Rethinking the Financial System
In the wake of what has been called the worst economic meltdown since the Great Depression, theories about what started the financial crisis and how that crisis may have worsened the current recession are ubiquitous. Less common, however, is sound, politically unencumbered empirical research on the causes and consequences of the crisis. With this in mind, the Russell Sage Foundation has joined with the Century Foundation to support a group project to reconsider the American financial system. The project, directed by Alan Blinder (Princeton University), Andrew Lo (MIT) and Robert Solow (MIT, emeritus, and RSF Merton Scholar), will commission several papers that, in the broadest sense, achieve two specific goals: to provide not only a retrospective analysis of the financial crisis but also develop useful ideas for immediate attempts to reform financial regulation; and to reflect a considered view of what modern economics understands about the interaction between financial activity and the “real” economy of production, employment, consumption, and investment.
The project is currently considering several topics which will be researched and developed into potential book chapters. For example: Is the financial system overgrown? The basic socially valuable function of finance is to improve the efficiency of the real economy by mobilizing dispersed savings and allocating them to those business firms with the most productive uses of capital, and also by redistributing the risks that inevitably arise in production and investment from those who are least willing or able to bear them to those who are most willing and able. There is plenty of evidence from emerging economies that the absence of financial depth is a handicap in the process of economic growth. It is possible, however, that modern, elaborate financial systems have exhausted those opportunities and by now cater mainly to speculation and the exploitation of asymmetries in information. A related but slightly different topic for exploration is about the economic value of financial innovations. While it is likely that new, exotic securities add to the liquidity of financial markets, which enhances the productivity of the real economy, it is less certain whether such innovations actually help to equalize rates of return on capital across economic sectors—one measure of the real efficiency of finance. It may be that financial innovations, by demanding more knowledge than market participants can have, and by enlarging the differences among market participants in what they actually know, contribute to market instability and to the likelihood of breakdowns. This topic encompasses such issues as the sources of massive mortgage defaults (inappropriate borrowers, sharp lending practices, opaque lending terms, excessive optimism about house prices, etc.). The topic could be enlarged to address such issues as the implications of the non-recourse character of mortgage loans in the United States and the much broader issue of the role of securitization and the lend-and-distribute model, not only in mortgages but also in student loans, auto loans, etc.
Other questions under consideration include whether the recent crisis has changed our understanding of the transmission mechanism that runs from the financial system to the real economy. If financial shocks cannot be wholly avoided, how can the working of the real economy best be insulated against shocks that originate in finance? The project will continue its work through 2011, which includes refining topics under consideration and commissioning authors for the research papers. The resulting book will be published by the Russell Sage Foundation.