How NBER Corporate Finance Program’s research work helps understand the current crisis?

I had mentioned previously what a rich resource was NBER Reporter, a NBER publication.

The Dec-09 Reporter carries a very useful summary of the research done in NBER’s Corporate Finance Program. It is written by Raghuram Rajan who directs the program. Usually, the reporter carries a survey of the program but Rajan prefers to focus on the papers that help us understand the current crisis.

The NBER’s Program on Corporate Finance was founded in 1991, and has initiated some very promising avenues of research since then. Narrowly interpreted, corporate finance is the study of the investment and financing policies of corporations. Because firms are at the center of economic activity, and almost any topic of concern to economists –from microeconomic issues like incentives and risk sharing to macroeconomic issues such as currency crises — affects corporate financing and investment, it is however increasingly difficult to draw precise boundaries around the field.

The range of subjects that Corporate Finance Program members have addressed in their research reflects this broad scope. Rather than offering a broad brush survey of all the work currently being done, however, I thought it would be most useful to focus on what our researchers have contributed to the analysis of the ongoing financial crisis. Even here, I have had to be selective, given the large number of papers on this subject in the last two years. I should also note that even prior to the crisis, Corporate Finance Program members had done important work on such topics as credit booms, illiquidity, bank runs, and credit crunches. This work laid much of the foundation for the more recent analyses. In the interests of space, though, I will not survey that earlier work.

He says there is some consensus on causes of the crisis:

A number of papers offer an overview of the crisis (Brunnermeier, 14612; Diamond and Rajan, 14739; Gorton, 14398). There is some consensus on its proximate causes: 1) the U.S. financial sector financed low-income borrowers who wanted to buy houses, and it raised money for such lending through the issuance of exotic new financial instruments; 2) banks seemed very willing to take risks during this time, and a significant portion of these instruments found their way, directly or indirectly, into commercial and investment bank balance sheets; 3) these investments were largely financed with short-term debt. But what were the more fundamental reasons for these proximate causes?

He then explores papers which look at these causes. He covers papers in 7 broad heads:

1. Why Low Income Borrowers?
2. Were banks more willing to take risks?
3. Financing with Short-Term Debt
4. The Panic and Fire Sales
5. The Rescue Efforts
6. What did not cause the panic?
7. Other Issues

Very good literature survey from Rajan. I mean you have all the major papers that are cited to explain the crisis in one place. And then you know what each paper attempts to say.

Highly recommended reading.

Economics in 10 easy steps

Ross Gittins, Herald’s Economics Editor, has written a very nice article on principles of economics (HT: Greg Mankiw).  He says there are 10 broad principles of economics:

Here’s a never-to-be-repeated holiday special: all you need to know about economics in 10 easy steps. They come courtesy of the best-selling introductory economics textbook by Gregory Mankiw of Harvard University (with Joshua Gans and Stephen King co-authors of the Australian edition).

Economics is the study of how society manages its scarce resources, where ”scarce” means there are fewer resources than we’d like to be able to use.

The 10 principles are divided into 3 sections. Here is a further summary of the 10 principles:

• Section 1: How people make decisions?
  • Principle 1: Economics is about trade-offs – efficiency vs equity
  • Principle 2: Opportunity cost – Joining a Univ vs Working fulltime
  • Principle 3: Marginal Thinking – The pricing should be in line with marginal costs
  • Principle 4: Incentives matter
• Section 2 : How people interact?
  • Principle 5: Trade makes everyone better off
  • Principle 6: Markets are a good way to organise economic activity. Central Planning doesn’t work
  • Principle 7: Govt can improve market outcomes in case of market failures, market power, spillovers etc
• Section 3: How Economy works?
  • Principle 8:  Country’s standard of living depends on its ability to produce goods and services.
  • Principle 9: Prices rise when the government prints too much money
  • Principle 10: Society faces a short-run trade-off between inflation and unemployment

Notice how principles move from ‘within individual’ to ‘between individuals’ to ‘country level economics’.

Very useful summary of principles of economics.

Chiang Mai Initiative signed finally

I first learnt of Chiang Mai Initiative (CMI)  via a Barry Eichengreen paper.

Wikipedia offers some light:

The Chiang Mai Initiative (CMI) is an initiative under the ASEAN+3 framework which aims for creation of a network of Bilateral Swap Arrangements (BSAs) among ASEAN+3 countries. After 1997 Asian Financial Crisis member countries started this initiative to manage regional short-term liquidity problems and to facilitate the work of other international financial arrangements and organizations like IMF.

What lessons are offered for Teaching Economics from the current crisis?

John Taylor has a super post on the topic. He says:

People ask how I think introductory economics teaching should change as a result of the financial crisis. It’s an important question. At the upcoming American Economic Association Annual Meetings, my colleague Bob Hall, next AEA President and Program Director, has included on panel on the topic.

Clearly we need to include more on financial markets, but based on my experience teaching in the two-term introductory course at Stanford, I think the single most important change would be to stop splitting microeconomics and macroeconomics into two separate terms. The split has been common in economics teaching since the first edition of Paul Samuelson’s textbook, which put macro first. Many courses now have micro in the first term and then macro in the second.

But regardless of the order now used, I think a reform that integrates micro and macro throughout is worth considering. There were arguments for doing this before the crisis, including the fact that in research and graduate teaching the tools of micro have now been integrated into macro.

I have always found the distinction between macro and micro very confusing.

• You come across economists who say I am a macro person and don’t follow much of micro and vice versa. It is actually seen as a statement of prestige – what person (micro or macro that is) you are – and is followed by nods and appreciation by fellow economists. But there are so many linkages between the two, how can you possibly be from different fields. I can understand the area of research is different but that is where it ends.
• The distinction is appalling in the case of professors of finance. I mean why the distinction. You have professors of economics with specialisation in healthcare, international trade, agriculture, development etc. Same should be the case with finance as well. Clearly the academia has also been taken by the finance tide/wave. Then there are some professors of finance (atleast I have met them) who have a very limited know-how of economics especially macroeconomics. Much of financial markets move because of developments in economy, so you cannot ignore it. But Professors of finance can.
• Then you have students who study finance. Most have a very limited knowhow of economics. Infact, you can pass as an MBA in finance without understanding the linkages of economics. This clearly is a problem with the way they are taught and not really a problem of students.

Prof Taylor further explains:

The financial crisis clinches the case for full integration in my view. The crisis is the biggest economic event in decades and it can only be understood with a mix of micro and macro. To understand the crisis one must know about supply and demand for housing (micro), interest rates that may have been too low for too long (macro), moral hazard (micro), a stimulus package (macro) aimed at such things as health care (micro), a new type of monetary policy (macro) that focuses on specific sectors (micro), debates about the size of the multiplier (macro), excessive risk taking (micro), a great recession (macro), and so on. It you look at the 22 items that the Financial Crisis Inquiry Commission has been charged by the Congress to examine, you’ll see that it is a mix of micro and macro. Defining the first term as micro and the second term as macro, or visa versa, is no longer the best way to allocate topics.

This is precisely the problem with teaching finance without much attention to economics. They are not mutually exclusive subjects!

Prof Taylor is already trying to usher changes this time at Stanford. He also points to challenges that text-books are still carry micro-macro distinction. But it is not hard to mix and match. Read the post for details.