2012.04.11 - Learning from the Global Financial Crisis with Economics Nobel Laureate Peter Diamond « hongkongandbeyond

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11/04/12 19:00Learning from the Global Financial Crisis with Economics Nobel Laureate Peter Diamond « hongkongandbeyond
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Posted by: Reyhan | December 5, 2011
Learning from the Global Financial Crisis with Economics
Nobel Laureate Peter Diamond
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11/04/12 19:00Learning from the Global Financial Crisis with Economics Nobel Laureate Peter Diamond « hongkongandbeyond
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I attended a fascinating and very entertaining talk given by Peter Diamond, the 2010 Economics
Nobel Laureate, this evening on Monday December 5th, 2011 at the Chinese University of Hong
Kong. The lecture was part of their Nobel Laureates Distinguished Lectures series sponsored
by the Sun Kai Properties, and Peter Diamond was the twenty-third Nobel Laureate to speak
under this program. The MIT Professor Emeritus Mr. Diamond discussed the process of
learning from various economic crises, paying specific attention to the current global economic
crises, but also mentioning the stagflation of the 1970’s and the collapse of communism. He
reviewed the influences of the current crisis, as well as how these issues should be addressed
through further economic research and practical economic policy to prevent further economic
disasters.
Diamond began by discussing how economic crises play crucial roles in determining the way
policy makers respond to economic shocks and other situations which may be perceived as
potential crises. He drove the point that policy should not be stagnant, but rather dynamic and
flexible to change to match the changing world that we live in. Specifically he referred to the
stagflation of the 1970’s where both high rates of inflation and unemployment were present,
defying the classic notion of the Phillips Curve, which states that inflation and unemployment
should be negatively correlated. However, as Diamond points out, the original Phillips Curve
failed to account for how consumer expectations can interact with macro policy. It was
previously believed that loose monetary policy, essentially printing money, was an effective way
to combat recession by pumping liquidity into the system. However, in the case of the 1970’s,
11/04/12 19:00Learning from the Global Financial Crisis with Economics Nobel Laureate Peter Diamond « hongkongandbeyond
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which was instigated by the OPEC oil shock, the growth of money supply was excessive;
workers and firms anticipated inflation from the expansionary monetary policy, thus negotiating
higher wages to offset inflation, leading to a higher level of unemployment. As a response to the
discovery of the role expectations play in the effectiveness of monetary policy, the Central Bank
now surveys individuals to assess their expectations to determine how successful proposed
policies will be. Similarly, other economic policy developments were determined from the
lessons learned from stagflation such as dynamic stochastic trends and real business cycles.
Diamond also addressed the lessons learned from the collapse of communism, specifically the
fact that creating a successful market economy is a quite difficult task. While the West was a
strong proponent of capitalism, creating a capitalist economy in a former state controlled
economy is not as simple as it seems. Elements such as firm behavior, consumer behavior,
market infrastructure, and government regulation influence the shaping of the market economy.
Regarding the current global financial crisis, Diamond mentioned the misconceptions of the Fed
concerning bubbles. Alan Greenspan believed that he was very familiar with managing bubbles,
given his past experience with the stock market, so it is not surprising that his successor Ben
Bernanke maintained similar notions regarding the appropriate policy for bubbles, and
underestimated the housing bubble. Diamond makes the obvious but very valid point that
houses are a very different commodity than stocks in terms of their liquidity, volatility, and the
difference in the social effect of a housing-based economic crisis from one in the stock market.
He notes that a very small number of citizens actually hold a concentration of their wealth in
stocks, relative to the number of home owners and those affected by the sub-prime mortgage
crisis in America. While a stock market crash is catastrophic, the biggest losers are typically
those who are most able to bounce back. It is much easier for stocks to regain their value than
for homes that have plummeted in worth to return to their original value. Furthermore, homes
are not liquid assets, and are sold much less frequently; they are not easily transferrable
assets, as evident in the current crisis. Therefore, it is not surprising that the Fed was not able
to fix the fallout from the housing ordeal by pumping liquidity into the system, and instead their
efforts were met with a “liquidity trap.” Diamond also briefly touched on the issue that the
bubble was allegedly caused by the Fed maintaining low interest rates longer than it should
have, making borrowing easier than it should have been.
In addition to the housing bubble, Diamond discussed the role of mortgage backed securities
and derivatives in the global crisis. It was the usual story of the severe deterioration in credit
standards from the ability of financial institutions to remove their risk by selling it to third parties,
creating acute moral hazard. Similarly, as a result of the irresponsibility of lenders, borrowers
were encouraged to borrow more than they should, with questionable mortgage deals on the
table, such as the adjustable-rate mortgages. Therefore, Mr. Diamond believes it is crucial to
develop organizations that protect borrowers from unscrupulous lenders, and he praised the
efforts of the creation of the Consumer Financial Bureau, which is designed to protect
consumers’ interest from the moral hazard of financial institutions, a legislation that was very
unpopular with banks. He notes that its major proponent Elizabeth Warren argues that “We
should protect consumers financially like we do to protect the public of their physical safety.”
