Friday, October 19, 2007


The 2007 Nobel Prize in the Economic Sciences was just awarded to three U.S. economists, all mathematicians, in what is part of a watershed movement to bring back economics that benefits public institutions, as well as private individuals. Their research into “mechanical design theory” has made financial markets more workable for the many, rather than leave them to the devices of the “invisible hand” of Adam Smith, our first free market economist.

Also, major banks have agreed to set up a $200B fund to increase liquidity in non-subprime commercial paper markets. Why? The credit crunch is caused by mortgage lenders unable to sell their non-conforming, jumbo loans into the secondary market. And so by providing liquidity to the short end of the secondary market (i.e., 90-day commercial paper has the cheapest rate.) that buys shorter-term consumer loans, it should ease the credit crunch and make more money available.

What is the real cause of the credit crunch? Fed Chairman Bernanke claimed in his most recent speech it was the fault of sloppy underwriting of subprime loans: “The rate of serious delinquencies has risen notably for subprime mortgages with adjustable rates, reaching nearly 16 percent in August, roughly triple the recent low in mid-2005. Subprime mortgages originated in late 2005 and 2006 have performed especially poorly, in part because of a deterioration in underwriting standards.”

Yet the Fed has raised short-term interest rates 4.25 percent over that time in chasing the phantom of inflation. This in fact has doubled mortgage payments in many cases; something that no borrower (or maybe lender) could have anticipated—whether prime or subprime loan. Therefore, the Fed should be shouldering much of the blame. It created the problem, not faulty underwriting.

The economics prize Nobel press release stated that “Whether one considers auctions, elections or the taxes we pay, our lives are governed by mechanisms which make collective decisions, while attempting to take account of individual preferences. Such mechanisms are designed to deliver the greatest social good despite the fact that individual participants may act for their own gain, rather than for the general well-being of society.”

This is bringing us back to a form of Keynesian economics that sees a role for government and regulation. The latest research is moving economics away from libertarian or so-called supply-side economics, in a word, which had enshrined unregulated, free markets that tended to cause greater income inequality.

What is the research? It is a branch of Game Theory (remember the film, “A Beautiful Mind”?) that helps to determine the best market outcomes for the “general well-being of society”, in the words of the Nobel committee.

Markets do not do this automatically. For example, those with insider information tend to profit more from market information that is not readily accessible to all. So government regulation does not have to be a bad thing. That is why we have the Federal Reserve, whose charge is to regulate banks and the money supply. Without the Fed, recessions would be deeper and inflation swings more volatile. Hence one of its mandates is to “manage” inflation.

Copyright © 2007

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