Microeconomic in February of 2007  Research Proposal

Excerpt from Research Proposal :

They will only respond to outcomes that they feel directly. Thus, the government's actions are not having the desired impact on consumer behavior.

A disagree with the government's approach. The interest rate cuts are particularly worrisome. The massive cuts in the early 00s helped to spur the crisis because they had a profound impact on the money supply and helped to restore consumer confidence. Cuts of the same magnitude have been implemented now, but without the same results that were seen in the early to mid 00s. Worse yet, if those results were seen, we could find ourselves in a repeat of the housing bubble. If something spurs a surge in consumer confidence, for example a strong holiday retail season, this could help convince banks to loosen their credit. With the low rates, the market would once again be flooded with capital. This would spur a resurgence in the housing market. At first, a glut of homes would be available, put on the market by homeowners who are no longer underwater. But once this initial supply of homes is exhausted, the bubble would begin to grow, especially since new housing starts tends to lag the housing market by at least a year. I feel that the Fed's approach to this market failure is risky, and if they did not increase rates quickly at the first sign of market recovery another bubble could easily follow.

I believe the Fed must keep rates where they are for now because raising them would send the wrong signal to the market and only serve to further erode consumer confidence. But I would highly recommend that rates are increased at the first sign of improved confidence. The Fed added too much fuel to the fire in the early 00s. This time they should be more cautious and keep rates increasing incrementally, low enough to spur the economy but increasing slowly to keep it from overheating. I would recommend strongly against lowering rates further. If consumers and financial institutions are not responding to the current rate levels, give them time to build their confidence. To lower rates further would increase the risk of stagflation and a Japanese-style prolonged recession.

A also do not agree with the bailout of the financial industry.

If we go back to the savings & loan crisis two decades ago, the industry received a $160 billion bailout. This was felt by many observers at the time to be the wrong move, because it would insulate the financial services industry from the lessons of the free market (Brown, 2008). The government claimed the bailout was necessary for the public good. History has shown that the financial services industry did not learn its lessons about bad mortgages, contributing to the current crisis. In a free market, such behavior would be punished with the effect that the banks would not repeat the behavior. Yet, government interference in the name of the public good had the effect of changing that behavior (or not changing it, to be more accurate). Thus, I feel that the government is repeating their error with this current bailout package. The markets want banks to suffer.

In a state of perfect competition, poor managerial decision making will result in the failure of the firm. When the government introduces such legislation, the market is rendered imperfect, changing the outcomes.

I would instead allow the free market to do its job and punish those who have made poor decisions. In the long run, this benefits the economy because bad behaviors are ultimately not repeated. Had the financial services industry not been bailed out at the end of the savings & loan crisis, bank managers may not have been so eager to overlook their own rules with regards to subprime lending. They may have remembered that some of the competitors were driven out of business by poor practices and thus not engaged in those same behaviors in the early part of this decade. This strategy would result in a decline in consumer confidence and a decline in demand. The economy would enter into a recession, but I feel would emerge stronger. The lessons of the past would not be so easily forgotten.

The recession would also have the effect of improving our current account balance. One side effect of this will be to reduce foreign demand for U.S. Treasury securities. When the government reduced supply of these securities, this shifted the demand towards other instruments, including MBSs. By improving the current account balance, this will reduce demand for Treasury bills, bringing it more in line with supply. Had this occurred earlier, the impacts of the current crisis would not be so widespread.

The other strategy I would adopt is to improve information. Imperfect information on the parts of both consumers and investors played a significant role in the development of this crisis. It is clear that there must be improvements in financial literacy. I would include more basic economic training in the K-12 educational system. This will help people understand the risks they are taking and hopefully avoid people taking on mortgages that they cannot afford. Moreover, I would insist that financial instruments be structured in ways that reasonably well-educated investors can understand. The risks in MBSs were not known except to those who structured them, which led to a demand level much higher than would have been expected had perfect information existed. This resulted in a greater diffusion of the risk, making the crisis worse that it needed to be. These strategies would have little direct economic impact, but would set the course in the future for better decision-making both inside and outside the financial services industry.

Works Cited

Boeri, Tito & Guiso, Luigi. (2007) Subprime Crisis: Greenspan's Legacy. Vox. Retrieved November 19, 2008 at http://www.voxeu.org/index.php?q=node/488#fn2

Brown, Jeff (2008) Subprime Crisis: A Bouquet of Opportunity Masked a Reek of Risk. Knowledge @ Wharton. Retrieved November 19, 2008 at http://knowledge.wharton.upenn.edu/article.cfm?articleid=1995

Bagley, Nicholas. (2008). The Federal Role in the Subprime Mortgage Mess. Sacramento Bee. Retrieved November 19, 2008 at http://www.treasurer.ca.gov/beyondthehorizon/20080128.pdf

Thoma, Mark. (2008). The Fed's View of the Sub-Prime Mortgage Market. Economist's View. Retrieved November 19, 2008 at http://economistsview.typepad.com/economistsview/2007/03/the_feds_view_o.html

Wade, Robert. (2008). "Explaining U.S. financial instability and its global implications" the Asia Pacific Journal. Retrieved November 19, 2008 at http://www.japanfocus.org/products/details/2536

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