Crisis Commentary
Krannert faculty members offer economic insights

In the rising wake of what many studied observers describe as the worst economic crisis since the Great Depression, everyone has an opinion — including the Krannert School’s esteemed faculty.

Their perspectives, theories, and specialties may differ, but members of the academic community share an obligation and desire to address the many problems we now face in an open, thoughtful, and positive forum.

Krannert faculty members led off the discussion in October 2008 with a panel about the causes and implications of the still unraveling U.S. financial markets. In February this year, a faculty panel shared its thoughts and answered questions about the role of corporate governance in the financial storm.

Video clips from selected forums can be viewed online at www.krannert.purdue.edu/news/video, and we offer the following collection of commentaries for the written record.

“Many people have questions and concerns about what the economic crisis means for them and for our country,” says Dean Rick Cosier. “We want the public and our students to learn about the issues on their own time from trusted experts who give both context and perspective to the problems.”

David Hummels, Professor of Economics

Global Tradeoffs
The slippery slope of exports and borrowing
By David Hummels, Professor of Economics

I’m writing this during a high-level conference in Sydney, Australia, on international trade issues. The mood here is grim — Europe and Asia have slid into recession with the United States, and ports around the world are congested with empty cargo ships at anchor.

The International Monetary Fund (IMF) has grown significantly more pessimistic about the world economy, revising its estimates downward four times in the last few months. It is now forecasting the lowest level of worldwide economic growth since World War II.

Why does this matter to us? The good news is that falling demand globally has sharply cut the prices of commodities, and notably oil. We have all seen the precipitous declines in gas prices since the mid-summer highs, and this drop is mirrored in nearly every tradeable bulk commodity. This at least removes one barrier to spurred growth and will provide some relief to cash-strapped consumers.

Stacked against this good news are three very big pieces of bad news. First, when a single economy slides into recession in isolation it can hope that foreign demand for its products will help spur a recovery. The usual mechanism is that the currency depreciates in value, making the country’s exports cheaper and imported goods more expensive for domestic consumers. Both spur output growth. Unfortunately, with all major economies slowing down at once, there is no one left to sell to.

Second, politicians have historically responded to slowed growth by turning to protectionist measures. The thinking is that shutting off foreign firms’ access to markets will enable domestic firms to increase their local market share and avoid substantial layoffs. Whatever limited sense this might make is wholly counteracted by the prospect of all countries turning to the same measures at once. The U.S. might be able to boost economic performance with a unilaterally applied tariff, but if trade partners retaliate we will all be worse off.

For these reasons, I believe that neither the U.S. nor any other major country can export its way out of the crisis. This means looking inward for sources of aggregate demand growth. The current stimulus package put forth by the Obama administration calls for massive new spending and tax cuts. Similar stimulus efforts are in the offing around the world, and that suggests a third bit of bad news. All these measures are, by definition, funded by debt, which means that some saver somewhere must provide the loans for governments to operate.

It is often argued that government borrowing will crowd out private investment by raising interest rates. This is not necessarily true if the country can count on large inflows of foreign investment to fund both private and public borrowing. In fact, the U.S. has engaged in a tremendous amount of public borrowing over the last eight years with little discernible effect on private investment precisely because foreign lenders were willing to step into the breach.

But, at the end of the day, the world faces an aggregate constraint on borrowing. If the governments in Europe, Asia, and South America all need capital to fund stimulus packages, they are competing with the U.S. government for that capital. This makes the crowding out problem much more likely and suggests our debtor habits could grow much more expensive.

None of this is meant to suggest the situation is hopeless, or that a stimulus package is unnecessary or counterproductive. Rather, it simply means that the simultaneous worldwide plunge into recession will make it much harder for any of us to borrow or export our way out of the crisis.

Steve Martin, Professor of Economics

Reasonable Conduct
Setting regulations that work
By Steve Martin, Professor of Economics

In Renaissance Florence, Italy, neighborhood teams played a game that combined elements of modern football and soccer. The game had rules about the composition of teams and the ways teams could score, but there were essentially no rules for conduct.

A modern version of this game also is played, largely for the benefit of the tourist trade. Contemporary promoters have found it prudent to add some rules on conduct, so that (for example), it is no longer licit to bite off the ears of members of the opposing team. The ideologically blinded, no-regulation approach that has characterized recent economic policy has been the functional equivalent of playing sports without rules on conduct, and the result is that the public has had its collective ears bitten off.

