Sunday, January 25, 2009

Acemoglou on the origins of the current crisis

I recently read this article by Daron Acemoglu of MIT (The Crisis of 2008: Structural Lessons for and from Economics) in which he points at 'three notions (which) impelled us to ignore these impeding problems and their causes'.

The first one was the mistaken belief that 'the era of aggregate volatility had come to an end'.
We believed that through astute policy or new technologies, including better methods of communication and inventory control, the business cycles were conquered
But, he continues, 'greater interconnections that are an inevitable precipitate of the greater diversification create potential domino effects among financial institutions, companies and households'. Also, much of the Schumpeterian 'creative destruction' that takes place at the micro level may (now) have aggregate implications as replacement of core businesses by new forms and new products takes place (now) in companies that are large in size.

The second notion focuses on the role of institutions but not as they relate to the development process (an issue we discussed recently in class) but as they change 'in the face of ever evolving economic relations' in advanced economies.
Forgetting the institutional foundations of markets, we mistakenly equated free markets with unregulated markets. Although we understand that even unfettered competitive markets are based on a set of laws and institutions that secure property rights, ensure enforcement of contracts, and regulate firm behavior and product and service quality, we increasingly abstracted from the role of institutions and regulations supporting market transactions in our conceptualization of markets.

Few among us will argue today that market monitoring is sufficient against opportunistic behavior. Many inside and outside academia may view this as a failure of economic theory. I strongly disagree with this conclusion. On the contrary, the recognition that markets live on foundations laid by institutions -that free markets are not the same as unregulated markets- enriches both theory and its practice. We must now start building a theory of market transactions that is more in tune with their institutional and regulatory foundations. We must also turn to the theory of regulation -of both firms and financial institutions- with renewed vigor and hopefully additional insights gained from current experience. A deep and important contribution of the discipline of economics is the insight
that greed is neither good nor bad in the abstract. When channeled into profit-maximizing, competitive and innovative behavior under the auspices of sound laws and regulations, greed can act as the engine of innovation and economic growth. But when unchecked by the appropriate institutions and regulations, it will degenerate into rent-seeking, corruption and crime. It is our collective choice to manage the greed that many in our society inevitably possess. Economic theory provides guidance in how to create the right incentive systems and reward structures to contain it and turn it into a force towards progress.
The last notion is that the discipline considered that 'even if we could not trust individuals, particularly when information was imperfect and regulation lackluster, we could trust the long-lived large firms'. These large companies would 'monitor themselves and their own because they had accumulated sufficient reputation capital'. We had called this 'reputation capital' in class 'brand name'. We had mentioned (I think) that Burger King, for example, would not serve lower quality burgers anywhere, even on a highway, because it would risk losing millions it had invested in its brand name image.
Our trust in the self-monitoring capabilities of organizations ignored two critical difficulties. The first is that even within firms, monitoring must be done by individuals -the chief executives, the managers, the accountants. And in the same way as we should not have blindly trusted the incentives of stockbrokers willing to take astronomical risks for which they were not the residual claimants, we should not have put our faith in individuals monitoring others simply because they were part of larger organizations. The second is even more troubling for our way of thinking about the world: reputational monitoring requires that failure should be punished severely. But the scarcity of specific capital and know-how means that such punishments are often non-credible. The intellectual argument for the financial bailout of the Fall 2008 has been that the organizations that are clearly responsible for the problems we are in today should nonetheless be saved and propped up because they are the only ones that have the 'specific capital' to get us out of our current predicament. This is not an invalid argument. Neither is it unique to the current situation. Whenever the incentives to compromise integrity, to sacrifice the quality, and to take unnecessary risks are there, most companies will do so in tandem. And because the ex post vacuum of specific skills, capital and knowledge that their punishment will create make such a course of action too costly for the society, all kinds of punishments lose their effectiveness and credibility.
(but, even if it makes sense to 'save' the organizations, what is it that prevents punishment of (some) of the individuals? I must admit that I lost his argument here)

The rest of the article is also interesting. I want to conlude this post with one last quote from this short paper:
It is one thing for the population at large to think that markets do not work as well as the pundits promised. It is an entirely different level of disillusionment for them to think that markets are just an excuse for the rich and powerful to fill their pockets at the expense of the rest.
The article is useful for IB economics candidates as it exposes them to higher level arguments (beyond referring to the subprime crisis) in discussions regarding the possible origins of the current mess(for exams, commentaries, presentations etc).

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