Seppo Honkapohja
Kunniatohtorin puhe
Turun kauppakorkeakoulun tohtoripromootio 14.5.2010

How does the current crisis influence economic and financial research?

Honorable Rector Mr. Virtanen, Director of the School Mrs. Lähteenmäki, Conferrer Mr. Paasio, Professors, Young Doctors, Colleague Honorands, Ladies and Gentlemen

The current economic and financial crisis has now lasted over two and half years. It is the biggest peace‐time economic crisis since the Great Depression of the 1930s. The Second Great Contraction, as it is often called, has had huge ramifications to economic and business life. The crisis has also sparked – as indeed it should – a lively debate about misguided orientations in economic and financial research. Today I want to offer a short overview of new research directions that economics and finance seem to be taking.

There was no single cause for the Second Great Contraction. A number of developments in the financial system contributed to a huge credit boom that turned into a global crisis. The boom was fuelled by financial innovations, which initially looked good but turned out to be disastrous.

There were also macroeconomic causes. Global imbalances between countries, in particular between China and the United States, had a major impact by providing funds to the boom. Monetary policy in the early years of the past decade has also been blamed, though there are disagreements about its significance.

Looking at the financial system, one set of problems arose from distorted incentives in financial intermediation. Attempts to improve distribution of risks motivated wide‐spread issuance and sale of asset backed securities. These included bundles of mortgages, consumer credit and business loans, as well as further layers of structured assets.

One problem in the process of securitization was that it weakened lenders’ incentives to properly assess borrower quality. A second distortion turned out to be the fact that, for a number of reasons, risks were not sufficiently spread outside the banking system. A third distortion has been the form of remuneration. Many contracts essentially offered unbounded upside rewards but capped downside losses and thus encouraged excessive risk taking.

Information problems were another cause for the financial crisis. The new complex securities that were created in the hectic boom were one source of information problems. Assessing risk exposure and the value of even simple bundled securities is not straight‐forward. These assessment difficulties were multiplied in more sophisticated securities that included embedded options, multi‐layer structures, and hierarchies. Another set of information problems arose from the appearance of significant counterparty risk during the crisis and its impact on the behavior of highly‐leveraged financial intermediaries.

Financial‐system causes for the crisis have taught important lessons for economic and financial research. The problems just outlined are amenable to economic analysis. However, the appropriate theories are quite different from the efficient markets hypothesis which postulates that financial markets function well and are free from bubbles and excessive volatility.

There were also macroeconomic causes for the Second Great Contraction. Of these, the phenomenon of global imbalances is more a failure of economic policy and politics than of economic science. However, some major lessons for macroeconomic research have also become apparent.

Study of economic history should have a much more prominent place in macroeconomics curricula. It has become painfully clear that financial booms and busts occur with significant regularity. They are not just a “rare event”. Deeper understanding of earlier financial crises yields insights to the analysis of the current crisis. Right now, it is particularly instructive to study the history of past sovereign debt crises.

Recent economic history also teaches another, very different lesson. Academics and policy makers should not be fooled by periods of macroeconomic tranquility. The two decades before the current crisis – called the Great Moderation – were, overall, a period of relative calm in the international economy.

Great Moderation influenced risk perceptions of actors in financial markets, including regulators and central bankers. In addition, it influenced the views of the economics profession about the role of money and credit in the macro economy. The canonical macroeconomic models relegated money and credit to a side show. The key frictions in the economy were thought to be in the real sector.

The current crisis has made it clear that credit, and banking must have a central place in macroeconomics. Moreover, financial factors are not just small frictions that can somewhat amplify business cycles in the economy. The financial system can occasionally be a source of major shocks and disruptions. Understanding their consequences will require a new generation of macroeconomic models.

To conclude, it may be recalled that, after the work of John Maynard Keynes, the Great Depression of the 1930s led to a revolution in macroeconomics. In contrast, the Second Great Contraction has so far not brought about a scientific revolution. We are seeing a lively reassessment and reorientation of prevailing economic and financial theories. It is encouraging that the economics profession is taking initial steps in new research directions underscored by the crisis.