The current U.S. and world economic crisis did not have to happen. It is a direct consequence of an ideological worldview that financial houses’ pursuit of their own self-interests would be enough for markets to avoid a buildup of risky financial assets.

Former Federal Reserve Board Chairman Alan Greenspan has testified before Congress that he was “shocked” to find flaws in this ideology. He may have been shocked, but he should not have been surprised. Minimal regulation of product and financial markets, without day-to-day oversight, should be restored.

The number of times we have heard the phrase “too big to fail” since the collapse of financial markets is striking, but one should ask, how did (for example) Bank of America become too big to fail? Despite compelling evidence that most mergers do not work (for acquiring firms, for customers, for society: AOL-Time Warner and DaimlerChrysler are two of many examples), enforcement of existing U.S. merger control rules under the exiting presidential administration fell to all-time lows.

Simply enforcing existing law in this area would go a long way toward maintaining markets in which firms can succeed if they compete on the merits, or fail if they do not.

Specifically regarding financial markets, one of the lessons of the subprime mortgage crisis is that the risks associated with credit default swaps and futures contracts in collateralized securities were not well understood by those dealing in them. It is one thing for financial markets to trade in collateralized mortgages and similar assets; trade in higher-order derivatives should be ruled out.

The call for setting structural rules and then letting markets work should not be controversial — as far as financial markets are concerned, blocking trading in higher-order derivatives is in line with Alan Greenspan’s congressional testimony of October 23, 2008. It is a middle course, recognizing that day-to-day market regulation, given the limited information, analytical ability, and uncertain incentives of those who staff government agencies, can be as bad as no regulation at all.

Set rules so that markets can work, and let all participants leave the field at the end of the day with the same number of body parts they started with.

Professor and Olson Chair in Management Mark Bagnoli and Professor Susan Watts, Accounting

Playing Fair
The role of mark- to-market accounting
By Professor and Olson Chair in Management Mark Bagnoli and Professor Susan Watts, Accounting

One of the most controversial aspects of the current financial crisis is the role played by a recent accounting rule, Statement of Financial Accounting Standard No. 157, 2006 (SFAS 157), that specifies how public companies determine the “fair values” of financial assets and liabilities that are reported on the financial statements they release to the public.

This rule, with our italics added, defines fair value as “… the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Recognizing that the definition essentially requires determination of a market price, the Financial Accounting Standards Board (FASB) included the following guidelines in SFAS 157: If there is an active and liquid market for the asset (liability), its fair value is the observable, current market value (Level 1 input); if the market for the asset (liability) is inactive, fair value is based on a model in which the input(s) are observable and could include, for example, the market price of similar assets or interest rates (Level 2 inputs); and if there are no observable inputs (the trickiest case), the reporting entity is required to make assumptions that market participants would use to determine the value of the asset or liability (Level 3 inputs).

The problems associated with determining fair value under SFAS 157 were well understood and debated prior to its adoption in 2006. In fact, critics referred to the three levels in the rule as mark-to-market, mark-to-model and mark-to-make-believe. However, at that time, FASB believed that improved consistency and comparability in fair value measurements as a result of the new rule outweighed potential valuation difficulties.

What was not foreseen in 2006 was the extent of the losses that would be taken as many financial firms were forced by SFAS 157 to write down illiquid assets, such as collateralized debt obligations (CDOs) related to sub-prime mortgages and the associated credit default swaps (CDSs), after the housing market collapsed in 2008. As housing prices dropped, the markets for these mortgage-backed securities froze up and as a result, market prices were not always observable. When they were, the observed price was often the result of a distressed, as opposed to an orderly, sale.

Faced with this, many financial companies used these observable “fire-sale” prices (e.g., 22 cents on the dollar) to comply with SFAS 157 and reported unprecedented write-downs on their financial statements. Soon after, the (virtual) closing of the credit markets due to banks’ reluctance to extend credit worsened the financial crisis.

Critics of fair value accounting argue that the provisions of SFAS 157 were an important cause of this reluctance. They argue that not only did banks become afraid that a revaluation of their own assets (due to SFAS 157) would put them at risk of insolvency, but also the lack of transparency on the balance sheets of other banks (due to SFAS 157) increased the risk of default on loans that they might make to those banks (counter-party risk).

Proponents of fair value accounting argue that the disruption in the credit markets was the result of economic changes and the natural inclination to reduce risk when economic conditions deteriorate — and not an accounting rule on how to measure fair value.

While it will most likely take years to achieve a full understanding of the current financial crisis, it does seem clear that the stresses on credit markets caused market values to fall which, in turn, exacerbated the stresses on credit markets. Was the cause of crisis mark-to-market accounting? Or did it exacerbate the problem?

