The global financial crisis: two camps

Economist Assaf Razin on financial deregulation, risk-shifting behaviour and the Philips curve

videos | September 9, 2015

What are the factors that led to the financial crisis of 2008? What are the two opposing views on the 2008 financial crisis and the ways of its resolution? What are the policies that need to be undertaken in case of a crisis? These and other questions are answered by Professor of Economics at Cornell University and Tel Aviv University Assaf Razin.

The global financial crisis started with what was called subprime mortgage crisis, but then it got into an explosion state when Lehman Brothers investment bank failed, that was in September 2008. So the collapse of Lehman Brothers started a collapse and meltdown of the entire financial system in the U.S. ,and it moved very rapidly to Europe and to the rest of the world, although, of course, the emerging markets, chiefly among them China, were not really affected so much. So you have this financial meltdown, and then after a few months through bailout efforts by the federal reserve, which is the central bank of the USA, and by central banks across Europe the financial situation stabilized, and within a year there was no memory of the hardship during this financial crisis, but then came the big depression which was something very much like the big depression from the 1930s. The financial crisis, although it was short-lived, transformed itself into huge depression which created unemployment and loss of output and a lot of hardships, economic hardships across the globe.

Economists, most of them didn’t really predict that we will get a second kind of a crisis in a century: the first one was the Great Depression of the 1930s and this one was in 2008, many decades later, because the economists were used to business cycles which were much more shallow, much more quick to be recovered, so it caught most of professional economists by surprise.

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And then when you thought about it, you saw that there were many factors behind it. Let me just give you a short list all of the many factors that were behind it: so, for example, it was the cumulative effect of financial deregulation – deregulation of banks and deregulation of the financial system. Hedge funds which were not regulated and were subject to runs on their money. Electronic trading, which was in some cases dangerous, because they were probing in the wrong way in terms of the amount of trading and all that. There will be moral hazards, basically misincentive across the financial system to misbehave, so people became more promiscuous, more risk taking, because they basically had a one-way gamble, so if they win, they win big, but on the downside they were protected by limited liability and all of that. So that created risk-shifting behavior. There was the regulatory laxness, the regulatory institutions were very laxing in terms of looking after the operation of the credit and the banks and so forth. There was more deep economics issue of how the Central Bank is running the show.

For economists since 1960s there was the notion of Central Bank going around the Phillips curve. Namely, there’s a trade-off between inflation and unemployment, and when there is high unemployment, you become more expensive in terms of your monetary policy, because you are less afraid of inflation, so the interest rate went down, went down on many-many steps. What happened that it went all the way down to zero. And the zero lower bound is a very dangerous place to be. because it creates, completes this equilibrium, and we are not accustomed to it, because we saw that the Central Bank can avoid going into all the way to the zero lower bound. And then the the U.S. Crisis swept into Europe, and Europe was really ripe for such a crisis, because Europe also had bubbles – like in Spain, the real estate bubble, or in the UK, or in Ireland.

We didn’t know it, but Europe, especially those who are inside the Eurozone, were basically very fragile when a shock like that happens

Because the eurozone is about of a single currency area where there is just one central bank (in Europe it is the ECB), and the individual, the national central bank cannot really do stabilization on their own, so when a shock comes into Spain or to Ireland, the ECB is very, very late in attending the shock. In the U.S. it was instantaneous, because it is a federal system, Fiscal Union, Banking Union – everything is coordinated from the center, and they could react very quickly. Not so in Europe. And this is why Europe is still in crisis many-many years after the U.S. recovered.

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About economists: I just described to you the complexity of what is going on, and the surprise among economists of the actual thing that happened. But then when it happened, the economists split into two groups, or two camps if you like, two intellectual camps.

The one camp, which I’ll call a “Ricardian camp”, believes that the market can solve everything as by itself, so that there is a built-in stability within the market economy. I call it ‘Ricardian’ after the name of David Ricardo from the early 19th century, because the model that these guys, or this camp, were using is a model where capital flows smoothly, there is an arbitrage relationship between the short-term interest rate and the long-term interest rate. The long-term interest rate is just a compounding of a sequence of short-term interest rates, so arbitrage conditions, which means that there is perfect choice whether to buy long-term or short-term and the arbitrage will make everything very unified. Credit flows smoothly, prices are not very sticky for a long run, so unemployment is reversed relatively quickly. So this camp, the Ricardian camp, when they were faced by the crisis, and they saw the bailout policies by both the Treasury and the Central Bank, they were very-very worried. They thought, according to their model, that because they believed that there would be a quick recovery and the credit flow would be zoomed very quickly, that it will be extremely inflationary. So they predicted back in 2008 and 2009 that the policies will create an inflationary situation.

And obviously they were wrong, but they basically extrapolated from what they had experienced during the Great Moderation period. Prior to this crisis there was what the economists called ‘the Great Moderation’ where credit flowed very nicely, where arbitrage across different assets and all of that was very smooth and very well-functioning markets. And the business cycles were very, very… You know, not too volatile. So there were ups, and there were downs, but not too much. And they believed in what is called the real business cycles, so the cycles, according to them, of the business are basically coming from the supply side, from productivity changes, there is an up in productivity because of innovation like Internet or something like, and that that would create a boom. And then there will be some other shocks on the supply side that will create a trough. But all of that will be self-equilibrated. So they basically took their experience from the Great Moderation period and they were completely wrong.

The other camp basically looked back at the literature prior to this Ricardian model of economics and the real business cycle economics, and they looked back at what John Maynard Keynes was doing. And John Maynard Keynes was basically analyzing the Great Depression. So this is why the other camp was looking at John Maynard Keynes – because the depression that came after 2008 crisis was very much similar to the depression in the 1930s. And in both cases the interest rate went all the way down to zero, it reached the lower bound. It’s called liquidity trap, and that was the main part of the Keynesian theory that you have to learn from.

So, where the other camp was basically saying: “okay, we are in an entirely different world, economically speaking, than a Ricardian economy, because credit is not flowing, arbitrage is not taking place, everything comes to a standstill, and the interest rate is all the way down to the lower bound of the interest rate which is zero”. And when it is zero, all sorts of crazy things can happen, because there would be excess-saving overinvestment at a zero level. So you have a very big reason for unemployment of resources, so you have to use policies, like actually the Federal Reserve was doing, of bailing out financial institutions. You have to do stimulus package on the fiscal side, like the Treasury did. So all the policies that were basically advocated by Keynes during the Great Depression were basically the policies that were used into 2008 and on. And that was basically to the idea… The theory behind it was residing with the other camp.

So there were two camps: there was the Ricardian camp, and there was the non-Ricardian camp. The Ricardian camp was preaching for fiscal austerity. The non-Ricardian camp was preaching for stimulus on the fiscal side – the opposite of austerity. The Ricardian camp was predicting inflation; the non-Ricardian camp was worried about deflation when prices are persistently falling from one period to the other. And this is deflation which creates a lot of problems in terms of the running of the economy, the activity level. So at the end, now as we look today at what happens in the economics profession, the Ricardian camp lost ground in terms of its understanding of depression like shocks, like the one that came in 2008. But the non-Ricardian camp which is now the mainstream camp basically studied very carefully what you do when you get into a deep depression, and it takes years to do the leveraging of the debt that cannot be paid very quickly and that creates a long recession and a long recovery period. Basically in the economics profession there is a winner and there is a loser: the winner is the non-Ricardian camp, the loser is the Ricardian camp.

Professor of economics, Cornell University and Tel Aviv University
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