and restricting them is not only inhuman, but impossible. We need to embrace them as members of our community who are facing immense struggles.

The Fall 2012 issue of Pathways, a magazine produced by the Stanford Center on Poverty and Inequality, features several RSF-funded briefs on the social fallout of the Great Recession. The reports are part of the Foundation's Great Recession initiative, which has funded more than two dozen projects in the last two years that will assess the effects of the Great Recession on the economic, political, and social life of the country.

Here are brief descriptions of the articles in Pathways:

Douglas S. Massey: The Great Decline in American Immigration?

Immigration has been a major component of demographic change in the United States over the past several decades, constituting at least a third of U.S. population growth and up to half of labor force growth in any given year. By any standard, it is a central feature of the nation’s political economy and thus especially important to monitor as the Great Recession plays out. This brief reviews levels and patterns of immigration to the United States over the past three decades, with a particular focus on their implications for the nation as it recovers from the worst economic downturn since the 1930s.

Christopher Uggen: The Crime Wave That Wasn't

This brief review of statistics before and since the Great Recession’s onset provides clear evidence for a decline in crime from 2007 to 2010. It also shows a consistent, albeit less steep, drop over that period in most correctional populations. To date, then, there is little evidence that great numbers of people have “turned to crime” in response to economic recession.

Sarah Burgard: Is the Recession Making Us Sick?

We pose the following questions: Is the recession lowering the aggregate level of physical well-being in the U.S.? Is it lowering the aggregate level of mental wellbeing? How has access to health care changed, if at all, with the recession?

S. Philip Morgan, Erin Cumberworth, and Christopher Wimer: Sheltering the Storm: American Families in the Great Recession

The decision to have a baby, to form or end a union, and to return to the nest are all family behaviors that might be sensitive to economic downturns. Is the recession indeed changing the family? And are "red" and "blue" families reacting differently?