writing assignment about microeconomics

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 state of macroeconomics (the study of the determinants of an economy’s level of output and employment) 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 markets and how the government tries to address conditions that lead to “bad” decisions. And it has not suffered any serious intellectual setbacks from the current Great Recession. Indeed, the causes and cures of this recession are more about microeconomics than about macroeconomics.

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

The market failure that generated the current crisis is by now well-known: the rapid growth of subprime mortgages and the failure of many homebuyers and investors to understand and properly weight credit risks. Unfortunately, banks and rating agencies underestimated the probability of a major decline in housing prices and believed that they could measure the interrelatedness of credit risks. Financial firms, consumers and regulators did not adequately account for outliers–very low-probability events–that turned out to be important, leading to a wave of financial institution failures that caused great 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 triggered the financial collapse. Even some of Bernie Madoff’s operations were subject to federal

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

Calls for improved financial market regulation are understandable, because unregulated mortgage brokers offered many households mortgages that they subsequently could not afford once home prices stopped rising. But these brokers did so only because regulated financial institutions willingly bought those mortgages. Many of the dodgiest mortgage products ended up in off-balance-sheet entities of regulated financial institutions less than 10 years after Enron collapsed when its off-balance-sheet entities imploded.

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

Now that we are well into the Great Recession, little evidence exists that the proliferation of Treasury and Federal Reserve bailout operations is bringing us out of it any more rapidly than we might have expected from normal market forces. A major easing of monetary policy should prove helpful, but will there be any evidence that the various twists and turns in the Troubled Asset Relief Program (TARP) or the Term Asset-Backed Securities Lending Facility (TALF) actually shortened the recession? And plenty of economists question the efficacy of the stimulus package, given the slow disbursement 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 generally learn–and learn quickly–from market failures attributable to imperfect information. Both have moved aggressively to shore up their balance sheets. Risky, subprime mortgage originations have all but disappeared. Indeed, there is little historical evidence that the costs of alleged information failures have merited much attention. The events of the last few years were surely different, but their possibility was not ruled out by established 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 government action addressed the problems in the housing market created by excessive speculation and by the encouragement of non-creditworthy buyers to assume large mortgages. As economists would expect, recovery in housing could occur only when prices fall to sustainable 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, TALF or government seizure of Fannie Mae and Freddie Mac .

Equally important, the credit markets have stabilized and credit spreads have narrowed substantially, 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 financial institutions now appears to have been overstated as large volumes of those positions have been successfully unwound with little systemic effect.

Throughout this economic crisis, no one has presented credible evidence that the deregulation of transportation, energy and communications markets has been a mistake. Whatever the market failures in the early 20th century, government efforts to correct 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 other than by directly regulating leverage more carefully. In the meantime, Americans can rest assured that financial markets are quite sensitive to the interrelatedness of credit default risks and that renewed efforts are being made–and will continue to be made–to manage financial 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 the distribution. The next financial market failure will result in still another advance in the market’s ability to manage risk and in the unsettling realization that government can do little to prevent markets from failing and to improve how they self-correct.

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