Eric Maskin: on credit markets and potato markets

Eric Maskin, the Albert O. Hirschman professor of social science at the Institute for Advanced Study, has addressed several business groups in the last year, including chambers of commerce in Italy and China. Based on his theory of mechanism design – for which he shared the 2007 Nobel prize in economics – he explained the basics of this financial crisis to the Princeton Regional Chamber of Commerce today. His 20 minute lecture, at first, might have seemed almost elementary. But Maskin’s “elementary” is also “elegant” in its simplicity.

It reminded me of how my father taught human anatomy, presenting the information like a story, on a very basic level. Often the medical students thought they knew it already. Years later they would come back and say, “Remember that lecture you did on such and such? It really stayed with me.”

So although I considered myself ‘well-read’ on the sub-prime debacle, the credit crisis, and the bailouts, I realized — as Maskin took us through it, comparing the credit market to, of all things, the potato market — that I didn’t really comprehend the whys and wherefores. Then he introduced the economists’ term “externality,” the effect your actions have on others that you
don’t take into account. That added a whole new facet to my understanding.
I asked him for his Power Point notes, and he obliged.

Financial Crises: Why They Occur and What to Do about Them

Eric Maskin

Institute for Advanced Study

Princeton Regional Chamber of Commerce

January 8, 2009

• Current financial crisis

– only latest in long sequence

– history of credit crises goes back hundreds of years

• probably crises will continue in future

– each crisis somewhat different

– even if we “fix” mortgage loan market, something else will happen

• Today’s topic:

– why do credit market have repeated crises and other markets don’t?

– why does credit market require substantial intervention (and others don’t)?

Why is credit market different?

(1) credit lifeblood for rest of economy

− if crisis in market for potatoes, won’t bring down market for automobiles

− if credit market doesn’t work, enterprises in all markets will have trouble investing and meeting payrolls

(2) small shock to credit market often magnified

− if some potato growers fail, won’t cause other growers to fail

− if some banks fail, may well cause other banks to go under

(3) credit market not self-correcting

− if some potato growers fail, others will step into breach no outside intervention needed

− if some banks fail, credit market can get “stuck” – – no banks willing to lend

Elaboration on points 2 and 3

• Suppose drought wipes out potato crop in Idaho

• What will happen?

– immediate effect is fall in overall potato output

– but demand hasn’t changed – – fewer potatoes to go around

– so price of potatoes will be bid up

– induces other potato suppliers to grow and sell more

• So potato market “self-correcting”

– crop failure hurts consumers in short run – – higher prices

– but high prices induce suppliers to expand output

– so effect of drought mitigated in long run

• Government intervention not needed

• Government interference in potato market likely to make things worse

• Suppose puts cap on potato price or taxes “windfall” profits

– discourages expansion of output that can make up for crop failure

this creates potato shortage or black market in potatoes

• Credit market is just the opposite

• Suppose a few banks get into trouble

– make subprime mortgage loans

– borrowers can’t repay loans and housing prices fall, so can’t refinance

• these banks have other borrowers

– have to call loans in on these borrowers

– so borrowers have to scale back activities that depended on these loans

– thus will have harder time repaying loans from other banks

• so these other banks now may get into trouble

– may have to call in loans from their borrowers

– and refuse to make new loans

• what started as a local problem (subprime mortgage lending) spreads

to entire credit market

• initial problem not self-correcting (as in potato market)

– gets aggravated

end up with credit crunch

• in economics jargon, bank exerts an externality on other banks by calling in loans

– externality: effect your actions have on others that you don’t take into account

– when bank calls in loans, puts other banks in jeopardy

– but doesn’t factor this effect in when calls in loans (not harmed by it)

• markets with significant externalities often don’t work well on own

take clean air, for example

• Why isn’t there a market for clean air?

• in fact, there is such a market, but so limited we hardly see it

• suppose laundry next door to steel plant

– smoke from steel plant interferes with laundry

– laundry may offer to pay steel plant to reduce smoke (so market for smoke reduction exists)

– but smoke doesn’t just affect laundry – – affects many others

– by paying for reduction, laundry confers benefit on these others (externality)

– laundry doesn’t take this into account

– so likely to underpay for reduction – – smoke not reduced as much as should be

• solution: government imposes cap or fine on smoke emissions by steel plant

Solution for credit market:

If some banks get into trouble,

• government can bail them out

– infuse with capital so can continue to lend

• but bailout important primarily for other banks that would be hurt if bailed-out banks failed

Bailout policy comes at cost:

• if banks anticipate being bailed out when get in trouble

– have incentive to take on highly risky loans, e.g., subprime mortgage loans (moral hazard)

• so solution to financial crisis actually makes crisis more likely!

• Hence, bailout policy only partial solution

• Also need to regulate banks

– e.g., impose rules preventing subprime loans

bailouts and regulation go together

• Actually, two reasons why regulation needed

– prospect of bailouts induces banks to make too risky loans

– bank ignores externality imposed on other banks by too-risky loans – – undervalues cost of these loans

• If credit crisis allowed to spread to rest of economy, bailout policy may be insufficient

• just as important externalities in credit market, important externalities at level of whole economy

• Suppose one employer lays off workers (because it loses credit line)

– workers lose income

– demand less

– other employers get into trouble

– they lay off workers

• So, “stimulus” for real (nonfinancial) economy needed

– purpose: to prop up demand, so employment kept high

• temporary measure: until credit market healthy again

• Well-designed regulation/bailout package

– can prevent “many” crises from getting started – – rules against subprime loans would have prevented this one

– can resolve them if do occur

• stimulus package needed if bailout applied too late

• can’t hope to prevent credit crises completely and still allow for creativity

– can’t anticipate all possible innovations by banks

– so can’t have rules that prevent only harmful innovations

But can do a lot better than we’ve done this time.

3 thoughts on “Eric Maskin: on credit markets and potato markets

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  3. Professor Maskin’s presentation to the Princeton Chamber of Commerce last January 8th was didactic, enlightening, and, as good teachers usually do, he left me wondering about new issues and problems. In the case of financial markets, given that externalities and lack of self-correcting mechanisms do call for regulation, my question is who has the best information to actually draft “good regulation.” How much regulation can the government impose without consultation with the financial institutions that run the business? Do the financial institutions have any incentive at all to provide the government with the information needed to actually have “good regulation”? Is “self-regulation” bad in the case of financial institutions? And what are the criteria to actually say with objectivity (and before a crisis occurs!) whether a particular set of rules is good or bad? Can regulation prevent a financial crisis? Can regulation cause a financial crisis? I would enjoy a follow up to the January presentation of Professor Masking where he offers insights on how his mechanism design theories/techniques enlighten the process of drafting regulation. And I can’t help ending my comment with one more question: In the case of large externalities and no self-correcting mechanisms, can mechanism design theory tell us about instances when we are better off without regulation? Rita L. Murray or

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