Perspective on: Lessons from financial crises

Scheinkman at board

José Scheinkman, the Theodore A. Wells '29 Professor of Economics, is teaching a class on "Financial Crises" for the first time this semester. He said there are similarities among the current U.S. recession and other economic crises in modern history, including bad and lax regulation of the financial industry.

Photos: Brian Wilson

Name: José Scheinkman
Title: Theodore A. Wells '29 Professor of Economics
Scholarly focus: Economic theory with a focus on financial crises, asset market bubbles, informal labor markets and asset prices.
Your class "Financial Crises" is being taught for the first time this semester. How does the current global financial crisis fit into the curriculum?
The unfortunate opportunity, so to speak, of the financial crisis that began in August 2007 led us to design this class. The course brings together elements of classes previously offered by the Department of Economics, but with a different focus and more depth. My colleagues and I have taught classes that included examinations of past financial crises, but this is the first time we have a class that is so focused on what is happening right now.
In the class, we are using economic theory and models to study the causes of financial crises and also discuss the effectiveness of policy responses to these episodes. We started with an overview of the major economic crises in the U.S. and internationally during the past century, and are moving to the present day. Studying past crises can inform our understanding of what is happening with our financial markets today, though this course is primarily focused on discussing models developed by economists to understand different kinds of financial crises.
The challenging times we're currently experiencing tend to attract the intellectually curious to economics, and my goal is for students to use economics as an engine of inquiry to better understand what is happening broadly in the world today.

Scheinkman lecturing

Scheinkman's new course examines the causes of the current financial crisis and the effectiveness of policy responses to those issues. "What happened in the U.S. this time is that taxpayer money covered the losses that major financial institutions incurred by taking large risks, and that is the worst of all worlds," he said.

Are there similarities among the current U.S. recession and other economic crises in modern history?
Yes, a lot of the aspects of today remind us of things policymakers should have learned from previous experiences. That is one of the things that I emphasize to my students: When you look at the historical evidence, you find many recent risks in the U.S. economy that were repetitions of things that happened in the past.
Bad and lax regulation of the financial industry played a big role in this and previous crises. Regulation tends to ebb and flow. During the past 10 to 15 years there was a loosening of government regulation of banks and investment firms, which allowed financial institutions to take more risks. There also are common elements of moral hazard, when people took actions expecting that they would not suffer the consequences in the case of a disaster, but would benefit from the upside.
There also is a recurring element of financial bubbles, when prices for certain assets rapidly increase as their value is overestimated, followed by a bursting of the bubble and a sharp decline in prices. 

Students concentrating

Scheinkman hopes students will use the course as a springboard for the study of broader issues affecting the world today.

You and other Princeton faculty have focused research on financial market bubbles. Why is understanding bubbles so important?
There is often an association of financial bubbles preceding periods of economic crisis, though the severity of the crises have varied in degree. The current economic crisis was preceded by the credit market and real estate bubbles, and in the early 2000s we had the "dot-com" bubble when Internet-related stocks boomed and then crashed. Financial bubbles historically are linked to new technology, such as railroads, electricity or automobiles. The recent credit market bubble occurred at a time when new methods of financial engineering improved risk management. The introductions of these new technologies often coincide with speculative periods that drive up prices of associated assets. Financial experts working in areas related to these new technologies have an incentive to exaggerate values, and investors often do not understand how much an innovation is really worth because it's new.

The work being done in our department is focused on understanding the logic behind financial bubbles. It is not necessarily about predicting when bubbles may occur or implode, but knowing the kinds of symptoms financial bubbles generate. Policymakers could watch these symptoms and take preventive measures to limit possible market fallout. Even if you can't detect a financial bubble for sure and even if there are costs to intervening in the situation, it doesn't mean you should not do it. It is for the same reason you do not cross a busy street even if you are not certain that you will be a hit by a car.

How do you see the United States pulling out of the recession based on the lessons from past crises?
Every crisis is a little different so it's difficult to say certain things need to happen before we get better. Still, we do know that the size of economic crises varies a lot, and a big variable is how deeply a crisis affects a country's banking system. Starting from the premise that a modern economy needs a financial system that works well, which I think the economic data show, the question for the future is what are the conditions that would make the U.S. banking system more immune to the kind of disasters it has had recently?

We also can examine why some countries' economies fared better than the United States' during this latest crisis. We talk about lax regulation as one of the causes, and we see that countries that had more rigorous banking regulations, such as Canada, experienced a milder crisis.

While part of the story is still being told, the evidence seems to point to needing a system in which financial institutions are better regulated and are restricted in the kinds of risks they take. What happened in the U.S. this time is that taxpayer money covered the losses that major financial institutions incurred by taking large risks, and that is the worst of all worlds.