A panel of Harvard economists discussed causes of the recent economic crisis, historical comparisons, various recommended regulatory responses, and the long-term effects of the downturn on employment and prospects for jobs at a session convened by President Drew Faust on October 12 in Sanders Theatre. The event reprised a 2008 panel (see also part two of a report on that event) that focused on the crisis as it was unfolding. (For additional background, see “After Our Bubble,” from the July-August 2010 issue.)
Faust noted that the discussion two years earlier had taken place at a time of “great turmoil” in which the “financial system was thought to be on the verge of collapse.” Then, the panelists had pointed to credit default swaps, excessive leverage, and deregulation as drivers of the crash. This time, she said, the participants would “take advantage of two years’ distance to seek some clarity about the causes of the crisis and the path to recovery.” Serving as moderator, she opened with a question for John Y. Campbell—Olshan professor of economics, chair of the department of economics, and a member of the board of Harvard Management Company (which invests the University endowment): “With the advantage of hindsight, how would you nuance this picture of the crash?”
Drawing an analogy to a sick patient, Campbell distinguished between the long-term or chronic problems in the economy—a low household-savings rate, underfunded and growing pension and healthcare liabilities, an inefficient tax system, and insufficient investment in public goods such as research and infrastructure—and the proximate or acute cause of the crash, which involved excessive risk-taking by major financial institutions. The rise of “shadow banks” was a particular problem, he said: these financial institutions don’t take deposits, and therefore weren’t subject to government regulation.
Brigitte Madrian, Aetna professor of public policy and corporate management at the Harvard Kennedy School and director of the social-science program at the Radcliffe Institute for Advanced Study later noted that before the crisis, American households were saving just 1 percent to 3 percent of their disposable income. That jumped suddenly to 6 percent, partly because access to easy credit was cut off. A higher savings rate is good, Madrian noted, but the consequence of that change in behavior is to prolong the crisis.
The road to recovery is a balancing act, Campbell emphasized: “The tough challenge we face is to rebalance the economy so that households save more and the government borrows less, but this rebalancing must be gradual to prevent the collapse of economic activity [and] to avoid damaging prospects for long-run growth.” But the balancing act is not only domestic, he said, with reference to the global imbalances in which the United States and other developed countries are borrowing and consuming unsustainably, while export-driven economies loan Americans the money to continue doing so. The path to recovery “requires cooperation from foreign countries that should rebalance their economies in the opposite direction,” Campbell said, summing up with another analogy: “The economy is like a bus on a winding mountain road. It needs to turn a corner, but can’t do so quickly or it will tip off the road altogether. And other drivers coming the other way must give us the space we need to make the turn.”
David S. Scharfstein, Converse professor of finance and banking at Harvard Business School, said that the regulatory system in place before the crisis was intended to deal with traditional banks that take in deposits and make loans. These institutions are inherently unstable without government support because they are subject to “runs” if panicked depositors all try to take out their money at once. But banks, including the “shadow banks” mentioned by Campbell, turned toward “market-based” banking—and that system proved unstable, too. The Dodd-Frank financial regulatory reform legislation is a step, he said, toward creating “a regulatory regime for dealing with non-bank financial institutions that pose systemic risk. Scharfstein noted that it is a constant struggle for regulators to keep up with innovations in financial products—which remain an important way of channeling savings to entrepreneurs. And he reserved some blame for “we financial economists [who] dropped the ball as this new system was forming….We can’t leave it to regulators to duke it out with Wall Street.”
Cabot professor of public policy Kenneth Rogoff, former chief economist and director of research for the International Monetary Fund, drew on his recent book on financial crises, This Time Is Different (reviewed here), to note that a common theme in such events is the “complacency” that builds up during a boom. But because—if things are being run well—such disasters happen “about as frequently as Halley’s comet,” such events fade from collective memory. What’s ahead, based on his studies? A combination of bad news and good: the bad news is that banking crises are followed by sovereign nations’ debt crises (as with Greece). The good news is that the crisis will end.
But high levels of unemployment could last 10 years before returning to normal levels, said Ascherman professor of economics Richard Freeman. We face a very difficult and slow recovery. Faust asked why China has recovered so much more quickly than the United States. Freeman said that China’s stimulus program was more effective, in part because the government could order the banks to lend the money they’d been provided. And China has lots of room for investment in necessary infrastructure projects. The massive layoff of workers in the cities did not lead to a crisis, as many economists had predicted, because these peasants returned home to their previous agrarian lives.
Faust then asked whether the United States had addressed housing as a distinct problem. Campbell replied that the country has not. Fannie Mae and Freddie Mac continue to be a problem, he said, and political pressure led the nation to go too far in pushing homeownership. A home “can be a ball and chain.”
The discussion then turned to the prickly problem of stimulus, which involves issuing more federal debt. How much stimulus is enough to avoid a double-dip recession, and, on the flip side, how much debt is too much? Freeman noted that the British are trying to cut their deficit now and we will be able to watch what happens to their economy, which bears some similarities to our own. They could push themselves into another recession, he said. Rogoff, who is concerned about the rising U.S. debt, nevertheless concurred: “There is nothing you should do [about debt] quickly,” he said. “But eventually something has to change”: taxes must go up, or spending must go down.
Campbell emphasized the political difficulties of enacting reforms before the next crisis hits. In some sense we are lucky, he said, because interest rates remain low and borrowing costs do, too. Noting the problems projected to face Social Security in 2040, for example, he said that politicians must at least “show that we can take some pain now,” perhaps by raising the retirement age. The problem of a shortfall is much easier to fix now than it will be as 2040 nears.
Returning to the analogy of the economy as a bus on a narrow mountain road, Faust asked for an assessment of how well we are driving. Madrian noted that “we don’t have a lot of experience with such crises—they don’t come along that often.” Freeman noted that the government’s ability to collect information about the economy is not very good. “We’re relying on old-fashioned” data-gathering techniques, so the “drivers don’t have such good information.” Campbell expanded on the thought, noting that the field of academic economics is likewise “slow-moving. We have very good, insightful papers coming out now about the technology boom” of the late 1990s. What we need, Scharfstein concluded, is for academic economists “to be engaged not just in academic debate, but to be more engaged with actual policy—and more engaged with Wall Street.”