McArthur University Professor Robert Merton, a 1997 Nobel laureate in economics for his work on options pricing and risk analysis, advanced the importance of "functional analysis of the financial system." (His experience with the system is both theoretical and actual; he was a principal in Long Term Capital Management, the extraordinarily leveraged investment firm whose collapse in 1998 nearly precipitated a world financial crisis and necessitated a bailout negotiated by the Federal Reserve; see a review of books on that precursor of the current situation here).
Although current concerns focus on liquidity and the credit markets, Merton said, it was essential to note that as too-high housing prices deflated, perhaps $3 trillion to $4 trillion of actual wealth had been lost in the last year alone—and was unlikely to return. With each successive decline in the value of an asset held on a leveraged basis, he said, an owner's effective risk and effective leverage ramped up at an accelerating rate, underlining the destruction of the financial institutions that held the underlying failed mortgage loans and securities based on them. In addition, such deterioration prompts "feedback": for instance, banks and thrift institutions held Fannie Mae and Freddie Mac preferred stock as part of their presumably safest, most reliable capital; when the government took control of those institutions, the banks' and thrifts' capital absorbed immediate, large losses—instantly increasing their own leverage and decreasing their ability to make loans, worsening the underlying housing crisis.
Financial innovation and "engineering" are widely blamed for causing, or worsening, the current crisis, and in a sense, they have, Merton said. Innovations inherently involve the risk that some ideas will fail, and inherently outrun existing regulatory structures. But rather than clamping down so severely that financial innovation is choked off, he argued that regulation must allow for further, future innovation as an engine of growth, because the functional needs—consumers' need to finance their retirements, developing nations' ability to fund economic development—remain intact. Thus, he urged that the focus remain on the necessary financial functions, and not on saving any particular form of institution that currently meets those needs, or did until recently.
Jobs in finance, he told the anxious M.B.A.s, would be "tough" to come by. But the solution for society would not be to rid financial institutions of highly trained, innovation-oriented financial engineers. Rather, he insisted, management teams, boards of directors, and regulators needed much more such expertise in their own ranks so they could understand the products they were offering and acquiring—as they so apparently did not in the recent past.
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Beren professor of economics N. Gregory Mankiw, who teaches the perennially popular Economics 10 introductory course and and is the author of the core introductory textbook in the field, said that "the basic problem facing the financial system is that lots of people made very big bets that housing prices could not fall 20 percent," despite evidence to the contrary in the Great Depression and more recently in Japan. The resulting losses wouldn't matter in classical economic theory, he said—taking risk entails absorbing loss—except that the simultaneous large bets undercut much of the financial system all at once, and that system, as readers of his textbook know, is vital for the economy as a whole. Federal Reserve chairman Ben S. Bernanke '75 (access his June Commencement address here) focused on just this problem in his examination of the role of bank failures in worsening the Great Depression, Mankiw noted.
How should one view the proposed $700-billion federal financing initiative, Mankiw asked. One theory, advanced by President George W. Bush the night before, was that financial institutions' damaged assets have value greater than their current price, and only the federal government has the resources to buy and hold them to maturity. Wall Street economists, Mankiw said, like that interpretation. Their (tenured) academic counterparts are skeptical: the Treasury, they say, will overpay, thus bailing out failed managers who don't deserve it; and/or the funds will be insufficient to recapitalize banks, given the real magnitude of the losses they face.
Academic economists' alternatives are three: let the market handle the situation (as hedge funds and private-equity funds step forward where they see attractive opportunities to invest fresh capital); have the government somehow take equity positions in troubled banks and other institutions, directly infusing them with capital but benefiting as they recover (much as investor Warren Buffett put $5 billion into Goldman Sachs, with the right to invest $5 billion more on favorable terms); or force banks to raise capital, no matter what (in the friendly manner, Mankiw suggested, of a Mafia enforcer dropping by for a chat with management).
As for the presidential candidates, Mankiw said, Barack Obama, J.D. '91, seemed to be saying that the market had run wild, inflicting on the public the downside of unfettered capitalism. Recalling his service from 2003 to 2005 as chair of the president's Council of Economic Advisers, Mankiw said that he had tried to rein in the government-sponsored Fannie Mae and Freddie Mac. Predecessors in the Clinton administration, he said, found the task impossible, too. This was a known "time bomb," he said, not a market problem. Nor was it simply a problem of lax underwriting standards for loans.
Of John McCain's emphasis on Wall Street "greed" and "corruption," Mankiw said, there was scant evidence that corruption was the problem. Many people made ill-advised bets, he said, but that was not criminal. And he suspected that greed would be a factor in the markets that any future administration would encounter.
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Cabot professor of public policy Kenneth Rogoff, former chief economist and director of research for the International Monetary Fund, tried to put the "truly incredible" recent developments in some larger context.
The financial sector of the economy, he said, had become "bloated"—accounting for 7 to 8 percent of jobs (including insurance employees), but capturing 10 percent of wages and 30 percent of profits. Such evidently huge returns naturally attracted torrents of new investment, making the financial sector as a whole a bubble: "It is too big, it is not sustainable, it has to shrink" even beyond its already depleting ranks. The problem, he said, is not merely bad debts held by institutions, but "bad banks" themselves: the whole sector of financial enterprises begs to be restructured. (Rogoff noted that he had for several months forecast the collapse of at least one large investment bank, but even he was surprised at the near-collapse of nearly all the principal investment banks virtually overnight.)
Much as auto makers or steel companies in the past argued that they were basic to the economy and therefore required federal support, he said, today the "country is being ransomed by the financial sector" in the demand for the $700-billion bailout, which would have the effect of maintaining management salaries, bidding up the prices of stock and bond holdings in their companies' portfolios, and so on. Today, unlike during the Great Depression, Rogoff argued, the shrinkage of such institutions would be "not unproductive" for the economy as a whole. (As an aside, he noted that all those Harvard students who marched off to investment banking "will be freed to go into other activities.") Given the difficulties of conducting auctions to buy distressed assets with the government's largess without letting excess funds leak back into the financial sector, Rogoff was sympathetic with Warren's argument for focusing on the needs of homeowners.
In international perspective, he said, the United States "has been running spectacular deficits" for 15 years or more. The availability of foreign funds has enabled the country to keep interest rates low—maintaining abundant liquidity—but has exposed the fragility of the system if federal budget deficits balloon. In the present instance, he said, the issue becomes a question of whether Beijing wishes to lend the United States $700 billion to repair American financial institutions. Americans aren't immediately going to be the source of those funds, he noted: "We're supposed to keep consuming." In other words, the country is saying, "We borrowed too much, we screwed up, so we're going to fix it by borrowing more."
He said a better strategy was required—but not at the expense of excessive regulation that would choke off innovation, one of the few flagships of American economic growth and strength in recent decades (a point also made by Merton at HBS on September 23, and again after Rogoff's presentation). After the dot.com bust of 2000-2001, Rogoff said, the technology sector regained its footing. Today, it is equally important not to overreact, so that a dynamic financial sector, corrected by "tough love," can resume its proper and important role in the economy and in future growth.