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BraDforD Cornell visiting profEssor of financial Economics california institutE of tEchnology
the poverty of stimulus
most Economists think that macroEconomic disruptions, such as thE currEnt
rEcEssion, can BE undErstood in tErms of aggrEgatE indicators such as total
EmploymEnt, thE pricE lEvEl, and thE monEy supply. But this viEw is mislEading,
particularly in thE currEnt Economic situation. worsE yEt, it mislEads us into
countErproductivE Economic policiEs.
the economist Fischer Black explained, an economy If the government could identify how the economy needed to
matches a population’s desires to the available be restructured and provide incentives to move resources more
resources and production technology. When an quickly in that direction, a properly designed program could
economy is operating efficiently, expectations are largely alleviate and shorten the recession. But, if the government could
fulfilled; desires, resources, and production technology are well do that, central planning would be a good deal simpler.
matched; and people are reasonably satisfied with their plans, Moreover, just as a command economy is invariably less
relations, and contracts. efficient at resource allocation and production than a market
But if the world evolves in a markedly unanticipated direction, economy, a general stimulus program will, in all likelihood, lead
people’s existing plans, relations, and contracts require to highly inefficient allocations, effectively burning resources at
revision. The existing matches between desires, resources, and a time when they are scarce and particularly vital to restart and
production technology deteriorate. While this revision occurs, re-align our beleaguered economies. To the extent that it is used
resources are diverted from production, which is less efficient to prop up declining industries, the stimulus could even prove
and less well matched with consumer desires, resulting in a harmful by delaying necessary adjustments.
reduction in the value of output – a recession. Viewed from a matching perspective, there is no failure of
This “realignment theory” helps explain the current downturn. “aggregate demand” – whatever that means. Instead, there
From 2000 through 2007, millions of american homeowners is a complex misalignment problem – too many autoworkers
entered into mortgage contracts to finance their homes. when too few people want new cars, for example – that results
Securities based on those contracts ended up, in part, in the in a decline in overall output. Thus, it is possible that increased
hands of financial institutions. But the adequate servicing of government spending – say, to boost car purchases – could
the debt and, therefore, the performance of the securities, were exacerbate the misalignment.
based on expectations of continued rises in housing prices that Given the central role of financial intermediation in the
proved to be unrealistic. When housing prices fell, so did the current crisis, the government should instead expedite the
value of the mortgages and the securities based upon them. restructuring process through bankruptcy law. The key is to
Because financial institutions held much of these securities, accept bad news: losses must be recognized before efficient
their market values declined as well, leaving balance sheets in realignment can occur.
need of restructuring, particularly given their highly leveraged This suggests the following solution to the banking crisis.
capital structures. Awaiting that restructuring, financial First, the value of financial institutions’ investments should
institutions could not perform as usual, which impeded financial immediately be marked down to their market values. Based on
intermediation and called into question plans, relations, and those values, contracts with existing equity and debt holders
contracts – such as corporate and residential investment or should then be restructured. If the losses are big enough that
refinancing. existing equity and debt holders are wiped out, government
Meanwhile, consumers who held a substantial fraction of
their wealth in housing were forced to revise their consumption
plans in the face of declining values. This affected all the
producers, distributors, and retailers whose plans and contracts
Consumers who held a substantial fraction
were based on now-obsolete expectations.
of their wealth in housing were forced to revise their
and so it goes. Eventually, the required restructuring became
consumption plans in the face of declining values.
so widespread that it impacted virtually every sector of the
This affected all the producers, distributors,
economy. The current recession is as deep as the misalignment
and retailers whose plans and contracts were
of specialized plans, relations, and contracts is extensive.
based on now-obsolete expectations
construction workers cannot become software developers
overnight. automobile companies cannot adjust immediately to
a change in consumer preferences regarding what type of cars
they want to purchase, or how frequently. Would-be financiers
cannot adjust to these plans overnight.
an obvious question is whether the government can do
anything to speed the restructuring process or reduce its cost.
March 2010
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