This year’s guest at The University’s Henry George Lecture was Anthony O’Brien. He is an economics professor at Lehigh University and is fairly well known to anyone who has taken an economics course at The University; his name, in big bold letters, is slathered across the textbooks professors here use for principles of economics. The theme of his lecture? The financial crisis of 2008 and why economists did not see it coming.
Economists saw an unsustainable increase in housing prices in the 2000s,. The rise in prices caused a panic among homebuyers who wanted to purchase a new house right away, before prices could get any higher. As the demand rose, the prices rose, but supply did not increase quickly enough to meet the needs due to the difficulties zoning laws produce. When housing prices finally began to drop, economists did not think anything significant was happening. They said the decline in the housing market would not affect the real economy or even the financial economy. O’Brien then went on to explain to his audience how problems in the financial sector affect the real economy. He described three types of channels: 1) destruction of wealth leads to a fall in spending; 2) deteriorating balance sheets make it harder for borrowers to obtain credit because the net worth of borrowers decreased, so the bank either has the option to increase interest rates, which will decrease investment, or lend to fewer people (they chose the latter); 3) the decline in intermediation disrupts credit flows.
The second half of the lecture consisted of a discussion on shadow banks and the financial system. Shadow banks include mutual funds, investment banks, hedge funds and more. Most of the regulatory structure of the financial system was focused on commercial banks rather than shadow banks, which are problematic. Shadow banks relied on borrowing short term to invest long term, which is something that never should be done. They were also more highly leveraged than commercial banks, meaning they had higher debt than equity. In addition, they invested more heavily in exotic securities. Exotic securities have their own issues because of the failures of risk management practices at financial firms that did not do stress tests and their overreliance on credit rating agencies. The credit rating agencies had to be more lenient lest their clients go to their competitors.
The financial system, which is made up of financial firms and federal regulators, grew in a way that made it more fragile due to shadow banks in the 2000s. The financial firms were private, profit-making companies that strived to produce services better than their competitors; they had to be innovative. Financial innovation increases efficiency, increases the risk of financial instability because shadow banks offer better services than commercial banks, and is difficult to contain. Regulators have no idea if innovation is going to impact financial stability; the only thing they can do is sit around and worry.
O’Brien concluded his lecture with three statements. One was that economists failed to predict the 2008 crisis because they did not realize that financial innovation had reduced financial stability. The next was that they are unlikely to predict the next one. And finally, he stated that the Dodd-Frank Act, which established that the federal government could no longer lend to any individual or firm, left the federal government less capable of responding to financial crises than it was in 2008.