Read the Forbes article, What About Microeconomcs?, by Robert Crandall and Clifford Winston. (It is accessible under the Articlestab on the Blackboard menu). Consider the authors’ points of view in relation to Mankiw’s discussion of basic principles of economics, the distinction between macro and microeconomics, how economists use models to develop “theories” about how the economy works, and why economists sometimes (frequently?) disagree. Then respond to the following questions/prompts:

1. Clarify, in some detail, the distinction between macro and microeconomics, as both Mankiw and the authors of the article describe it.
2. Discuss Principles #6 and #7 (Mankiw Chapter 1, Ten Principles of Economics); Do the authors agree or disagree with these principles?
3. In the view of the authors, was the “Great Recession” of 2008-09 a macro or microeconomic problem? Why?
4. What is the authors’ view of the efficacy of government actions to aid recovery from the 2008-09 recession? Do you have a view?
5. Discuss: “Deregulation leads to market failures”.
6. What do you think “tails of the distribution” means?

FORBES
Robert W. Crandall and Clifford Winston

10/05/2009 @ 12:01AM

What About Microeconomics?

In a recent New York Times Magazine article, Paul Krugman laments the current stateof macroeconomics (the study of the determinants of an economy’s level of output andemployment) that blinded us to the forces that, in his view, caused the current recession.However, he never mentions the state of microeconomics.

Microeconomics is the study of how firms and consumers make decisions in marketsand how the government tries to address conditions that lead to “bad” decisions. And ithas not suffered any serious intellectual setbacks from the current Great Recession.Indeed, the causes and cures of this recession are more about microeconomics thanabout macroeconomics.

Microeconomists’ theoretical and empirical contributions have taught us that marketfailures do exist but that the government rarely, if ever, can be counted on to correctthose failures efficiently. Nothing in the last two years has undermined microeconomicanalyses that influenced the deregulation of the airline, trucking, railroad, natural gas,crude oil, telecommunications and cable television markets. These deregulatorysuccesses have not been compromised by the market failures that originated in thefinancial sector and are at the heart of the Krugman lament. But even if Krugman coulduncover a theory that integrates irrational exuberance in financial markets withmacroeconomic performance, it would hardly guarantee improved performance ofgovernment regulators. Nor would it enhance our considerable knowledge of howmarkets correct after sharp downturns.

The market failure that generated the current crisis is by now well-known: the rapidgrowth of subprime mortgages and the failure of many homebuyers and investors tounderstand and properly weight credit risks. Unfortunately, banks and rating agenciesunderestimated the probability of a major decline in housing prices and believed thatthey could measure the interrelatedness of credit risks. Financial firms, consumers andregulators did not adequately account for outliers–very low-probability events–thatturned out to be important, leading to a wave of financial institution failures that causedgreat pain to the real economy.

Most of the defaults were centered in regulated financial institutions that purchased,securitized and even invested in the subprime and Alt-A mortgage debt that triggeredthe financial collapse. Even some of Bernie Madoff’s operations were subject to federal

regulation. Notably, though posting large losses, unregulated financial institutions, suchas the large hedge funds, have not required the government’s assistance to survive.

Calls for improved financial market regulation are understandable, because unregulatedmortgage brokers offered many households mortgages that they subsequently could notafford once home prices stopped rising. But these brokers did so only because regulatedfinancial institutions willingly bought those mortgages. Many of the dodgiest mortgageproducts ended up in off-balance-sheet entities of regulated financial institutions lessthan 10 years after Enron collapsed when its off-balance-sheet entities imploded.

Krugman argues that economists need new models that incorporate irrational behaviorin financial markets. But will such theoretical models keep regulators from making thesame mistakes when the next speculative bubble occurs?

Now that we are well into the Great Recession, little evidence exists that theproliferation of Treasury and Federal Reserve bailout operations is bringing us out of itany more rapidly than we might have expected from normal market forces. A majoreasing of monetary policy should prove helpful, but will there be any evidence that thevarious twists and turns in the Troubled Asset Relief Program (TARP) or the TermAsset-Backed Securities Lending Facility (TALF) actually shortened the recession? Andplenty of economists question the efficacy of the stimulus package, given the slowdisbursement of funds and the use of these funds on a variety of dubious projects.

On the other hand, there is substantial evidence that consumers and firms generallylearn–and learn quickly–from market failures attributable to imperfect information.Both have moved aggressively to shore up their balance sheets. Risky, subprimemortgage originations have all but disappeared. Indeed, there is little historical evidencethat the costs of alleged information failures have merited much attention. The events ofthe last few years were surely different, but their possibility was not ruled out byestablished microeconomic theory.

In retrospect it will be clear that markets responded quite well to the financial crisis,generating an economic recovery–much as they always do. No emergency governmentaction addressed the problems in the housing market created by excessive speculationand by the encouragement of non-creditworthy buyers to assume large mortgages. Aseconomists would expect, recovery in housing could occur only when prices fall tosustainable levels, excess inventories are drawn down through a reduction of new starts,and financial institutions write down the debt that they issued on over-valued houses.All of those market corrections are well underway and have little to do with TARP, TALFor government seizure of Fannie Mae and Freddie Mac .

Equally important, the credit markets have stabilized and credit spreads have narrowedsubstantially, particularly for firms that have managed their balance sheets
well. Microsoft has recently issued bonds that sold at very low spreads over Treasuries.Even the concern over credit-default swaps issued by large, troubled financialinstitutions now appears to have been overstated as large volumes of those positionshave been successfully unwound with little systemic effect.

Throughout this economic crisis, no one has presented credible evidence that thederegulation of transportation, energy and communications markets has been amistake. Whatever the market failures in the early 20th century, government efforts tocorrect them failed. Deregulation was and still is the correct policy in those sectors.

Moreover, it will be quite difficult for policymakers to improve financial regulation otherthan by directly regulating leverage more carefully. In the meantime, Americans can restassured that financial markets are quite sensitive to the interrelatedness of credit defaultrisks and that renewed efforts are being made–and will continue to be made–to managefinancial risks more effectively with a theory of finance that goes beyond a focus on the“mean and variance” of returns and pays appropriate attention to risks at the tails of thedistribution. The next financial market failure will result in still another advance in themarket’s ability to manage risk and in the unsettling realization that government can dolittle to prevent markets from failing and to improve how they self-correct.

Robert W. Crandall and Clifford Winston are senior fellows at The BrookingsInstitution. Winston is the author of Government Failure Versus MarketFailure (Brookings, 2006).