Learning from the Nobels

The global credit crunch took center stage both in the formal program of the economic sciences meeting and in informal discussions. The meetings were held August 20–23, five months after JP Morgan Chase swallowed up Bear Stearns and two to three weeks before the rescue of Fannie Mae, Freddie Mac, and AIG by the U.S. government. The first day commenced with a wide-ranging panel discussion of systemic risks in financial markets, moderated by David Wessel of the Wall Street Journal and taking in comments from Stiglitz, Scholes, and Yunus, as well as Daniel McFadden. Stiglitz in particular was highly critical of both the behavior of financial market participants and the government response, arguing that much of the blame for the crisis could be assigned to inadequate regulation and an “anything goes” culture on Wall Street. Scholes offered some defense of the laissez-faire status quo, although he too had some criticisms at the margins. Both elaborated further on their arguments at their individual speaker sessions later in the program.

For Stiglitz, the current crisis-the worst faced by the United States since the Great Depression-is an example of microeconomic failures translating into macroeconomic ones. He argued that financial sector firms, despite record profits in recent years, failed in their core roles of allocating and managing risk, an example of market failure more generally.

Information asymmetries were at the center of his account. For instance, securitization, while creating opportunities for efficient risk dispersal, also exacerbated agency problems. Mortgage originators, who made loans to borrowers with inadequate assets and incomes that they quickly repackaged and sold on as apparently safe securities, provide the most obvious example, but these kinds of information and agency problems were widespread throughout the system. The difficulty in valuing many of these opaque securities and related contracts, which has been hampering efforts to clean up banks’ balance sheets, further illustrates Stiglitz’s point.

Other market failures have come to the fore. For instance, Scholes emphasized how externalities in financial markets have been heightened by the increased leverage of market participants. Leveraged financial firms that are forced to dump assets in an effort to strengthen their own balance sheet create externalities for others holding the assets, who see the price slump and may be forced into fire sales of their own. This...