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Read the Forbes article, What About Microeconomcs?, by Robert Crandall and Clifford Winston. (It is accessible under the Articlestab on the Blackboard menu). Consider the authors’ points of view in relation to Mankiw’s discussion of basic principles of economics, the distinction between macro and microeconomics, how economists use models to develop “theories” about how the economy works, and why economists sometimes (frequently?) disagree. Then respond to the following questions/prompts:Clarify, in some detail, the distinction between macro and microeconomics, as both Mankiw and the authors of the article describe it.Discuss Principles #6 and #7 (Mankiw Chapter 1, Ten Principles of Economics); Do the authors agree or disagree with these principles?In the view of the authors, was the “Great Recession” of 2008-09 a macro or microeconomic problem? Why?What is the authors’ view of the efficacy of government actions to aid recovery from the 2008-09 recession? Do you have a view?Discuss: “Deregulation leads to market failures”.What do you think “tails of the distribution” means?FORBES
Robert W. Crandall and Clifford Winston
10/05/2009 @ 12:01AM
What About Microeconomics?
In a recent New York Times Magazine article, Paul Krugman laments the current state
of macroeconomics (the study of the determinants of an economy’s level of output and
employment) that blinded us to the forces that, in his view, caused the current recession.
However, he never mentions the state of microeconomics.
Microeconomics is the study of how firms and consumers make decisions in markets
and how the government tries to address conditions that lead to “bad” decisions. And it
has not suffered any serious intellectual setbacks from the current Great Recession.
Indeed, the causes and cures of this recession are more about microeconomics than
about macroeconomics.
Microeconomists’ theoretical and empirical contributions have taught us that market
failures do exist but that the government rarely, if ever, can be counted on to correct
those failures efficiently. Nothing in the last two years has undermined microeconomic
analyses that influenced the deregulation of the airline, trucking, railroad, natural gas,
crude oil, telecommunications and cable television markets. These deregulatory
successes have not been compromised by the market failures that originated in the
financial sector and are at the heart of the Krugman lament. But even if Krugman could
uncover a theory that integrates irrational exuberance in financial markets with
macroeconomic performance, it would hardly guarantee improved performance of
government regulators. Nor would it enhance our considerable knowledge of how
markets correct after sharp downturns.
The market failure that generated the current crisis is by now well-known: the rapid
growth of subprime mortgages and the failure of many homebuyers and investors to
understand and properly weight credit risks. Unfortunately, banks and rating agencies
underestimated the probability of a major decline in housing prices and believed that
they could measure the interrelatedness of credit risks. Financial firms, consumers and
regulators did not adequately account for outliers–very low-probability events–that
turned out to be important, leading to a wave of financial institution failures that caused
great pain to the real economy.
Most of the defaults were centered in regulated financial institutions that purchased,
securitized and even invested in the subprime and Alt-A mortgage debt that triggered
the financial collapse. Even some of Bernie Madoff’s operations were subject to federal
regulation. Notably, though posting large losses, unregulated financial institutions, such
as the large hedge funds, have not required the government’s assistance to survive.
Calls for improved financial market regulation are understandable, because unregulated
mortgage brokers offered many households mortgages that they subsequently could not
afford once home prices stopped rising. But these brokers did so only because regulated
financial institutions willingly bought those mortgages. Many of the dodgiest mortgage
products ended up in off-balance-sheet entities of regulated financial institutions less
than 10 years after Enron collapsed when its off-balance-sheet entities imploded.
Krugman argues that economists need new models that incorporate irrational behavior
in financial markets. But will such theoretical models keep regulators from making the
same mistakes when the next speculative bubble occurs?
Now that we are well into the Great Recession, little evidence exists that the
proliferation of Treasury and Federal Reserve bailout operations is bringing us out of it
any more rapidly than we might have expected from normal market forces. A major
easing of monetary policy should prove helpful, but will there be any evidence that the
various twists and turns in the Troubled Asset Relief Program (TARP) or the Term
Asset-Backed Securities Lending Facility (TALF) actually shortened the recession? And
plenty of economists question the efficacy of the stimulus package, given the slow
disbursement of funds and the use of these funds on a variety of dubious projects.
On the other hand, there is substantial evidence that consumers and firms generally
learn–and learn quickly–from market failures attributable to imperfect information.
Both have moved aggressively to shore up their balance sheets. Risky, subprime
mortgage originations have all but disappeared. Indeed, there is little historical evidence
that the costs of alleged information failures have merited much attention. The events of
the last few years were surely different, but their possibility was not ruled out by
established microeconomic theory.
In retrospect it will be clear that markets responded quite well to the financial crisis,
generating an economic recovery–much as they always do. No emergency government
action addressed the problems in the housing market created by excessive speculation
and by the encouragement of non-creditworthy buyers to assume large mortgages. As
economists would expect, recovery in housing could occur only when prices fall to
sustainable levels, excess inventories are drawn down through a reduction of new starts,
and financial institutions write down the debt that they issued on over-valued houses.
All of those market corrections are well underway and have little to do with TARP, TALF
or government seizure of Fannie Mae and Freddie Mac .
Equally important, the credit markets have stabilized and credit spreads have narrowed
substantially, particularly for firms that have managed their balance sheets
well. Microsoft has recently issued bonds that sold at very low spreads over Treasuries.
Even the concern over credit-default swaps issued by large, troubled financial
institutions now appears to have been overstated as large volumes of those positions
have been successfully unwound with little systemic effect.
Throughout this economic crisis, no one has presented credible evidence that the
deregulation of transportation, energy and communications markets has been a
mistake. Whatever the market failures in the early 20th century, government efforts to
correct them failed. Deregulation was and still is the correct policy in those sectors.
Moreover, it will be quite difficult for policymakers to improve financial regulation other
than by directly regulating leverage more carefully. In the meantime, Americans can rest
assured that financial markets are quite sensitive to the interrelatedness of credit default
risks and that renewed efforts are being made–and will continue to be made–to manage
financial risks more effectively with a theory of finance that goes beyond a focus on the
“mean and variance” of returns and pays appropriate attention to risks at the tails of the
distribution. The next financial market failure will result in still another advance in the
market’s ability to manage risk and in the unsettling realization that government can do
little to prevent markets from failing and to improve how they self-correct.
Robert W. Crandall and Clifford Winston are senior fellows at The Brookings
Institution. Winston is the author of Government Failure Versus Market
Failure (Brookings, 2006).

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