Undoing the Damage
Harvard Gazette, October 12, 2010
Experts at Harvard and elsewhere say that getting the world economy back on track will take time, despite the fact that the National Bureau of Economic Research recently said the US recession was technically over a year ago.
In a nod to the lasting and dramatic impact of the lagging economy and the urgent need to explore creative ways to improve it, Harvard President Drew Faust convened a University-wide forum on Tuesday (Oct. 12) to discuss the fiscal malaise, including its historic context, and possible policy solutions, including tighter regulations and financial reforms.
"The Economic Crisis, Two Years Later: A Panel of Harvard Experts" took up where a discussion in the fall of 2008 left off. Then, students, faculty, and staff assembled in similar fashion at Sanders Theatre as Harvard authorities explained the Wall Street meltdown.
"We had help then, as we do now, to understand how we got where we were and what the future might hold," said Faust, who turned to the five Harvard scholars on the panel for their insights on the stalled economy that were gained in the last two years.
The regulatory failures that helped to worsen the financial crisis were largely a result of an outdated system that had been designed to handle traditional banking transactions, such as deposits and loans, and was not geared for the "revolution in banking" that occurred in the past 30 years, said David S. Scharfstein, Edmund Cogswell Converse Professor of Finance and Banking at Harvard Business School.
Discussing the fiscal reforms contained in the newly passed Dodd-Frank law, Scharfstein said the revisions affect a longstanding, market-based system of finance in which banks over time pooled loans, issued securities based on such loans, and traded them.
"We did not adapt a regulatory system to deal with that new form of banking," or "shadow banking," he said, and he called the Dodd-Frank reforms an important first step in creating a regulatory regime that can begin to police banks more strictly, as well as "non-bank financial firms that pose systemic risk."
The challenge, he conceded, is for regulators to find the right balance between too much and too little regulation.
The nation is going to have trouble figuring out what to do with its "exploding debt," said Kenneth Rogoff, the Thomas D. Cabot Professor of Public Policy, who predicted that a raise in taxes, a drop in government spending, or most likely some combination of the two will be required to address the ongoing problem.
But there will be good news eventually, said Rogoff, author of This Time Is Different: Eight Centuries of Financial Folly.
Though recovery is "slow and sometimes painful," and almost impossible to predict accurately, it always arrives eventually, he said.
An ironic byproduct of the recession, one that financial authorities have advocated for years, is part of what propels continuing hard times, said Brigitte Madrian, director of the social science program at the Radcliffe Institute and Aetna Professor of Public Policy and Corporate Management at the Harvard Kennedy School.
Partly because of a dried-up consumer credit market, and partly because of a shift in the public mindset concerning spending, worried Americans have begun saving more.
"This restraint is ... keeping us mired in the recession to some extent," she said, adding that, on a brighter note, such saving would keep consumers better prepared for future downturns.
Adjustable-rate mortgages are simply "unhealthy," suggested John Campbell, chair of Harvard's Economics Department, Harvard College Professor, and Morton L. and Carole S. Olshan Professor of Economics, who called for a stable restructuring of mortgages and a reassessment of the social goal of home ownership for most people, since renting would be a better option for some.
The problem, he said, involves the institutions established by the government to promote long-term, stable mortgages, Fannie Mae and Freddie Mac. In the end, they "really got out of control," becoming both part of the shadow banking system and too big to fail, which meant the government had to step in to support them financially.
"Unfortunately we have not yet confronted this problem ... This is unfinished business" even with the Dodd-Frank reforms, he said.
In terms of the banking and corporate bailouts underwritten by the government, the panelists agreed that Washington's interventions, including the Troubled Asset Relief Program, saved the country from a full-blown depression and also will cost the public significantly less than initially predicted.
"I think that the goal of stabilizing the financial system was really a home run," said Scharfstein.
Moving forward, the panelists said that economists will have an important role to play in helping to avoid future crises. Campbell called for greater collaboration among economists, who too often work on small, segregated sections of much bigger problems.
"A lot of people had specialties and could only see a piece of it," he said, referring to the financial crisis. "It was very hard to put it together."
For Scharfstein, working directly on policy issues is an important way for economists to have a greater impact down the road.
"Engagement with policy and engagement with Wall Street in understanding what is going on is very important, both because I think we have a lot to add to that and because it enriches our research," he said.
Richard Freeman, the Herbert S. Ascherman Professor of Economics, also participated in the discussion.