In the middle of the night, a policeman on his beat finds an economist walking around a lamp post, looking down at the ground. “What are you doing?” the policeman asks. “Looking for my wallet,” says the economist. “Where did you lose your wallet?”, the policeman wants to know. The economist points to the other side of the street. “It might be a better idea to look over there,” the policeman advises. “Yes, but it’s too dark over there.”
In some respects, this story relates to the financial crisis and its relevance for economic research. The crisis revealed that there were many things about financial markets which we did not know, and that much of what we thought we knew was not reality-based. This is not least because, some of the time, we economists act much like the one in the story. Often, we were looking where the light was, not necessarily where the knowledge was.
In that vein, precisely what the standard macroeconomic models were lacking was the financial sector, which made these models incapable of predicting the financial crisis. The framework of these models therefore needs to be broadened. In the meantime, many high-ranking economists are working on integrating the financial sector into standard macroeconomic models: Mark Gertler, Lawrence Christiano, Massimo Rostagno, Roberto Motto and Markus Brunnermeier, to name just a few.
But why was the financial sector missing from the models? Well, it is undoubtedly very difficult to model it mathematically. This seems to have been a hurdle initially not regarded as being worth overcoming. For we thought we knew something about the financial markets which has now turned out to be false.
We believed the financial markets would generally perform their task efficiently and smoothly. And if financial markets do what they are supposed to, at least most of the time, there is no need to model them specifically. However, it was the financial crisis, if not beforehand, which showed that the financial markets sometimes do not do what they are supposed to do — and on a large scale.
One issue in particular turned out to be a major problem in the crisis: banks’ systemic importance, the so called “too big to fail” problem. It is a core tenet of market economies that firms can fail. The economist Allan Meltzer once remarked that “Capitalism without failure is like religion without sin. It doesn’t work.”
THE SIDE EFFECTS OF FAILURE
Not taken into account with regard to banks were the side effects of failure. And one thing came to light in the crisis: these side-effects can be so severe that failure is no longer the basis of a healthy market but, in a worst case scenario, the downfall of the market. In order to prevent such a downfall, central government has to intervene and rescue banks. By creating flawed incentives, this implicit government guarantee ultimately exacerbates the underlying problem — a problem that the markets believe has still not yet been solved, as recent studies by the IMF and other institutions show.
Are these really new insights? To some, the issue sounds rather familiar. The premises of the Ordoliberal school of thought are often cited in this context. Walter Eucken is quoted again and again with respect to the “too big to fail” problem. More than 60 years ago, he came up with a short and snappy solution to the problem: “Whoever reaps the benefits must also bear the liability.”
Incentives are appropriate only where the banks’ shareholders and creditors are liable. And only where the banks’ shareholders and creditors are liable will taxpayers not be asked to foot the bill. The knowledge that regulatory policy came up with a fundamental answer to the “too-big-to-fail” problem decades ago is not the end of the road, however.
Although the principles of Ordnungspolitik are pointing in the right direction, they do not give us the precise route. They do not tell us the size at which a bank actually becomes “too big to fail”. They cannot help us understand the exact routes of contagion channels in the financial system. And they cannot help us develop the precise mechanisms for bailing in shareholders and creditors.
We need formal models to solve these problems. And this brings us to what post-crisis economic research needs to achieve: it must pour old knowledge into new models. Economics needs to seek the answers to its questions where they are actually to be found, even though there might not be a lamp to shine a light on the solution. I am confident, though, that the minds of those seeking the answers are bright enough to find the solutions no matter how dark it might be.