Reforming U.S. Financial Markets
Calabria, Mark, Freeman
Reforming U.S. Financial Markets by Randall S. Kroszner and Robert J. Shiller; edited by Benjamin M. Friedman MIT Press * 201 1* 176 pages * $19.95
Reviewed by Mark Calabria
In April of 2009 Harvard University's economics department hosted a symposium on the financial crisis, featuring as the main event Professors Randall Kroszner and Robert Shiller. This "face-off," along with the comments of four discussants, more or less constitutes the text of Reforming U.S. Financial Markets.
While the intent was to offer differing "ends of the spectrum," the symposium inadvertently illustrates the narrowness of the conventional wisdom on both diagnoses of and responses to the financial crisis. Perhaps it is due in part to having the symposium so soon after the crisis, but the solutions and analysis offered appear only remotely informed by the events of 2008; instead they reflect more the conclusions and biases held by the participants prior to the crisis.
After a brief and informative introduction by Harvard's Benjamin Friedman, the first chapter, "Democratizing and Humanizing Finance," offers a comprehensive overview of Yale Professor Robert Shiller's research in behavioral finance. Shiller is best known for his book Irrational Exuberance and for a long, distinguished academic career. This chapter largely updates Irrational Exuberance. It also serves as a nice summary of the arguments advanced in Shiller's 2008 book Subprime Solution, which was, if not the first pop-academic book published on the crisis, certainly close.
The thrust of Shiller's position is that neither financial markets nor the existing regulatory structure incorporates how economic agents really make financial decisions. Shiller is quite explicit in seeing the efficient markets hypothesis (EMH) as a driver of both deregulation and lack of regulatory response to the speculative forces that led to the housing bubble. Since the EMH, in its simplest form, rejects the possibility of asset prices deviating from their fundamentals over long periods, Shiller sees the dominance of modern finance in the thinking of financial regulators as explaining the refusal of regulators to prick the housing bubble. Certainly the comments of regulators such as then-Chairman of the Federal Reserve Alan Greenspan lend credence to this view.
Unfortunately, Shiller does not consider other alternatives that could explain the same set of observed facts. Nowhere does he discuss the possible relationship between low interest rates and high home prices. Nor does he consider Public Choice explanations for the reluctance of regulators to address the growing housing bubble. As someone who spent that time as staff on the U.S. Senate Banking Committee, I can say those of us who attempted to get regulators to address the growing bubble were a small minority. Those opposed to restraining the housing market were not making efficient markets arguments; they were enjoying the political advantage that comes with trying to prolong an asset bubble. And in seven years on the Banking Committee staff, I never once heard a member of Congress or regulators invoke the EMH or anything resembling it. To lay the responsibility for the crisis at the feet of the University of Chicago's economics department is to grossly exaggerate the influence of academia on actual policymaking.
Like Subprime Solution, Shiller's analysis here is an important part of the debate over both the crisis and how financial markets work in general. Unfortunately and also like Subprime Solution, Shiller offers and endorses a variety of policies that either do not actually flow from his own analysis or that had almost no relationship to the crisis. For instance, he praises Dodd-Frank's creation of a Consumer Financial Protection Bureau, but leaves out the important detail that almost everyone involved in the crisis, like Fannie Mae and your local real estate agent, is actually exempt from this agency's rules. …