Monday, December 17, 2007

The Crisis of 2007: The Same Old Story, Only the Players Have Changed

A well known tradition in monetary economics which goes back to the nineteenth century and in the twentieth century was fostered by Wesley Mitchell ( 1913), Irving Fisher (1933), Hyman Minsky (1957) Charles Kindleberger (1978) and others. It tells the tale of a business cycle upswing driven by what Fisher called a displacement (an exogenous event that provides new profitable opportunities for investment) leading to an investment boom financed by bank money (and accommodative monetary policy) and by new credit instruments --financial innovation. The boom leads to a state of euphoria where investors have difficulty distinguishing sound from unsound prospects and where fraud can be rampant. It also can lead to a bubble characterized by asset prices rising independently from their fundamentals. The boom inevitably leads to a state of overindebtedness, when agents have insufficient cash flow to service their liabilities. In such a situation a crisis can be triggered by errors in judgement by debtors and creditors in an environment changing from monetary ease to monetary tightening. The crisis can lead to fire sales of assets, declining net worths, bankruptcies, bank failures and an ensuing recession. A key dynamic in the crisis stressed by Mishkin ( 1997) is information asymmetry ,manifest in the spread between risky and safe securities, the consequences of which( adverse selection and moral hazard) are ignored in the boom and come into play with a vengeance in the bust. (Michael D. Bordo, Rutgers University and NBER Remarks prepared for the Federal Reserve Bank of Chicago and International
Monetary Fund conference; Globalization and Systemic Risk.
Chicago, Illinois September 28, 2007)