Michael Spence and Root Causes

Michael Spence is a Nobel Prize winner in economics for his analysis of markets with asymmetric information. In a Financial Times Economist Forum titles, "Balance sheets and income statements: breaking the downward spiral" he gives his opinion about the causes of the current financial crisis and recommendations on how to solve it.

I recommend this article. For those who do not wish to read it, here is a quick synopsis. The financial crisis which is international in scope was due to extreme leverage, an underestimation of risk, and the growing correlation of risk between assets. As an example of the correlation of risks between assets, the risk that housing prices in Atlanta would fall at the same time that housing prices in Las Vegas fell increased. The falling housing values were also linked to the default rate on mortgages. Assets and liabilities are found on balance sheets and the correlations were not limited to housing.

Developed economies have to deleverage, lower asset values, and temporarily reduce consumption, but the process may be going too far. Investment, consumption and employment, all part of our national income statement have entered a feedback loop with the balance sheet that is creating a sort of negative bubble. Asset values are being reduced too much, and this in turn results in too great a reduction in investment, consumption and employment. The loop then passes through the loop again.

Spence recommends a large stimulus package, hopefully international in nature, as well as announced in advance. He notes that addressing asset deflation is crucial and very difficult. He also recommends that governments buy assets. He notes that under current conditions, governments will make many mistakes, opening themselves to critics. He ends by noting that it is fortunate that the government's deeds will be done before the critics pens have cooled.