Most economists think that macroeconomic disruptions, such as the current recession, can be understood in terms of aggregate indicators such as total employment, the price level and the money supply. But this view is misleading, particularly in the current economic situation. Worse yet, it misleads us into pursuing counterproductive economic policies.
As the economist Fischer Black explained, an economy matches a population’s desires to the available resources and production technology. When an economy is operating efficiently, expectations are largely fulfilled; desires, resources and production technology are well matched; and people are reasonably satisfied with their plans, relations and contracts.
But if the world evolves in a markedly unanticipated direction, people’s existing plans, relations and contracts require revision. The existing matches between desires, resources and production technology deteriorate. While this revision occurs, resources are diverted from production, which is less efficient and less well matched with consumer desires, resulting in a reduction in the value of output — a recession.
This “realignment theory” helps explain the current downturn. From 2000 through 2007, millions of US homeowners entered into mortgage contracts to finance their homes. Securities based on those contracts ended up, in part, in the hands of financial institutions. But the adequate servicing of the debt and, therefore, the performance of the securities, were based on expectations of continued rises in housing prices that proved to be unrealistic. When housing prices fell, so did the value of the mortgages and the securities based upon them.
Because financial institutions held much of these securities, their market values declined as well, leaving balance sheets in need of restructuring, particularly given their highly leveraged capital structures. Awaiting that restructuring, financial institutions could not perform as usual, which impeded financial intermediation and called into question plans, relations and contracts — such as corporate and residential investment or refinancing.
Meanwhile, consumers who held a substantial part of their wealth in housing were forced to revise their consumption plans in the face of declining values. This affected all the producers, distributors and retailers whose plans and contracts were based on now-obsolete expectations.
And so it goes. Eventually, the required restructuring became so widespread that it affected virtually every sector of the economy. The current recession is as deep as the misalignment of specialized plans, relations and contracts is extensive. Construction workers cannot become software developers overnight. Automobile companies cannot adjust immediately to a change in consumer preferences regarding what type of cars they want to purchase, or how frequently. Would-be financiers cannot adjust to these plans overnight.
An obvious question is whether governments can do anything to speed the restructuring process or reduce its cost. If governments could identify how the economy needed to be restructured and provide incentives to move resources more quickly in that direction, a properly designed program could alleviate and shorten the recession. But, if governments could do that, central planning would be a good deal simpler.
Moreover, just as a command economy is invariably less efficient at resource allocation and production than a market economy, a general stimulus program will, in all likelihood, lead to highly inefficient allocations, effectively burning resources at a time when they are scarce and particularly vital to restart and realign our beleaguered economies. To the extent that it is used to prop up declining industries, the stimulus could even prove harmful by delaying necessary adjustments.
Viewed from a matching perspective, there is no failure of “aggregate demand” — whatever that means. Instead, there is a complex misalignment problem — too many autoworkers when too few people want new cars, for example — that results in a decline in overall output. Thus, it is possible that increased government spending — say, to boost car purchases — could exacerbate the misalignment.
Given the central role of financial intermediation in the current crisis, the government should instead expedite the restructuring process through bankruptcy law. The key is to accept bad news: Losses must be recognized before efficient realignment can occur.
This suggests the following solution to the banking crisis: First, the value of financial institutions’ investments should immediately be marked down to their market values. Based on those values, contracts with existing equity and debt holders should then be restructured. If the losses are big enough that existing equity and debt holders are wiped out, government insurers should make up the difference to protect depositors. Following that, the restructured bank can be recapitalized by raising new debt and equity. From that point, the bank should operate normally.
Unfortunately, this elegant solution assumes away all the problems associated with the complex web of contracts and relationships that constitutes the financial system, the limited information of all the affected parties and the incentive of each of those parties to protect its own interests. For example, there is no agreement on the market values of financial institutions’ housing-related assets. As a result, restructuring has been time consuming, costly, and characterized by intense lobbying, rent-seeking, stop-and-go policy making and the continued failure of credit markets to function efficiently.
If the government could help break this logjam, in a fashion similar to the manner in which courts expedite corporate bankruptcy, the benefits could be large. To the extent that government becomes involved in restructuring financial institutions, it should avoid unnecessary wealth transfers from taxpayers to the security holders of the financial institutions. Beyond that, the realignment process is best left largely to private agents. The government has neither the necessary information nor the proper incentives to do the job.
Bradford Cornell is visiting professor of financial economics at the California Institute of Technology.
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