In April of 2009 Harvard University’s economics department hosted a symposium on the financial crisis, featuring as the main event Professors Randall Kroszner and Robert Shiller. This “face-off,” along with the comments of four discussants, more or less constitutes the text of Reforming U.S. Financial Markets.
While the intent was to offer differing “ends of the spectrum,” the symposium inadvertently illustrates the narrowness of the conventional wisdom on both diagnoses of and responses to the financial crisis. Perhaps it is due in part to having the symposium so soon after the crisis, but the solutions and analysis offered appear only remotely informed by the events of 2008; instead they reflect more the conclusions and biases held by the participants prior to the crisis.
After a brief and informative introduction by Harvard’s Benjamin Friedman, the first chapter, “Democratizing and Humanizing Finance,” offers a comprehensive overview of Yale Professor Robert Shiller’s research in behavioral finance. Shiller is best known for his book Irrational Exuberance and for a long, distinguished academic career. This chapter largely updates Irrational Exuberance. It also serves as a nice summary of the arguments advanced in Shiller’s 2008 book Subprime Solution, which was, if not the first pop-academic book published on the crisis, certainly close.
The thrust of Shiller’s position is that neither financial markets nor the existing regulatory structure incorporates how economic agents really make financial decisions. Shiller is quite explicit in seeing the efficient markets hypothesis (EMH) as a driver of both deregulation and lack of regulatory response to the speculative forces that led to the housing bubble. Since the EMH, in its simplest form, rejects the possibility of asset prices deviating from their fundamentals over long periods, Shiller sees the dominance of modern finance in the thinking of financial regulators as explaining the refusal of regulators to prick the housing bubble. Certainly the comments of regulators such as then-Chairman of the Federal Reserve Alan Greenspan lend credence to this view.
Unfortunately, Shiller does not consider other alternatives that could explain the same set of observed facts. Nowhere does he discuss the possible relationship between low interest rates and high home prices. Nor does he consider Public Choice explanations for the reluctance of regulators to address the growing housing bubble. As someone who spent that time as staff on the U.S. Senate Banking Committee, I can say those of us who attempted to get regulators to address the growing bubble were a small minority. Those opposed to restraining the housing market were not making efficient markets arguments; they were enjoying the political advantage that comes with trying to prolong an asset bubble. And in seven years on the Banking Committee staff, I never once heard a member of Congress or regulators invoke the EMH or anything resembling it. To lay the responsibility for the crisis at the feet of the University of Chicago’s economics department is to grossly exaggerate the influence of academia on actual policymaking.
Like Subprime Solution, Shiller’s analysis here is an important part of the debate over both the crisis and how financial markets work in general. Unfortunately and also like Subprime Solution, Shiller offers and endorses a variety of policies that either do not actually flow from his own analysis or that had almost no relationship to the crisis. For instance, he praises Dodd-Frank’s creation of a Consumer Financial Protection Bureau, but leaves out the important detail that almost everyone involved in the crisis, like Fannie Mae and your local real estate agent, is actually exempt from this agency's rules. Shiller further praises Dodd-Frank for increasing the discretion given to financial regulators. He argues that effective regulation “depends on the judgments of skilled regulators” while ignoring that these same regulators had a tremendous amount of discretion and power before the crisis yet still failed to effectively regulate. Perhaps this is Shiller’s greatest flaw; he correctly sees imperfect markets everywhere, but builds his solution on the false premise of perfect government.
What is ultimately so frustrating about Shiller is that while behavioral analysis is certainly an important part of the explanation, he too easily dismisses the explanatory power of market participants responding rationally to incentives. Why is a borrower, who is not being asked to make a down payment and is immune from recourse, somehow irrational in speculating in the housing market? And as Public Choice analysis demonstrates, the actions of both politicians and regulators, while socially irresponsible and reckless, were perfectly rational from their individual perspectives. Given the perverse incentives facing market participants, it should not be a mystery or challenge to modern economics why we observed so much perverse behavior. The mystery is: Why is the role of incentives, in both the private and public sectors, almost entirely absent from Shiller’s narrative?
The second chapter, by University of Chicago’s Randall Kroszner, appears to be intended to represent the Chicago efficient markets approach to financial regulation. In addition to his long history of scholarship in the area of banking regulation, Kroszner served as a governor at the Federal Reserve. This past is both a strength and a weakness. Having had a seat at the table during the crisis certainly provides Kroszner with some unique insights. But holding a leadership position at one of the institutions whose failures contributed to the crisis potentially biases his views.
For example: Not only do Kroszner’s remarks fail to even mention monetary policy; it is difficult to find any comment that challenges the current policy preferences of the Federal Reserve. The bulk of his remarks is essentially a laundry list of action items, such as reform of the credit-rating agencies, “improving” the resolution of financial institutions, encouraging centralized clearing for derivatives, and “improving” consumer protections. Where Shiller offers a sweeping theory of the crisis along with broad reform, Kroszner takes an incremental approach, keeping almost all of the current regulatory structure in place.
The most prominent feature of Kroszner’s chapter is actually what is missing: the influence of his own body of research. From this chapter you’d never guess, if you did not know already, that Kroszner has written on the ability of private markets to control financial market risk in the absence of government regulation. Despite his own research questioning the role of Glass-Steagall, he makes no mention of such. He advocates for centralized clearing of derivatives, again in contradiction of what his own research would suggest. One can only conclude that the chapter was written at a time when Kroszner expected to remain on the board of the Federal Reserve, for it appears to far more reflect the institutional biases of that entity.
Perhaps the most striking feature of Reforming U.S. Financial Markets is how much agreement, implied and otherwise, one finds in Shiller and Kroszner. Both appear to support the path ultimately taken in Dodd-Frank and both also accept a broad and expansive role for the federal government in regulating the financial markets. There is clearly far more agreement here than disagreement. But then that, I believe, is the real lesson of the symposium. Both left-center and right-center fail to see that this was not a crisis of markets, but of government-imposed distortions.