Some argue that the answer to both questions is no. We are skeptical and hope that the Securities and Exchange Commission’s recently issued clarifications on fair value accounting will contribute to economic recovery.

Kanda Naknoi, Assistant Professor of Economics

Money Matters
The U.S. dollar’s future as the international currency
By Kanda Naknoi, Assistant Professor of Economics

In the past few years, some economists predicted a doomsday scenario in which a financial crisis would bring an end to the international currency status of the U.S. dollar. However, the run on the dollar has not happened, and will probably not happen in the near future.

First of all, the economic theory predicting that financial crisis will bring a currency crisis assumes a small country in which bailing out banks is inflationary. Inflation presumably depreciates the value of national currency and also demand for the national currency as a store of values. This theory proved to be wrong for Japan. In a large country, a banking crisis is a large-demand shock that can offset or even dominate the inflationary pressure of bailouts.

Moreover, exporters to a large market are willing to reduce prices to maintain sales, and that will further reduce inflationary pressure. These mechanisms were instrumental in creating prolonged deflation in Japan, and they will likely play an important role in the U.S. as well. Beside these mechanisms, the U.S. labor market is much more flexible than Japan’s labor market. The recession will create a sharp decline in wages, and that will likely feed into deflationary pressure.

Secondly, liabilities of American banks are mostly in dollars, unlike the Asian banks in 1997, which held large liabilities in foreign currency. Thus, the Federal Reserve System can act as the lender of last resort, while the Asian central banks could not. Due to the global nature of the problems, the Fed can also initiate international coordination, such as currency swap lines with other central banks and a coordinated rate cut. For this reason, the Fed will continue to be the world’s most important central bank, at least in the next few decades.

The last reason is that currently, there is no alternative to the dollar. Having one central bank in Europe is not enough to turn the euro into the world reserve currency. Political integration, such as a federal system or a jointed trust fund, is necessary. Otherwise it is impossible for policy makers to coordinate policy responses. This financial crisis has proved that the Europeans do not have that system ready yet.

In Asia, there have been proposals for a monetary union such that an Asian common currency can emerge as a currency of choice for central bank reserves. The potential benefits from a monetary union for the Asian economies can be quite high. This is because Asian countries are major holders of U.S. Treasury bills, and thus face large capital losses when the dollar depreciates against their currency following years of large U.S. current account deficits. However, it will take decades for China, Japan, and South Korea to reconcile wartime history and move toward a monetary union.

Diane Denis, Duke Realty Endowed Chair in Finance

Best Interests
The evolution of corporate governance
By Diane Denis, Duke Realty Endowed Chair in Finance

Corporate governance refers to the set of mechanisms that seek to ensure that corporate managers act in the interests of their shareholders; two prominent mechanisms are the board of directors and executive compensation plans. There is no shortage of evidence that managers sometimes fail to act in shareholder interests, or that governance mechanisms have evolved over time in response to such evidence. It is not surprising that an economic crisis of the magnitude that we are currently experiencing would lead to calls for more drastic government-mandated governance reform.

However, while there are undoubtedly individual cases of governance failures in the current crisis, it is difficult to see how it can be viewed as a wholesale failure of our corporate governance system. Nevertheless, governance systems must continue to evolve toward boards of directors that clearly represent shareholders’ interests, and compensation plans that give executives incentive to operate efficiently and to take appropriate risks. The question is how best to accomplish this evolution.

When it comes to corporate governance, one size does not fit all. For example, those who call for governments to set ongoing salary caps for corporate executives or require shareholder votes on executive compensation must recognize that governments and well-diversified shareholders lack the time, the incentive, and the expertise to evaluate the varied labor markets in which individual firms operate. It is for this reason that the responsibility for setting top executives’ compensation rests with boards of directors.

Boards are not without their own problems, of course. However, optimal board structure differs across firms and cannot be achieved through government mandates. The many nuances of individual firms are best dealt with in a market in which firms must compete for investor resources.

Markets are not perfect but they become more efficient as market participants have more information and become more knowledgeable about how to interpret that information. Market participants will undoubtedly learn from our current economic crisis. It is important that in our rush to take short-term action, we also consider how best to ensure the long-term health of our corporations and our economy.

In the corporate governance arena, governments should focus on increasing the transparency of corporate actions and on protecting investors from corporate malfeasance. Management teams and boards of directors operating in a competitive market still make the best decisions about how corporations should be structured and operated.