Financial resources expected from development partners (grant or loan funding) have already been factored in the macro-fiscal framework used for working out spending limits and do not therefore constitute an additional source of funds available for spending.
“It is a little superfluous for any foreigner to come to Rotterdam to lecture about economics at all. I feel a bit like a 17th century New England smuggler lecturing on seamanship to Admiral Tromp. The trade in economics nowadays is as much the other way: we send our young men to Rotterdam to learn, not our middle-aged professors to teach. Indeed some of our best middle-aged professors are named Koopmans and Houthakker! I suppose the logic of the situation is that I am not import at all; I am to be processed and re-exported, like cocoa beans.”
-Robert M. Solow in 1963 when visiting the Rotterdam School of Economics.
If the financial crisis has taught us anything,” says Michael Taylor, “it is that too much conventional wisdom can be dangerous.”
Incorporating the factors that created problems in the financial markets makes the theory complex. But to be effective in the real world, to be able to communicate economic ideas, you have to simplify. Sometimes, you start believing your simplifications as if they were the general theory.
There are essentially five theoretical models or frameworks that are used by economists to explain credit booms and busts. These are (1) changes in fundamentals over time; (2) irrational myopia as reflected in euphoric greed followed by fear or depressive panic; (3) implicit or explicit government subsidies and guarantees; (4) multiple equilibria or knife-edge problem; and (5) agency problems in assets management. Each of these frameworks is used to analyze the current housing problems, which triggered a U.S. financial meltdown and impacted a global economic crisis.
In October 1989, I attended a conference at the National Bureau of Economic Research organized by Martin Feldstein, the Harvard economist, on “The Risk of Economic Crisis.” The conference still sticks in my mind because of a paper delivered there by Lawrence H. Summers, now the head of the president’s National Economic Council and the dominant economic intellectual at the White House. During the Clinton administration, Mr. Summers was Treasury secretary and backed legislation that helped deregulate financial markets; many analysts say the policies helped lay the foundation of the subsequent financial crisis. But back in 1989, because of his imaginative work, I came away with a recognition that a severe contraction, even a depression, could indeed come again....
Mr. Summers told a fictional but vivid story of a big financial crisis, complete with examples of specific events and how people might react to them. Seeing it concretized as an imaginary history, and placed in the near future — in just two years, in 1991 — made it seem more real and familiar.
He said that this crisis would be preceded by an enormous stock market boom, bringing the Dow to the unimagined high of 5,400 by October 1991. (The Dow was at 2,600 on the day of the conference; 5,400 would be 13,000 today if scaled up in proportion to gross domestic product.)
Euphoria gripped the investors of his fictional universe. “The notion that recessions were a thing of the past took hold,” Mr. Summers said. He added that over a 15-year period through 1990 — a time that included the 1987 crash — investors earned an average real return of 11 percent. The popular view was that “with a reduced cyclical element, the future would be even brighter.”
Furthermore, he said, “lawyers and dentists explained to one another that investing without margin was a mistake, since using margin enabled one to double one’s return, and the risks were small given that one could always sell out if it looked like the market would decline.”
Today, this sounds like a description of thinking that led to the 2000s boom, although the leveraging of investments tended to take a form other than that of traditional margin credit on stock purchases.
His fictional account went on to describe the early signs of the crisis, “In October 1991, problems began to surface,” he said, adding that a “major Wall Street firm was forced to merge with another after a poorly supervised trader lost $500 million by failing to properly hedge a complex position in the newly developed foreign-mortgage-backed-securities market.” He went on to describe how this provocation led to a change in psychology and a market crash and problems in banks and credit markets.
His fiction concluded, “The result was the worst recession since the Depression.”...
Ultimately, the record bubbles in the stock market after 1994 and the housing market after 2000 were responsible for the crisis we are in now. And these bubbles were in turn driven by a view of the world born of complacency about crises, driven by views about the real source of economic wealth, the efficiency of markets and the importance of speculation in our lives. It was these mental processes that pushed the economy beyond its limits, and that had to be understood to see the reasons for the crisis.
