Richard Dale, “The financial meltdown is an academic crisis, too”, Vox: Research-based policy analysis and commentary from leading economists (27 November 2008).
“Fifteen years ago, I argued that banks’ increasing involvement in securities activities worldwide could eventually lead to a repetition of the 1929/33 banking meltdown. My analysis rested on the observation that if banks were permitted to diversify away from non-core banking activities the moral hazard that is known to promote excessive risk-taking in traditional banking would be extended to these other activities, in particular securities markets. The question then was whether ‘the mixing of banking and securities business can be regulated in such a way as to avoid the danger of a catastrophic destabilisation of financial markets’. After considering all the regulatory options, I concluded that there was no solution: “Allowing banks to engage in risky non-bank activities could either destabilise the financial system by triggering a wave of contagious bank failures – or alternatively impose potentially enormous costs on tax payers by obliging governments or their agencies to undertake open-ended support operations.”
The prevailing view amongst finance academics at the time … was that financial structure was largely irrelevant to the question of systemic stability. According to the conventional wisdom we had learned from the 1929/33 crash, a monetary contraction such as occurred then could be neutralised by injecting reserves into the banking system and a flight to quality, because it merely redistributes bank reserves, “is unlikely to be a source of systemic risk”. This widely held view of the behaviour of financial markets turns out to have been entirely misguided. As we have witnessed in recent months, a major shock arising from publicised losses on banks’ securities holdings can have a domino effect on financial institutions, leading ultimately to a seizure in credit markets which central bankers, on their own, are powerless to unblock. Only drastic government intervention – guarantees for money market funds, guarantees for interbank lending, emergency deposit insurance cover, lending directly to the commercial paper market, and partly nationalising the banking industry – has prevented a full repetition of the 1929/33 financial meltdown.
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What we have witnessed in recent months is not only the fracturing of the world’s financial system but the discrediting of an academic discipline. There are some 4000 university finance professors worldwide, thousands of finance research papers are published each year, and yet there have been few if any warnings from the academic community of the incendiary potential of global financial markets. Is it too harsh to conclude that despite the considerable academic resources that go into finance research our understanding of the behaviour of financial markets is no greater than it was in 1929/33 or indeed 1720?”
http://voxeu.com/index.php?q=node/2618
Richard Dale is Emeritus Professor of International Banking, Southampton University, United Kingdom.
There is supposed to be a difference between practitioners of finance and professors of finance. Practitioners of finance are for the most part cheerleaders for innovation, entrepreneurship and the importance of saving and credit in the building of a prosperous economy. One expects them to exaggerate the possibilities of a successful investment and to be bullish about the prospects for the future, if only their advice were to be followed. They are almost always dressed impeccably in tailor-made suits, of good cheer, polished manner, energetic in their demeanor, and often of mischievous wit. Wonderful people, those who know them well love them but nonetheless always discount what they say about the market and their investment suggestions by half.
Professors of finance, on the other hand, live in a troubled world of risk and uncertainty. They are usually full of anxieties and anxious about the future, filled with an uneasiness that comes from the fear that they might say something that lead someone to do something that would cause the hearer to lose a fortune in the market on their bad advice. They speak more of financial institutions, regulatory reform and mathematical equations than of good investments, bond returns and dividend performance. Slovenly dressed in cheap suits, silent and lost in thought in the classroom, pessimistic of mind and lacking the grace of their soon to be well-paid students, they are slow and unexciting scholars of an urgent discipline that rewards the quick and imaginative. Beloved by all, especially their students, their every word is at once treasured and forgotten, treasured when its serene wisdom is helpful in the pursuit of market gain and forgotten when its nervous insight warns of the risks inherent in all investment strategies.
The events that that have unfolded this past year have been difficult for the practitioner of finance. He has gambled with the fickle future of financial success and he has lost, at least for the moment. The loss is deep and unsettling. But his spirit is not dejected because he also knows, however bad the immediate portents, the economy will recover and when it does his advice will be welcome again. Setbacks are, after all, mere setbacks, events to be overcome and providing challenges to be met once the economy inevitably recovers. So what if people believe only half of what the financial advisor says: At least he can say they believe, and more importantly that they trust and act on the advice he gives, which is more than can be said for most professions.
For the professor of finance (and of economics) the events of this past year have been devastating. It is not simply that no one foresaw the scale and scope and complexity of the disaster that has descended upon us. That would be bad enough. But by his teaching and his research he set the stage for the disaster. Unlike the market professional, the detached and objective financial scholar or economist is expected to identify and warn about the growing bubbles that have been wreaking havoc in financial markets, and he failed to do so. Unlike the financial executive dependent on his advice, the academic carries the burden of ensuring that the financial innovations and techniques he introduces to the firm are safe to use and reduce market volatility and the danger of financial collapse, and again he failed to do so. Unlike the government bureaucrat seeking counsel on regulatory matters, he is supposed to recommend changes that strengthen the financial system, not weaken it, and once again he failed to do so.
But it is even worse than this. None of the ideas offered by professors of economics and finance to rein in the crisis have worked. At each and every step on the rocky road to the present disaster their advice has failed to stem the decline. A year ago financial problems developed and the Fed was unable to prevent problems in one area, housing, from spreading throughout the entire financial system. Soon, production and employment across the real economy began to decline and decline steeply. The effects of the faulting U.S. economy were then transmitted to other countries, and the global economy began to weaken and may well be in freefall. At each step not only were the measures put in place inadequate and their implementation confused, they proved to be completely ineffective in reversing the downturn. This points to an intellectual failure to understand how a modern economy works and what can be done to manage its performance, the very responsibility of the academic, and yet another area of failure.
In short, unlike practitioners of finance and government officials, professors of finance (and economics) are expected to provide the ideas policymakers need to explain what is happening in the financial sector and the economy and to guide policy toward financial stability and the effective management of prosperity. Instead, they have made things worse than they might have been and still cannot seem to provide the intellectual leadership necessary to overcome the crisis. To that extent the financial crisis must be said to be their fault.
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