As recently as one month ago, some industrialized countries were still hesitating to admit that their economies were heading for a recession. Today the turmoil in financial markets may create a depression at a global scale. After the last crisis resembling today’s, the Wall Street Crash of 1929 that led to the Great Depression, the Dow Jones achieved its pre-1929 level only in 1954.
To make any forecast at this point in time would make astrology look respectable. But looking at the Nobel Prizes this year and in 1997, when a similar crisis emerged, provides some lessons for the future.
The 2008 Nobel Prize in economics was awarded to Paul Krugman this October just after the onset of the financial crisis. Krugman is an American economist who has been a critic of Long-Term Capital Management (LTCM), a hedge fund discussed below.
The 1997 prize was awarded to Myron Scholes. It came after many years of strong performance of financial markets but just before the financial crises in East Asia, Russia and Brazil. Scholes (together with Fisher Black who died in 1995 and could not therefore co-share the Nobel) came up with “a new method to determine the value of derivatives,” a framework for valuing options. The so called ‘Black-Scholes’ model became the global standard in financial markets. Trillions of dollars of options trades have been executed each year using this model.
Scholes and Robert Merton, another distinguished financial economist with whom he co-shared the Nobel Prize, were members of the board of the aforementioned LTCM. The fund was initially highly successful with annualized returns of over 40%. But following the application of the model, its equity ended up to be only 4% of its borrowed assets by the time of the 1997 financial crisis. It failed spectacularly after losing nearly $5 billion in less than four months. The Federal Reserve was so concerned about the potential impact of LTCM’s failure (of “only $5 billion”) on the financial system that it arranged for more than one dozen banks and firms to provide sufficient liquidity for the banking system to survive.
The hedge fund had more troubles. In 2005 its partners were implicated for avoiding paying taxes on profits from company investments. In the relevant court case, it was argued that the partners were not eligible for tax exemptions resulting from the millions of accounting losses their company generated but had no economic substance. Interestingly, the US taxman and courts decided that there was no economic basis in clever accounting practices, but politicians did not see much ground for introducing regulations in the financial markets.
Notwithstanding its analytical eloquence, today some would say that the Black-Scholes model is using “the wrong numbers in the wrong formulae to get the right prices.” And on the day of his award, Krugman argued that the original $700 billion rescue plan of the US administration to purchase toxic mortgage-backed securities was based “on a theory that … actually, it never was clear what the theory was.”
While the toxicity of fictitious assets on the real economy is known, what is also historically known is that a more promising solution to crises like the current one is for governments to provide financial institutions with more capital in return for a share of ownership. The question whether this “equity injection” is a return to (partial) nationalization and therefore socialism is an ideological one.
The British government was the first to adopt this injection approach and, following it, so did the other major economies of Europe and the EU at a more general level. Europe’s rescue plans already amount to more than $2.2 trillion (compared to $700 billion in the US). In our own region, while the UAE pledged $19 billion for its banks, Qatar said it would take stakes of up to 20% in banks, and Saudi Arabia is coming along with similar measures.
After a delay, the US administration reversed its course and, like the Europeans, will offer banks capital infusion and buy equity stakes rather than bad mortgage securities. What explains the original US choice? In Krugman’s own words “the initial response was distorted by ideology … a philosophy of government that can be summed up as ‘private good, public bad’.”
Still, nobody (except perhaps the astrologist) knows whether the European and GCC rescue policies will work. The LTCM’s loss (of only $5 billion) in 1997 is dwarfed by the write-downs taken today. The potential size of the current ‘black hole’ if measured by privately traded derivatives contracts — which played a critical role in the unfolding financial crisis by encouraging recklessness — ballooned to $62 trillion at the end of 2007 from practically nothing a decade ago. This figure dwarfs the money set aside by the Europeans and Americans, not matter how correct their policies might be.
If there is a bright spot amidst the current economic chaos, it is that future Nobel Prizes in economics may not need to be antidotes about correcting practices adopted on the basis of a previous award.
PROFESSOR ZAFIRIS TZANNATOS is a former advisor to the World Bank and chair of the economics department at the American University of Beirut.