Diamond remarked that derivatives are very different than just stocks, and that in recent years
they have become very complex repackaged securities that are not easy to properly value. He
mentioned the argument from fellow economist Samuelson, who argued that “leverages can
expose you to a far greater amount of risk than you are actually aware of,” and that you can
“have very large losses with derivatives.” Unlike stocks which have a maximum loss of zero
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when profit is zero, derivatives can potentially have an unlimited loss. However, Diamond also
points out the argument of the economist Merton, who states that “financial engineering has
greatly enhanced business around the world” so that capital can move across borders where it
needs to. Samuelson rebuts this by noting that innovators always move ahead of responses to
innovation, with these responses being the users of the innovation and the regulations that
governments place on that innovation. He notes that fasttrends must be watched very
carefully, because you “don’t build fast trains before you finish building the tracks or you will
have massive train crashes.” However, Diamond also addresses the issue that rule making
should still be monitored and flexible, as new rules with good intentions can have even worse
consequences.
Diamond contended that derivatives became very attractive during the Clinton administration
because derivatives had different rules for firms in terms of bankruptcy because derivatives
have collateral involved. He concurred with Mark Roe that a new set of bankruptcy laws for
derivatives is needed to properly address this problem. He also argued that the current
collateral rules for derivatives should perhaps be banned, as they put firms in a very vulnerable
position, susceptible to short-sellers and others who stand to profit off of their losses.
He also argued that the massive stock options given to CEOs should possibly be rethought.
While shares were originally given to CEOs as an attempt to address the principal agent
problem in corporation, that the CEO’s interest was not necessarily in-line with the shareholder.
However, Diamond argues that this is an unwise policy, and that alternative strategies that
focus more on the long term health and growth of the firm should be sought out instead, like
those suggested by Lucian Bebchuk. Bebchuk proposes that strengthening the rights of
shareholders would limit the incentive to take risk, but also notes that direct legislation from
government is still needed because shareholders do not necessarily hold the firm’s best interest
either. Additionally, Diamond argues that more attention should be placed on long-term
incentives as to focus on the long term growth of the firm.
Another topic Diamond addresses is the importance of liquidity for banks to remain liquid
enough to cover a significant portion of their liabilities to prevent moral hazard and bank runs.
He notes that some improvements have already been made, with the current Liquidity
Coverage Ratio, which requires significant financial institutions to maintain enough constant
liquid assets to cover outflows of 30 days. This essentially terminates the existence of the risky
banks that were reliant on daily rollovers to prevent their collapse. Similarly, the Net Stable
Ratio has been implemented, requiring significant financial institutions to cover a fraction of the
likely outflows over an entire year of estimated liabilities.
Diamond ended his presentation on negative externalities and risk. He comically noted that “if
you can make the generator of a negative externality pay 100% of the cost it would be okay,
but the world is more complicated than that.” Not only is it difficult to quantify the exact cost of
an externality, it is also difficult to make the offender pay for their transgressions. He notes that
oftentimes policy tends to concentrate on the behavior which can be regulated, and while this is
not a perfect solution, it’s the best one we have. He maintains that policy makers must find a
way to balance desired behavior with the unexpected unintended consequences of the
imperfect corrections of policy makers, which often distort decisions and results. He finally
notes that bankers should be more proactive with adjusting risk premia to its proper level, and
that if risk premia is going lower than it should, that bankers should take the initiative to raise it
to its proper value so that further crises can be avoided.
11/04/12 19:00Learning from the Global Financial Crisis with Economics Nobel Laureate Peter Diamond « hongkongandbeyond
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After his presentation, Diamond was asked a number of questions, one of which concerned
China. The exact question was, “Some say China is playing a Western game, but China’s
reaction has saved it from some of the current Western troubles, so what do you think of
China’s model?” Diamond responded to this question by mentioning the “introducing market
phenomenon,” stating that China has and had large potential labor forces in rural areas with low
productivity, so the migration of workers from places with low productivity to high resulted in
huge growth, similar to the migration from the agricultural sector to the industrial sector in the
US in the past. He agreed that although China was spared from some of the consequences that
came from buying complex derivatives, other countries such as Australia were not caught up in
buying toxic assets either. Diamond further stated that despite China’s extensive growth, it still
lacks adequate codes and a legal system to protect consumers and business owners, and that
the current system in place in China is not reliable or fully functional. He argued that China
currently does not have the same consumer protection that Western cities have, and that China
still needs to take more important steps in policy development to maintain stable growth in
regards to protecting entrepreneurs and innovation. He ended this comment by saying, “China
has a long way to go in economic reform to keep things going this well,” but he also noted that
he is hopeful that they can achieve this.
Another point Diamond mentioned during the Q&A session was that there are two things that
everyone should really take from the financial crisis. The first was that no one should be too
reliant on the rating agencies as before. He contested that this is already happening though,
with evidence of the dip and return of US interest rates after the downgrading of US bonds. The
second was that he hoped there will be more experimentation in policy regulation around
incentives and rules.
Reading Suggestions:
-Reinhart & Rogoff’s This Time is Different
Posted in Economics, Globalization, Intellectual Observations | Tags: banks, China,
Communism, CUHK, debt, derivatives, economic policy, economics, finance, financial crisis,
financial engineering, growth, Hong Kong, liquidity, macro policy, MIT, moral hazard, Nobel
Laureate, Peter Diamond, Phillips Curve, regulation, risk, stagflation, US Financial Crisis
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