The two best lessons economists have learned from the recent financial crisis are to not "overstate the contagion," and to focus on fixing long-term—not short-term—growth, said Edward Lazear, professor of economics and human resources management at Stanford University.
"No one denies that contagion is an important factor and that markets are linked, but contagion is not everything. If you tend to focus on it, you take your eye off the ball and probably miss the main problem going on in the economy," Lazear said during a Becker Brown Bag Series event sponsored by the "Becker Friedman Institute for Research in Economics at Harper Center on October 11."Secondly, we don't know how to fix the short run, in terms of economic prosperity," he added. "We should focus on those conditions that are conducive to long-term growth. That's about the best thing we can do to help our economy."
Lazear, who served as chief economic advisor to President George W. Bush, reviewed causes of the financial crisis in his presentation and discussed actions taken by the government that may have helped or hurt in solving the long-run problems we currently face. Lazear says that he and other economists made a few fundamental errors in addressing the crisis. The first was analyzing the crisis with the "domino theory" rather than the "popcorn" model.
"Under the domino theory of contagion, one domino falls and knocks over the other dominos, and they all topple, and you've got a mess on your hands," he said. "That's pretty much what we were thinking in saving Bear Stearns. That looked like the way to go. Unfortunately, the model was not dominos; it was popcorn.
"When you make popcorn, you heat it up in a pan and, as the kernels get hot, they pop. Taking the first kernel to pop out of the pan doesn't do anything. The other kernels are still getting hot, the heat is on, and they're going to pop no matter what. The underlying structure of the system is leading things to pop.Economists should have dealt with the problems in a structural manner, rather than a systematic manner of one issue at a time, Lazear said. "Various people realized this at different points in the evolving scenario. But by the time we realized it collectively and were ready to do anything about it, it was probably already mid- or late September 2008. At that point, all of these events, including Lehman Brothers, had already happened. So we went to Congress and asked for the Troubled Asset Relief Program."
The second mistake—the "clumsiest" in Lazear's time at the White House—was the handling of the TARP, he said. The Council of Economic Advisers estimated that toxic assets, defined as those with default rates above 20 percent, totaled about $3 trillion, Lazear said, and the first tranche of $350 billion took only about 10 percent of those assets off the market.
"That's not really going to clean the system out of all the kernels that are getting ready to pop," Lazear said. "Instead, our view, which became the view that was actually accepted, was that if you have a structural problem, you have to deal with it in a structural way. If you can't get all the poison out of the system, you have to get the patient strong enough to survive the fever. That was the second strategy of capitalizing the financial structure and making sure all the major financial institutions had enough capital to survive."The topic of Lazear's presentation, his work experience, and his reputation attracted Tim Meng, a second-year student in the Full-Time MBA Program, to the event. "What I learned was very interesting," Meng said. "As he laid out his arguments, I was able to clearly understand what he meant by the dominos and the popcorn models."